Modified NPV and Modified IRR

The NPV method assumes that cash flows are reinvested at the firms discount rate while the IRR method assumes that cash flows are reinvested at the projects IRR. However, it may be that neither of these assumptions are correct. Question: You are trying to choose between the following projects, but the correct reinvestment rate for your company is 15%, whereas the firms discount rate is 12%. Calculate each projects NPV, IRR, modified NPV and modified IRR and select the better project. Year 0 1 2 3 Answer: NPVa = $1,043.41 NPVb = $1,199.44 IRRa = 20.20% IRRb = 17.09% Notice that the NPV method argues for Project B, whereas the IRR method supports Project A. The reason for the dilemma is the reinvestment rate assumption. Calculating each projects modified NPV and modified IRR will allow you to choose the correct project. First, calculate the future value of the projects cash flows at the end of the last year of the project, using the 15% reinvestment rate. Year 1 2 3 Sum = FV of Project A 10,580 4,600 1,000 16,180 FV of Project B 1,322.5 4,600 10,000 15,922.5 Project A -10,000 8,000 4,000 1,000 Project B -10,000 1,000 4,000 10,000

To calculate modified NPV, find the present value of the sum of the future values and subtract the project cost: Thus, for project A: n=3 I = 12 FV = 16180 PMT = x PV = 11,516.6 - 10,000 = 1,516.6 = Modified NPVa For Project B: n=3 I = 12 FV = 15,922.5 PMT = x PV = 11,333.32 - 10,000 = 1,333.32 = Modified NPVb Thus, the modified NPV method argues for Project A. To calculate the modified IRR, find the I that equates the PV of the sum of the future values to the cost of the project. For Project A: n=3 I = ? 17.40% = modified IRRa FV = 16180 PMT = x PV = -10,000 For Project B: n=3 I = ? 16.77% = modified IRRb FV = 15922.5 PMT = x PV = -10,000 Thus, the modified IRR method argues for Project A, also.