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Hello John,
Hope you are doing well.
Many thanks again for the brilliant lectures as always.
I would be very thankful if you could explain the logic of the MIRR formula to me since, to be honest, I didn’t perceive the theory of MIRR.
Could you please advise why the assumption that the receipts are invested forever is so important here?Many thanks in advance!
You will know from Paper FM that you can get the situation where we have two projects and one project has the higher NPV but the other project has a higher IRR. We always choose the project with the highest NPV.
However this is always treating the projects as just one-off projects.
Suppose project A has an IRR of 10% and project B has an IRR of 11%. Both projects are giving returns of more than their IRR’s and so both of them have positive NPV’s. Suppose that A actually has the higher NPV and so we would choose project A.
But, again that it treating the projects as a one-off investment. If instead it was the case that the returns from A would always be reinvested at its IRR of 10% (so we would effectively be getting 10% for ever) and the returns from B would always be reinvested at its IRR of 11% (so we would effectively be getting 11% for ever), then B would actually be the better choice. So we would choose B – the project with the higher IRR.
That would not really be realistic. More realistic would be that if we chose A and kept reinvesting the returns then we would reinvest in the same sorts of projects and so would effectively be getting a return equal to the return from A for ever, and this would be more than getting the return given by B for ever.
So as always we should choose the project with the higher NPV even if it has the lower IRR. That is obviously confusing to explain to ‘non-accountants’ but if instead of quoting the IRR’s we quote the MIRR’s then the problem disappears because the project with the higher NPV will always also have the higher MIRR for the reasons I have outlined above.
It is really a bit of a cheat. If we as accountants try to explain the decision to non-accountants on the board of the company, then they will not understand what we mean by NPV’s but will be happy when we mention %’s – it will seem obvious to them that the one with the highest % must be the best. If we use IRR’s to explain then it can cause problems because the one with the highest IRR might not be the best. If instead we use MIRR’s to explain then we will end up always choosing the best and will not have the non-accountants thinking we are making the wrong decision 🙂
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