Internal Rate of Return & Modified Internal Rate of Return PWC Course Notes P53 Mark Fielding- Pritchard mefielding.com1

Advantages and Disadvantages of the IRR  Advantages  % so people feel they understand it  Rate of return  Relatively easy to calculate  Widely accepted  No need to pick a discount rate  Disadvantages  % so 20% of $1 is better than 15% of $1m  How to benchmark  Multiple IRRs mefielding.com2

We have a potential coal mining project in Scotland. There will be an initial investment in purchase of land, licenses, equipment. We can harvest coal from the surface so the NPV quickly becomes positive. Once exhausted we must dig down to the next seam which requires expenditure so the NPV becomes negative, once mining resumes we receive sales and he NPV becomes positive Net Present Values Year 1-20 Year 22.5 Year 3-6 Year 44.5 Year 512 Internal Rate of Return mefielding.com3

Internal Rate of Return mefielding.com4

Modified IRR  Used to counter the fact that we get multiple IRRs YearNet after tax cash flow $ Company uses discount rate of 10% Note that for exam purposes we are looking here at cash flows, not NPV mefielding.com5

MIRR YearNet after tax cash flow $ InflowOutflow x(1+0.1)³ = x1.1= Total What we are doing is smoothing the cash flows so that we don’t get multiple IRRS. We make 2 assumptions -All expenses (negative numbers) occur at time 0 -All income (positives) occur at time 4 -Discount rate 10% mefielding.com6

MIRR mefielding.com7