In effect the IRR overstates the profitability of profitable projects and

In effect the irr overstates the profitability of

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when the IRR is greater than the cost of capital, but it is greater than the IRR when the IRR is less than the cost of capital. In effect, the IRR overstates the profitability of profitable projects and understates the profitability of unprofitable projects. By forcing the correct reinvestment rate, the MIRR method provides decision makers with a theoretically better measure of a project's expected rate of return than does the IRR. In closing our discussion, note that the MIRR has other advantages over the IRR besides the proper reinvestment rate. Primarily, it avoids potential problems when a project has nonnormal cash flows. A project with normal cash flows has one or Healthcare Finance: An Introduction to Accounting & Financial Management, Sixth Edition Reprinted for ZIV54/29007015801288, York University Health Administration Press, The Foundation of the American College of Healthcare Executives (c) 2016, Copying Prohibited Page 17 of 28
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more outflows followed by one or more inflows, while one with nonnormal cash flows has outflows occurring after one or more inflows have occurred. In the nonnormal situation, it is possible for a project to have two IRRs or even to have no IRR. These unusual results occur because of the mathematics of the IRR calculation. The MIRR overcomes these problems, so it is the only rate-of-return measure that can be applied to some projects. Self-Test Questions 1. Briefly describe how to calculate net present value (NPV), internal rate of return (IRR), and modified IRR (MIRR). 2. What is the rationale behind each method? 3. Do the three methods lead to the same conclusions regarding project profitability? Explain your answer. Modified internal rate of return (MIRR) A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital. Some Final Thoughts on Breakeven and Profitability Analyses Although we have discussed one breakeven and three profitability measures, there are many other measures commonly used in project financial analyses. Today, virtually all capital budgeting decisions of financial consequence are analyzed by computer, and hence the mechanics of calculating and listing numerous breakeven and profitability measures are easy. Because each measure contributes slightly different information about the financial consequences of a project, managers should not focus on only one or two financial measures. A thorough financial analysis of a new project includes numerous financial measures, and capital budgeting decisions are enhanced if all information inherent in all measures is considered in the process. However, just as it would be foolish to ignore any of the quantitative measures, it would be foolish to base capital budgeting decisions solely on these measures. The uncertainties in the cash flow estimates for many projects are such that the resulting quantitative measures can be viewed only as rough estimates. Furthermore, organizational missions and strategic factors are important elements in capital budgeting decision making. Thus, qualitative factors should play an important role in the decision process. (We discuss one approach, project scoring, in a later section.) Finally, managers should be cautious of potential projects that have high expected profitability. In a highly competitive
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