MIRR: The Means to an End? Reinforcing Optimal Investment Decisions Using the NPV Rule

(ProQuest: . denotes formulae omitted.)INTRODUCTIONThe MIRR investment decision criterion yields mixed reviews from academia. Although the MIRR rule dates back to Duvillard in 1787 (Biondi, 2006), MIRR is often ignored in surveys of capital budgeting practices (Graham and Harvey, 2001 ; and Pike, 1996). Ross, Westerfield, and Jordan (2011) remark the acronym should stand for "meaningless internal rate of return. " In contrast, Kierluff (2008) argues MIRR is a more accurate measure of attractiveness of an investment alternative than NPV or IRR, and it is included in many introductory finance texts (Berk, DeMarzo, and Harford, 2012). We offer a third view of MIRR; as a means to bridge a gap between the practice of capital budgeting and the theory of capital budgeting. Finance texts give considerable space to discussing the cases when NPV and IRR conflict and why NPV should be the primary decision rule. E.g., Ross, Westerfield, and Jaffe (2013) spend approximately three pages discussing NPV, a like number of pages discussing internal rate of return (IRR), but close to nine pages on the problems with IRR. Given this emphasis on problems with IRR, one would assume the flaws are memorable, but Bums and Walkers' (1997) survey results for Fortune 500 CFOs suggest this is not the case. They provide evidence that 41% percent of respondents indicated that IRR took priority in the case of a conflict in decision rules versus 29% that indicated NPV took priority. Since financial theory indicates NPV should take priority, this reflects a gap between the theory of capital budgeting and its practice. Because the calculation of MIRR requires explicit treatment of intermediate cash flows, their reinvestment and discounting, we believe teaching the MIRR technique will reinforce the superiority of NPV over IRR as a decision rule, and work toward reducing this gap.Most projects involve intermediate cash flows, i.e., cash flows between the initial investment and the termination of the project. Both NPV and IRR make assumptions regarding these cash flows. NPV assumes cash flows are reinvested at the cost of capital, while IRR assumes cash flows are reinvested at the IRR. These reinvestment assumptions are implicit in that students are rarely asked to take the intermediate cash flows and compound them to the termination of the project when calculating NPV or IRR.1 However, with MIRR they must do exactly that. Students must find the present value of the project's investment cash flows (negative cash flows) and the future value of the positive project cash flows. The MIRR is then the rate that equates the present value of the project's investment cash flows with the future value of the project's positive cash flows. We illustrate this explicit treatment of cash flows below.EXPLICIT TREATMENT OF CASH FLOWS, DISCOUNTING AND REINVESTMENT RATES IN MIRR CALCULATIONSFinance texts such as Brigham and Daves (2013) usually describe a three step procedure for calculating MIRR. Periodic cash flows must be estimated for the project life, then negative project cash flows are discounted to time zero, while positive project cash flows are compounded until the project terminates (providing a terminal value). The MIRR is simply the rate that equates the required investment base at time zero to the terminal value. While it is generally agreed that the appropriate discount rate is the cost of capital, the choice of the appropriate compounding rate is more controversial. Based on Shull (1992), McDaniel, McCarty, and Jessell (1988), and others, we advocate the cost of capital as the appropriate discounting and compounding rate.A second issue is how to treat investment funds that occur after the initial investment, e.g., year three of a project requires additional capital investment for a maintenance overhaul, while positive operating cash flows have occurred prior to this outflow. Based on Shull (1992, p.9), we recommend using positive operating cash flows from the project to fund any subsequent cash outflows during the life of the project. …