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Subject

Paper No and Title Paper No 8: Financial Management

Module No and Title Module 9: Investment evaluation criteria III- IRR, MIRR
and discounted payback period
Module Tag COM_P8_M9

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TABLE OF CONTENTS

1. Learning Outcomes

2. Internal Rate of Return (IRR) Method

2.1. Meaning
2.2. Computation
2.3.Decision Making Criteria
2.4. Merits
2.5. Demerits

3. Modified Internal Rate of Return (MIRR) Method

3.1. Meaning
3.2. Computation
3.3.Decision Making Criteria
3.4. Merits
3.5. Demerits

4. Discounted Payback Period Method

4.1. Meaning
4.2. Computation
4.3.Decision Making Criteria
4.4. Merits
4.5. Demerits

5. Summary

1. Learning Outcomes

After studying this module, you will be able to

· Know the meaning of meaning, computation, merits and demerits of Internal

Rate of Return (IRR) Method of capital budgeting.
· Understand the meaning, computation, merits and demerits of Modified
Internal Rate of Return (MIRR) Method of capital budgeting.
· Appreciate the meaning, computation, merits and demerits of Discounted
Payback Period technique of capital budgeting.

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2. Internal Rate of Return (IRR) Method

2.1. Meaning

We noticed that the NPV considers the absolute amount of cash flows and does not give
us proper answer when the two projects have different initial outlay. In order to compute
the profitability of the project in terms of percentage of return, we use another measure
which is called internal rate of return. This is in contrast with the traditional measure
ARR in the sense that it takes into consideration the cash flows rather than the accounting
profits. This is also called time-adjusted rate of return, marginal efficiency of capital,
yield on investment and so on. This is the implicit rate of return from the project. It is
based on all the cash inflows and outflows of the project. It is the return which is
generated by the projects in percentage terms rather than absolute amount.
Mathematically, it is that rate of discount at which present value of cash inflows is equal
to the present value of cash outflows. Thus, it is that rate of discount at which the amount
of NPV becomes zero.

2.2. Computation

The situations under which we compute IRR are classified in two parts
(a) When cash inflows are equal
(b) When cash inflows are not equal

Let’s discuss these situations in detail.

(a) When cash inflows are equal
This situation arises when the future benefits in terms of cash inflows are equal. In
general, the process of computing the IRR is not simple, however under this situation we
can simplify the process. We can use the following steps to compute the IRR:
Step one: The first step is to compute the payback period of the investment proposal by
using the following formula:
=
Step two: In present value of annuity table, search in the row which is equal to the life of
the project and look for the value which is equal to the payback period. Generally, we do
not find the exact value and under this situation, note the two values, one greater than
payback period and one which is less than the payback period.
Step three: Look at the top of the column and note the rate of interest corresponding to
the two values found in step two, one is called lower discount rate and another high rate
of discount.
Step four: Compute the actual value of IRR by interpolation. We use the following
approach to solve
−
+ × ( − )%
−
Where, is the lower discount rate, is the higher rate of discount, is the
present value of net cash flows at lower discount rate, is the present value

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of net cash flow at higher discount rate and is

the present value of cash outflows.

Example: There is a machine costing Rs. 75,000. It is estimated that this machine will
generate Rs. 20,000 annually for the next 6 years. Find out its IRR.
Solution: Now, we will use the steps discussed above to understand its computation.
Step one: The computation of payback period
75000
=
20000
The payback is equal to 3.75 years.
Step two: In PVAF table , the values which are near to 3.75 in 6th year row are 3.784 and
3.685.
Step three: The discount rates corresponding 3.784 and 3.685 are 15% and 16%
respectively.
Step four: Computation of IRR using interpolation, here we will approach discussed
above:

−
+ × ( − )%
−
In order to use this approach, we need compute present value of cash inflows at two
discount rates 15% and 16%.
The present value of cash inflows at 15% discount rate is
20,000 × 3.784 = 75,680
And the present value at 16% rate of discount is
20,000 × 3.685 = 73,700
Now, interpolation is done as
75,680 − 75,000
15% + × 16 − 15 %
75,680 − 73,700
= 15.34%.

(b) When cash inflows are unequal

The process of computing IRR is not simple when the cash inflows are not equal. The
process requires the use of good sense of judgement to come out with IRR.
The following is the procedure to be used to compute IRR in case of unequal cash
inflows:
Step one: calculate the average cash inflows by taking their arithmetic mean. This is
called fake annuity.
Step two: Use the value of fake annuity computed above to get the fake payback period.
In order to obtain fake payback period, divide the original investment by the fake annuity.
Step three: Look at the PVAF table in the row corresponding to the life of the project and
search for the value close to fake payback period. Note the discount rate at the top of that
column.

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Step four: Before we proceed to use this discount rate to

search for actual IRR, sometimes we need to change the discount rate subjectively. When
higher cash inflows arise earlier then increase the discount rate by few percentages and if
the higher cash inflows occur in later life of the project, decrease the discount rate before
starting the trial and error method. However, when the cash inflows are very much
similar to the average cash flows, there is no need to make subjective changes in the
interest rates.
Step five: Now we use the rate of discount obtained in previous step to check whether
present values of cash inflows is equal to the present value of cash outflows at this rate of
discount i.e. whether NPV is zero or not. If not, we search for two discount rates at which
present value of cash inflows is higher and lower than the present value of cash outflows.
Step six: Use interpolation method as discussed above to compute the actual value of
IRR.
Example: Jerry ltd decides to purchase one machine for its production purpose. Machine
X is available in the market which is suitable for this purpose.
The following is the information related to the cash flows of machine x:
Year Cash Flows
0 40,000
1 10,000
2 14,000
3 16,000
4 17,000
5 15,000
Compute the internal rate of return of machine X.
Solution: IRR is obtained by using the following procedure.
Step one: computation of average cash inflows:
10,000 + 14,000 + 16,000 + 17,000 + 15,000
=
5
= 14,400
Step two: computation of fake payback period
40,000
=
14,400
=2.778 years
Step three: In 5th year row, the rate of discount at which PVAF is close to 2.778 is 23%
(2.803). As the cash flows are not significantly different from the average cash flows, we
will not change the discount rate before computing the present value of cash inflows.
Step four: computation of present value of cash inflows

PVF PVF PVF

Year NCF PV PV PV
@23% @22% @21%
1 10000.00 0.813 8130.081 0.820 8196.721 0.826 8264.463

2 14000.00 0.661 9253.751 0.672 9406.074 0.683 9562.188

3 16000.00 0.537 8598.143 0.551 8811.310 0.564 9031.583

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4 17000.00 0.437 7427.257 0.451 7673.784 0.467 7930.625

5 15000.00 0.355 5328.018 0.370 5549.989 0.386 5783.149

Total 38737.25 39637.88 40572.01

We start the trial and error process with 23% rate of discount. We find that the present
value of cash inflows is Rs. 38,737.25 which is less than the required value of Rs. 40,000
i.e. the amount of the investment. It means we need to increase the present value to make
it equal to the investment. Thus, next we should try a lower rate of discount because there
is inverse relationship between present value and discount rate, higher the discount rate,
lower is the present value. The next discount rate which is used is 22% but again at this
rate present value is less than the investment amount. Therefore, we need to repeat the
process with still lower discount rate which is 21% and at this rate the present value is
higher than the investment value. Now our iterative process is complete as we have found
two rates of discount one with lower present value than the investment and the other with
the higher present value. The next step is to use interpolation method to figure out the
IRR.
Step four: Interpolation method is used to find out exact rate of IRR which lies between
21% an 22%.

40572.01 − 40,000
21% + × 22 − 21 %
40572.01 − 39637.88
This is equal to 21.61% and it means that this machine would generate the revenue which
is 21.62%.

2.3.Decision Making Criteria

When we use IRR to make capital decision, we need to compare internal rate of return
with the cost of obtaining funds. This cost of funds is also called cost of capital and also
known as required rate of return. When the project generates internal rate of return
which is more than the cost of capital, we should accept that project. On the other hand,
when the cost of capital is more than the internal rate of return, we should reject that
investment proposal. The decision maker is in indifferent situation when internal rate of
return is equal to the cost of capital. The decision rules can be summarized as:
· If IRR>K, accept the investment proposal
· If IRR<K, reject the investment proposal
· If IRR=K, indifferent

2.4. Merits

Apart from NPV, this is most popular measure of capital budgeting technique. It offers
many benefits which are cited in this section.

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(i) IRR technique takes into account the time value of

money and accordingly different cash flows are given different importance depending on
the time period when the arise.
(ii) It is related to the wealth maximisation objective which is the main aim of modern
financial management. This is because when we accept an investment proposal which has
internal return in excess of cost of capital, this additional return results in the generation
of more wealth to shareholders.
(iii) This technique is also based on all the cash flows of a project just like NPV. The
complete life of the project is taken into account before any investment decision is made
which results in sound investment decision.
(iv) IRR uses cash flows to arrive at the rate of return rather than the accounting profits.

2.5. Demerits

We have cited various advantages of IRR; nevertheless, it suffers from some limitations
which we must know in order to take any informed decision.
(i) The computation of IRR is tedious and at times it becomes very complex as well.

(ii) There are some situations when we can have more than one IRR for the project and in
some other situations we have no IRR value. We will consider these situations.

(iii) One of the main limitations of IRR is related to the assumption under which it is
calculated. The assumption underlying the computation of IRR is that the amount of cash
inflows which is received in intermediate time period is reinvested at the rate which is
equal to the internal rate of return. This assumption is also called reinvestment rate
assumption. It means if the IRR of project is 20%, company is in a position to invest the
intermediate cash flows at 20% which is not feasible. The firms are able to invest the
cash inflows only at the rate which is available in the market.

3. Modified Internal Rate of Return (MIRR) Method

3.1. Meaning

A form of the internal rate of return that assumes all returns are reinvested at a
company's cost of capital. As such, it measures the profitability, as opposed to the
raw cash flow, of an investment or project. It is considered a more accurate way of
measuring the net present value of future cash flows.

3.2. Computation

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First step in calculation of MIRR involves finding the sum

of terminal values of all the net cash flows (other than initial investment) and then using
the following formulae to solve for MIRR:
MIRR = (Sum of Terminal Cash Flows / Initial Investment)1/n - 1
Where n is the number of periods.

Example: Suppose cash flows of a project are as given below.

Year Cash Flow

0 (18,000,000)
1 8,000,000
2 10,000,000
3 10,000,000

Discount Rate is 10%. We have to calculate MIRR of the project.

Solution: First we calculate the equivalent terminal cash flow for the project:

Year Cash Flows FV Factor Terminal Value

0 (18,000,000)
1 8,000,000 1.16640 9,331,200
2 10,000,000 1.08000 10,800,000
3 10,000,000 1.00000 10,000,000
30,131,200

Here, n = life of project (years) = 3, Sum of Terminal Cash Flows = 30,131,200 and
Initial Investment = 18,000,000.
MIRR = (Sum of Terminal Cash Flows / Initial Investment)1/n - 1
= (30131200/18000000)1/3- 1= 1.1874 – 1= 0.1874 or 18.74%

3.3.Decision Making Criteria

For Independent Projects:

· If MIRR>K, accept the investment proposal
· If MIRR<K, reject the investment proposal
· If MIRR=K, indifferent

For Mutually Exclusive Projects: Rank projects according to their MIRR and choose one
with highest MIRR.

3.4. Merits
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1: MIRR overcomes limitations of IRR like IRR’s multiple rate of return in some cases,
difference in ranking according to NPV and IRR in case of mutually exclusive projects.
2: MIRR like NPV & IRR is based on cash flows rather than accounting profit.
3: MIRR also incorporates the riskiness of the project in capital budgeting analysis
through use of an appropriate discount rate.
4: MIRR tells whether a project would increase firm’s value or shareholder’s wealth.
5: MIRR method differentiates between cash flows occurring at different points of time
and thus considers time value of money.

3.5. Demerits

1: It is difficult to compute as compared to other techniques of capital budgeting.

2: It requires computations of required rate of return to be used to discount future cash
flows.
3: Needs to compute present values and forecasting of future cash flows.

4. Discounted Payback Period Method

4.1. Meaning

The discounted payback period is an extension of the payback period. The addition is that
instead of taking cash flows into consideration, it takes discounted value of cash inflows
into account to compute the payback period.

4.2. Computation

This method captures the time value of money concept and incorporates it into analysis.
This technique is the combination of traditional and modern approach of capital
budgeting decision. Let’s consider one example to understand this method.

Example: There is a machine to produce the spare parts of a motor vehicle. The
followings are the cash flows related to the machine:
Year Cash Flow

0 -50,000

1 15,000

2 20,000

3 23,000

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4 25,000

5 28,000

Compute the discounted payback period when the required rate of return is 12%.
Solution: The first step is to compute the present value of all cash inflows. The next task
is to compute the cumulative value of discounted cash flows to figure out the discounted
payback period.
Year Cash Flow PVF@12% PV Cumulative PV

1 15,000 0.893 13,395 13,395

2 20,000 0.797 15,940 29,335

3 23,000 0.712 16,376 45,711

4 25,000 0.636 15,900 61,611

5 28,000 0.567 15,876 77,487

The target value is Rs. 50,000 i.e. the investment outlay. We can see from the above table
that the cumulative discounted value of cash inflows is Rs. 45,711 at the end of third year
and Rs. 61,611 at the end of fourth year. It means that the discounted payback period lies
between 3rd and 4th year. The actual value of discounted payback period is calculated by
using interpolation method which is
50,000 − 45,711
= 3+
15,900
= 3 + 0.269
= 3.269
Thus, the value of discounted payback period is 3.269 years.

4.3.Decision Making Criteria

The decision rule is again the same, that is, the computed value of discounted payback
period is compared with the predetermined value. When the computed value is less than
the predetermined period, we accept the project, otherwise we reject the investment
proposal. Suppose in the above example if the predetermined period is 3 years, then we
do not accept this investment proposal, on the other hand, if the predetermined period is 4
years, we accept this project.

4.4. Merits

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1: It provides a good measure of liquidity of project.

2: Unlike payback period, it considers time value of money.
3: Incorporates riskiness of project through appropriate discount rate.

4.5. Demerits

1: Is more difficult to calculate than simple payback period.

2: Requires computation of discount rate, which is a tedious task.
3: Like payback period, it also ignores cash flows occurring after the payback period.

5. Summary

Ø IRR is that rate of discount at which present value of cash inflows is equal to the
present value of cash outflows, i.e., NPV becomes zero. It is computed differently
depending upon whether annual cash inflows are equal or unequal.
Ø If project’s IRR > cost of capital (K) we should accept the project and vice versa.
Ø IRR considers time value of money, is based on cash flows, incorporates risk and
gives a percentage rate of return. However, it is difficult to calculate, can give
multiple rates of return and underlying assumption is not realistic.
Ø MIRR is a form of the internal rate of return that assumes
all returns are reinvested at a company's cost of capital. MIRR = [(Sum of
Terminal Cash Flows / Initial Investment)1/n - 1]. If project’s MIRR > cost of
capital (K) we should accept the project and vice versa.
Ø MIRR overcomes limitations of IRR, is based on cash flows, incorporates the
riskiness of the project and considers time value of money. However like IRR, it
is difficult to calculate, requires computation of discount rate and cash flows.
Ø Discounted Payback period is an extension of the payback period which uses
discounted value of cash inflows instead of non discounted cash flows to compute
the payback period.When the computed value is less than the predetermined
period, we accept the project, otherwise we reject the investment proposal.
Ø It is a good measure of liquidity, considers time value of money and incorporates
risk. However, is difficult to compute, requires tedious calculation of discount rate
and like payback period ignores cash flows occurring after payback period.

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