Internal Rate of Return Approach

Question 1

Describe the modified internal rate of return (MIRR) approach to capital project evaluation.

Answer 1

Evaluates a project by treating cash inflows and outflows separately and assumes inflows are reinvested at the firm’s reinvestment rate and outflows are reinvested at the firm’s cost of capital.

Question 2

Describe the internal rate of return (also called time adjusted rate of return) approach to capital project evaluation.

Answer 2

It evaluates a project by determining the discount rate that equates the present value of a project’s cash inflows with the present value of the project’s cash outflows.

Question 3

Compare the internal rate of return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).

Answer 3

The IRR approach computes the discount rate that would make the present value of a project’s cash inflows and outflows equal to zero.

The NPV approach uses an assumed discount rate to determine whether the net of the present value of a project’s cash inflows and outflows is positive or not.

Question 4

Identify the advantages of the internal-rate-of-return approach to capital project evaluation.

Answer 4

• It recognizes the time value of money.
• It considers the entire life and results of the project.
• Meaning of resulting rate is intuitive.

Question 5

Identify the disadvantages of the internal rate of return approach to capital project evaluation.

Answer 5

• It is difficult to compute.
• It requires estimation of cash flows over the entire life of project, which could be very long.
• It requires all future cash flows be in the same direction, either inflows or outflows.
• It assume cash flows resulting from the project are immediately reinvested at the project’s internal rate of return.
• Limited usefulness when comparing projects of different size, life or timing of cash flows.

Question 6

Under what conditions is the internal rate of return approach (to capital budgeting) not appropriate?

Answer 6

When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.