This method takes into account the magnitude and timing of cash flows. This method is also known as Discounted Cash Flow Method or Time Adjusted Rate of Return Method and is used when the cost of investment and the annual cash inflow are known while the unknown rate of earning is to be ascertained.
The Internal Rate of Return (IRR) can be defined as the rate which equates the present value of cash inflows with that of cash outflows of an investment. This means the internal rate of return will be that rate at which the present value of cash inflows and outflows set off each other or the NPV = 0.This is a trial and error method.
IRR is obtained by the below formula.
IRR indicates the maximum rate of return that a project can contribute and is mainly dependent on the internal cash inflows generated by it.
If the positive cash flows are reinvested at the firm’s cost of capital, then that rate is called as Modified Internal Rate of Return (MIRR) and the initial outlays are financed at the firm’s financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.
MIRR is calculated using the below formula.
Let us now see how to calculate IRR and MIRR using MS Excel (R).
EXAMPLE: CALCULATION OF IRR FOR A PROJECT
A project requires an Initial Investment of $60,000 and has life of 4 years. The Net Annual Cash Flows in $ for next four years are respectively 15000, 20000, 30000 and 20000. Let us calculate the IRR for this project.
EXAMPLE: CALCULATION OF MIRR FOR A PROJECT
Let us calculate the MIRR for the same problem above. Suppose if we assume that the reinvestment rate is 10%, the MIRR is calculated as below.