BFD – IRR and MIRR

By Taha Popatia
A. Internal Rate of Return (IRR)

Explanation of IRR

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O
IRR is the discount rate which delivers a zero NPV on a given project. It can also be thought of as the forecast
return for the project.

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H
NPV

SC
P
O Discount Rate

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ES
IRR

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NPV is always inversely proportional to the discount rate as you can see above the NPV decreases as Discount
rate increases and at intersection point P NPV becomes zero.
SI
BU
Formula
IRR = L+ NPVL x (H – L)
NPVL – NPVH
TT

Where, L = Lower Discount Rate

H = Higher Discount Rate
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NPVL = NPV at Lower Discount Rate

-A

NPVH = NPV at Higher Discount Rate

Steps for Computing IRR

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1. Calculate an NPV using a Discount rate.

2. Calculate another NPV using a different Discount rate.
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Note: Try to compute +ve & -ve NPVs because it will increase the accuracy of the answer if your first step
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gives you +ve NPV then just double the discount rate to find -ve NPV or vice versa. Remember it is not
compulsory to calculate +ve & -ve NPVs.
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3. Now, apply the IRR formula.

Decision Rule
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 If a project IRR is greater than or equal to the Target rate of return or Cost of Capital then, the project
should be undertaken.
 If a project IRR is lower than the Target rate of return or Cost of Capital then, the project should be
rejected.

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 BFD – IRR and MIRR
By Taha Popatia
Example 1

ABC Co. is considering to invest in a project Beta which will require an initial investment of $10,000. The Project

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will generate $6000 cash inflow for 4 years. The company’s Cost of Capital is 11%. Evaluate the project on the

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basis of IRR.

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Solution

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Step 1

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Discount
Present
Year Cashflows Factor
Value
10%

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O (10,000) 1 (10,000)

ES
1-4 3,500 3.170 11,095

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NPV 1,095
SI
BU

Step 2

Discount
Present
TT

Year Cashflows Factor

Value
20%
R

o (10,000) 1 (10,000)
-A

1-4 3,500 2.589 9,061.50

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NPV (938.50)
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Step 3
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IRR = 10 + 1095 x (20-10) 15.38%

(1095+938.5)
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The project should be accepted because IRR is greater than the Cost of Capital.
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Advantages

 It considers time value of money.

 It uses all relevant cashflows.
 It helps to select those projects which increase shareholders’ wealth.

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 BFD – IRR and MIRR
By Taha Popatia
Criticisms

 IRR produces multiple answers in case of non-conventional cashflows e.g. cash outflow, inflow and then

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outflow it may be possible to calculate two IRRs.

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Example 2

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ABC Co. is considering to invest in a project Alpha which requires initial investment of 50,000 and the project will

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generate cash inflows of 28,150 for 5 years and the 6th year of the project will require an outflow of 93,750 due

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to some restoration costs. The cost of the capital for the project is 10%. Calculate NPV & IRR.

Solution

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Discount

ES
Year Cashflows Factor 10% PV

0 -50000 1 (50,000.00)

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1 28150 0.909 25,588.35 SI
2 28150 0.826 23,251.90
BU

3 28150 0.751 21,140.65

4 28150 0.683 19,226.45

TT

5 28150 0.621 17,481.15

R

6 -93750 0.564 (52,875.00)

-A

NPV 3,813.50
If we calculate IRR using various discount rates then,
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Discount rate NPV

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0% -3000
3% 405
Po

6% 2488
9% 3594
12% 3978
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15% 3832
18% 3302
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21% 2495
24% 1493
27% 359
30% -861

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 BFD – IRR and MIRR
By Taha Popatia
NPV
IRR 1 2.56% 0
IRR 2 27.90% 0

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O
NPV

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5000

4000

H
3000

SC
2000

1000

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0
0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

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-1000

-2000

-3000

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-4000
SI
As you can see the project has a +ve NPV of 3813.5 but IRR is misleading because the negative sign cashflows
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occur twice.

 IRR is not helpful in choosing the best answer in case of mutually exclusive projects.
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Example 3
Suppose you have two projects A & B and both projects are mutually exclusive. The below graph shows
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the IRR of these two projects. X is the cost of capital. On the basis of IRR, project B should be selected but
-A

Project A has the higher NPV and Project A can maximize the financers wealth by a greater amount.
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pa
Po
ha
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 BFD – IRR and MIRR
By Taha Popatia
 It assumes that all cashflows are re-invested in the project at calculated IRR which may be not valid in
case of high IRR.

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B. Modified Internal Rate of Return (MIRR)

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MIRR is the IRR which would result without the assumption that project proceeds are reinvested at the IRR rate.

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Why MIRR is preferred on IRR??

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 In case of non-conventional cashflows MIRR produces a single answer.
 MIRR assumes re-investment of cashflows are at cost of capital which is more realistic in case of having a
very high IRR.

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 MIRR decision is in line with NPV decision so there are few chances of conflict.

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Formula

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SI
BU
TT
R

Example 4
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ABC Co. is considering to invest in a new project. The initial investment required for the project is 4000 and it will
generate cash inflows of 2600, 1400 & 2000 at the end of year 1,2 & 3 respectively. The company cost of capital is
10%. Calculate NPV and MIRR.
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Solution
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NPV Calculation
0 1 2 3
Po

Project Cashflow (4,000) 2,600 1,400 2,000

Discount Factor
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10% 1 0.909 0.826 0.751

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PV (4,000) 2,363 1,156 1,502

NPV 1021.8

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 BFD – IRR and MIRR
By Taha Popatia

MIRR
0 1 2 3

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Project Cashflow

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(4,000) 2,600 1,400 2,000
Year 1 Cashflow

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compounded @ 10% for 2
years 3146

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Year 2 Cashflow

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compounded @ 10% for 1
years 1540

Modified Cashflows
(4,000) 6,686

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ES
MIRR = [6686 ÷ 4000]1/3 – 1 = 18.7%

Alternatively, MIRR can also be computed by the below formula:

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SI
BU

Where PVR = the PV of the return phase (the phase of the project with cash inflows)

PVI = the PV of the investment phase (the phase of the project with cash outflows)
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re = the cost of capital

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n = number of years of the project

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If we continue with the example 4,

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PVR = 5022 [ 2363+1156+1502]

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PVI = 4000
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re = 10%

MIRR = [5022 ÷ 4000]1/3 x (1.1) – 1 = 18.7%

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MIRR & Non-Conventional Cashflows

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Example 5

ABC Co. is considering to invest in a project Gamma which requires initial investment of 50,000 at year 0. There
will be a further cash outflow of 15,000 in year 1 and after that project will generate cash inflows of 28,150,
31,000, 24,000 & 10,000 for year 2, year 3, year 4 & year 5 respectively. The cost of the capital for the project is
8%. Calculate NPV & MIRR.
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 BFD – IRR and MIRR
By Taha Popatia
Solution

NPV Calculation

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0 1 2 3 4 5

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Project Cashflow (50,000) (15,000) 28,150 31,000 24,000 10,000

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Discount Factor 8% 1 0.926 0.857 0.794 0.735 0.681

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PV (50,000) (13,890) 24,125 24,614 17,640 6,810

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NPV 9299

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ES
MIRR
Investment Phase Return Phase
0 1 2 3 4 5

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(50,000)
1
(15,000)
0.926
28,150
0.857
SI
31,000
0.794
24,000
0.735
10,000
0.681
BU

(50,000) (13,890) 24,125 24,614 17,640 6,810

TT

PVI PVR 73,189

63,890
R

MIRR = [73189 ÷ 63890]1/5 x (1.08) – 1 = 10.97%

-A

Or

Investment Phase Return Phase

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0 1 2 3 4 5
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(50,000) (15,000) 28,150 31,000 24,000 10,000

1 0.926 1.08^3 1.08^2 1.08 1
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(50,000) (13,890) 35,461 36,158.40 25,920 10,000

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PVI 107,539
63,890
MIRR = [107,539 ÷ 63,890]1/5 -1 = 10.97%
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Criticisms

Just like IRR, MIRR is also a relative measure so it doesn’t consider size of the project.
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