Modified Internal Rate of Return Calculation

E

Remember that the Modified Internal Rate of Return escapes many of the pitfalls associated with the traditional Internal Rate of Return calculation. One such pitfall is the fact that the traditional IRR cannot produce reliable calculations for "non-normal" projects, such as the project illustrated in this example. The Modified

Internal Rate of Return, however, escapes this basic flaw and can be used to evaluate virtually any project. The calculation of the answer in this example is as follows:

Step 1: Determine the Future Value of the cash inflows by compounding each positive inflow by the cost of capital. This value is often referred to as the "Terminal

Value." Remember that in this example, the positive cash inflows begin at period 3.

Step 2: Determine the Present Value of the cash outflows by discounting each negative inflow by the cost of capital. The cash inflows to be discounted occur in periods 1, 2, 8, and 9.

Step 3: Determine the rate that equates the PV of the cash outflows to the FV of the cash inflows. The calculation of the FV of the cash inflows is shown as follows:

FV of the cash inflows = {[$12,000,000 * 2.660] + [$20,000,000 * 2.313] + [$25,000,000 * 2.011] + [$25,000,000 * 1.749] + [$20,000,000 * 1.521] + [$500,000 * 1]}

= $203,100,000.

This is the terminal value.

The calculation of the PV of the cash outflows is calculated as follows:

PV of the cash outflows = {$50,200,000 + [$3,000,000 / 1.15] + [$1,500,000 /1.323] + [$1,500,000 / 3.059] + [$3,000,000 / 3.518]} = $55,285,596.07

Now that the present and future (terminal) values of the cash flows have been determined, the Modified Internal Rate of Return can take place. The following values are imputed into the Present Value worksheet on your calculator:

PV =($55,285,596), FV = $203,100,000, N = 10, PMT = $0.00, Compute I. Imputing these values will yield an answer of 13.896% for the Modified Internal Rate of

Return.