CP

Describe how NPV profiles are constructed, and define the crossover rate.

How does the “reinvestment rate” assumption differ between the NPV and IRR

methods?

If a conflict exists, should the capital budgeting decision be made on the basis of

the NPV or the IRR ranking? Why?

Explain the difference between normal and nonnormal cash flows, and their rela-

tionship to the “multiple IRR problem.”

Modified Internal Rate of Return (MIRR)

In spite of a strong academic preference for NPV, surveys indicate that many execu-

tives prefer IRR over NPV. Apparently, managers find it intuitively more appealing to

evaluate investments in terms of percentage rates of return than dollars of NPV. Given

this fact, can we devise a percentage evaluator that is better than the regular IRR? The

answer is yes—we can modify the IRR and make it a better indicator of relative prof-

itability, hence better for use in capital budgeting. The new measure is called the

modified IRR,or MIRR,and it is defined as follows:

(7-2a)

PV of terminal value

Here COF refers to cash outflows (negative numbers), or the cost of the project, and

CIF refers to cash inflows (positive numbers). The left term is simply the PV of the

PV of costs

Terminal value

(1MIRR)n

.

(^) a
n
t 0
COFt
(1r)t

a
n
t 0
CIFt(1r)n
t
(1MIRR)n
274 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
FIGURE 7-5 NPV Profile for Project M
100 200 300 400 500 Cost of Capital (%)
NPV
(Millions of Dollars)
1.5
1.0
0.5
0
–0.5
–1.0
–1.5
NPV = – $1.6 + $10
(1 + r)
$10
(1 + r)^2

IRR 2 = 400%

IRR 1 = 25%

272 The Basics of Capital Budgeting: Evaluating Cash Flows