Question

How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods? (LO12-4)

Short answer

Answer

1. Modified and traditional internal rate of return equalizes the initial investment and future cash inflows.

2. Modified IRR and NPV both implement re-investment rate assumptions.

Step-by-step solution

Definition of Internal Rate of Return

Internal rate of return is the rate which help the company to determine the profitability of the initial investment made by the business entity. It is calculated using the same formula as NPV is calculated.

Modified internal rate of return

The modified internal rate of return calculates the interest rates that will equalize the future inflows from the investment and the potential investment. This is done by the traditional internal rate of return. Modified internal rate of return also includes the reinvestment rate assumption used in net present value, which means that the project’s inflows are reinvested at the cost of capital.