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Another shortcoming of IRR is that it may overstate profitability. An implicit assumption contained in an IRR calculation is that all1 interim proceeds from the investment are reinvested at a rate equal to the IRR. ApreviousIRRexampleprovidedanHRRof61%;however,itmaybeunrealistictobelievethat the interim cash flows will be reinvested at a rate equal to 61%. Another caution for the analyst is to be aware that when using IRR as the sole measure to compare alternativeprojects,thelessprofitabledternativemaybechosen. Forexample,twoprojectswithalife of 3 years and an initial investment of $10,000 are compared. The cash flows for the two projects are different,asillustratedin Table 4-11. A nominal discountrate of 12%is used to calculateNPVs for this example. As illustrated in Table 4-11, if IRR was the sole measure used to decide on alternatives, Project B would be chosen over Project A when, in fact, Project A is the more profitable alternative using the discount rate of 12% for the NPV analysis. Worth noting is the fact that Project B might be perceived as less risky since the returns occur sooner than those of F’roject A. Table 4-1I . Results of Using IRR as a Sole Measure Year 0 1 2 3 IRR NPV Project A $ -10,000 3,000 5,000 10,000 28.9% $ 3,782 Project B $ -10,000 9,000 4,000 2,000 31-8% $ 2,648 Given these potential problems with IRR, it is recommended that IRR be used only when performing an acceptkeject analysis for single projects. The IRR is acceptable in this instance because when IRR is greater than the hurdle rate, the actual yield when accounting for reinvestment at the hurdle rate will also be greater than the hurdle rate (Ruegg and Marshall 1990). Modified Internal Rate of Return lntroduction For projects of different scale andlives, it is possible for different ranking criteria, such as NPV and IEUX, to produce conflicting results because of differing reinvestment assumptions. The NPV method assumes reinvestment at the discount rate, whereas the IRR method assumes reinvestment at the IRR rate. The modified internal rate of return (MIRR) accounts for varying reinvestment rates and should be used in thesecircumstances. MIRRiscalculatedbyassumingthatallcashinflowsreceivedbeforetheendofthe analysisperiodarereinvestedatthediscountrateuntiltheendoftheanalysisperiod. Theterminal(future value)mountattheendoftheanalysisisthendiscountedbacktothebaseyear. Thediscountratethat will equate the present value (in the base year) of the terminal amount to the present value of all investment costs is the MIRR. 54PDF Image | A Manual for the Economic Evaluation of Energy Efficiency and Renewable Energy Technologies
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