Corporate Finance

192
Corporate Finance

Investment Cash flows IRR percent NPV

12

A. 100,000 20,000 120,000 20 19,350

B. 100,000 100,000 31,250 25 18,045

Based on IRR rule, project B is better while on the basis of NPV, project A should be accepted. Why does
this conflict arise? The answer lies in the reinvestment assumption. The NPV rule assumes that intermediate
cash flows are reinvested at hurdle rate of 9 percent whereas the IRR rule assumes that intermediate cash
flows are reinvested at IRR of the project. If the cash flows were reinvested at the IRR of the project, the
balance at the end of the second year would be:

I (1 + IRR)^2

For project A, the balance would be Rs 100,000 (1.2)^2 = Rs 140,000

For project B, the balance would be Rs 100,000 (1.25)^2 = Rs 156,250

We are assuming that the firm will continue to reinvest at IRR (>cost of capital) year after year. We can
relax this assumption and consider a reinvestment rate equal to cost of capital in the future periods. This is
possible if we assume that super normal profits get wiped out in the long run due to entry of competitors.

Modified Internal Rate of Return (MIRR)

The IRR obtained by assuming that intermediate cash flows are reinvested at cost of capital is called MIRR.
To calculate MIRR:

1. Find the future value of all cash flows by compounding at the hurdle rate.


2. Add the future value of all cash flows.


3. Find the implied return.

Consider a project with the following cash flows:

Exhibit 9.6 NPV vs discount rate

B (^) IRRB = 18 percent
A
NPV
Discount Rate
14 percent
IRRA = 20 percent