Being in taxguru website, we assume all the readers reading this publication have already heard of the acronym IRR. Internal rate of return, commonly known as IRR, is a capital budgeting technique that is used for evaluation of any investment proposition. As the name suggest, this technique is used to calculate the rate of return (normally annual return) that is generated or is expected to be generated by an entity from an investment.
IRR gives an answer to one basic question “What return the investment will yield?” The answer to this question plays a pivotal role in making any investment decision. Not to mention here that before any investment decision is taken, various other aspects including technical, legal, operational, market and other financial aspects are also evaluated.
Now let us try to understand IRR by way of a simple example.
Eg. An entity is considering an investment proposal requiring an initial cash outflow of Rs. 100 crores and which is expected to generate cash inflow of Rs. 40 crores in each of the next 5 years. So, what is the IRR of this investment proposal? And whether the entity should invest in the proposal?
Here the cash flow of Rs. 40 crores expected to be generated in each of the 5 years are to be discounted using a percentage that brings the present value of the cash flows equal to the initial investment of Rs. 100 crores. The percentage where the sum of the present value of all the cash inflows (i.e. Rs. 40 crores in each of the 5 years) is equal to present value of cash outflow (i.e. initial investment of Rs. 100 crores) is the IRR of the project. For the given case, the IRR is 28.65%. In other words, we can say that the proposal will generate yield at the rate of 28.65%.
Coming on to the second question on entity’s decision to invest in the proposal; it would depend on whether the resultant IRR is higher than the entity’s cost of capital. Cost of capital means the rate of return that the capital is expected to earn in the best alternative investment of equivalent risk. It is the minimum rate of return expected by an entity to justify its investment. Here the entity should invest in the proposal, if the said IRR of 28.65% exceeds its cost of capital.
The fundamental flaw in the above IRR is that it assumes that the interim cash flows generated from the project are reinvested yielding the same return i.e. 28.65% as that of the project till the duration of the project, which is rarely the case in real life scenario. IRR can be true only if there is no interim cash flow or if the interim cash flow(s) are actually reinvested at IRR.
Practically reinvestment rate are independent of the return being generated from a project and therefore it should not be commingled with the IRR. It is wiser to assume a more logical and realistic rate of return for reinvestment, may be entity’s cost of capital, which is independent of the project return.
The above flaw in IRR can be mitigated by use of a more refined technique known as MIRR i.e. Modified IRR. The MIRR assumes that interim cash flows generated from a project are reinvested at the entity’s cost of capital and the initial outflows are financed at the entity’s financing cost. The MIRR, therefore, reflects more realistic rate of return generated from a project.
MIRR calculation includes calculating the future value of the positive cash flows at entity’s cost of capital and the present value of the negative cash flows at entity’s financing cost. The formula for MIRR is as follows:
MIRR = (Future value of positive cash flows at cost of capital / Present value of negative cash flows at financing cost) ^ (1/n) – 1.
where “n” is the number of equal periods at the end of which the cash flows occur.
As can be seen from the above, MIRR considers reinvestment of its cash flows at entity’s cost of capital unlike IRR, which gives more realistic and reliable figure for management to make its decision on any investment propositions.
The motive of this publication is not to elaborate on the formula or calculation methodology but to conceptualize the rational of using MIRR over IRR as capital budgeting technique. We hope the publication is informative and useful to the reader.