The process of capital budgeting in corporations involves selecting projects that add value to the organization. Capital budgeting can involve nearly everything like buying a new truck, replacing old machinery, and acquiring some land. In most cases, businesses, especially corporations, are required to conduct these projects in order to improve profitability and enhance the wealth of shareholders. The process of undertaking a capital budgeting decision requires the company to first determine whether the project will be profitable. The determination of the profitability of a project is accomplished through the use of several valuation methods like the Internal Rate of Return, Net Value Present, and Modified Internal Rate of Return. These approaches usually produce different results though the ideal capital budgeting solution should result in the indication of the same decision by the three metrics. Organizations tend to place more emphasis on one valuation method than others because of the management's preferences and selection criteria. However, each valuation method consists of common advantages and disadvantages that make them suitable or unsuitable for a particular corporation. Internal Rate of Return and Modified Internal Rate of Return are different valuation methods that could be used to determine the capital budget of an organization's needs.
Internal Rate of Return Valuation Method:
As previously mentioned, there are several valuation methods in capital budgeting that can be used to appropriately assign the required resources. The main objective of the use of these valuation methods is to enhance the timing and quality of the provided funds to speed up and improve the realization of profits for the organization. An example of such valuation method is the Internal Rate of Return (IRR) that is quite different from the other capital budgeting valuation methods.
This valuation method is a measure of an investment that considers internal factors in a company but does not evaluate interest rates or inflation. The Internal Rate of Return is used to determine the efficiency, quality, and yield of an organization's investment. This valuation method can also be considered as the discount rate that contributes to a net present value of zero. An increase in the discount rate results in the uncertainty and worthlessness of future cash flows because the net present value of a project is inversely connected with the discount rate. Consequently, the yardstick for Internal Rate of Return calculations is the actual rate that is used by the company or business to discount after tax cash flows. When this valuation method is used, a capital project is a profitable initiative when the IRR is greater than the weighted average cost of capital (Pinkasovitch, 2011). This means that a capital project endeavor is not profitable when the IRR is less than the weighted average cost of capital.
An internal rate of return valuation method is important for a business or company as its owners and investors use it to determine whether an investment will be greater than the real cost or capital invested in the project. Generally, this capital-budgeting model equates the price with the expected profits from the proposed transaction through the use of the discount rate. When evaluating the seller's business using the internal rate of return, the appraiser should calculate the IRR and compare it to the needed rate of return.
The main advantage of implementing this valuation method as a tool for decision-making is that it offers a standard figure for every project that can be evaluated in reference to the organization's capital structure. The IRR will normally produce similar kinds of decisions as the net present value models and enables companies to compare projects based on returns on invested capital. The main rule of this project is that the project should be accepted if the IRR is greater than the needed rate of return while the project should be rejected if the IRR is vice versa. The other advantage of internal rate of return is that IRR is easy to compute by either using a financial calculator or software packages.
Nonetheless, this valuation method has several disadvantages including the fact that it does not give the actual sense of the value that the project will add to the company. This is primarily because IRR merely provides a standard figure for projects that are acceptable depending on the company's cost of capital. Secondly, the IRR valuation method does not permit a suitable comparison of mutually exclusive projects. As a result, managers may be able to determine whether both projects are beneficial to the business but unable to decide which project is better if only one can be accepted by the company. Third, the use of IRR analysis results in extra cash outflows after the initial investment when the cash flow streams from a project are unconventional.
Modified Internal Rate of Return:
As the name suggests, the Modified Internal Rate of Return (MIRR) is an improved type of valuation method that covers the limitation of the Internal Rate of Return. This method is considered to reflect the profitability of an investment or project more practically than an Internal Rate of Return ("Financial Valuation Concepts," n.d.). The reason for the more logical determination of profitability by MIRR is that it assumes that every cash flow is to be reinvested at the firm's or investor's cost of capital. This is unlike the Internal Rate of Return that assumes the cash flow from a project or an investment to be reinvested at the IRR. The Modified Internal Rate of Return is mainly used in real estate financial analysis because of the nature and timing of investments and cash flows for investments in real estate.
The application of this valuation method is primarily based on three major steps i.e. estimating all cash flows like in IRR, determining the future value of every cash flow at the previous year of the project's life, and evaluating the discount rate that contributes to the future value cash inflows to equal the company's investment. While this method uses similar steps like an Internal Rate of Return, it goes a step further by evaluating the reinvestment of positive cash flows that an organization does with its income. As a result, the Modified Internal Rate of Return enables a more accurate account of the budget that a proposed project could bring to the firm's owners and investors.
In addition to providing a more realistic profitability of an investment or project, the Modified Internal Rate of Return also has other advantages including the fact that is solves the problem of reinvestment rate. The Modified Internal Rate of Return is the discount rate that makes the present value of a project's terminal value to be similar to the present value of costs. When using this valuation method, it reinvests the rate assumption since every cash flow is reinvested at the discounted rate.
Nonetheless, similar to the IRR, the Modified Internal Rate of Return has several disadvantages including the fact that it's not always easy to calculate. Secondly, this valuation method may be difficult to interpret, especially if the project or investment contains multiplers. Third, unconventional cash flows in Modified Internal Rate of Return may result in multiple answers and may sometimes result in incorrect decisions if the projects are mutually exclusive.
Better Valuation Method:
In real world situations, a company is usually faced with the choice of investing in various competing projects at the same time though the resources may be adequate for a single project. These companies need to select the most appropriate capital budgeting model in order to improve its profitability in the market. The company must make a choice on which project should be selected depending on the feasibility evaluated on various dimensions. Some of the dimensions that are used to determine the appropriate valuation methods in capital budgeting include qualitative and quantitative factors that change depending on the firm's priorities and circumstances. For instance, a manager can choose to overlook quantitative factors in expectation of securing future projects when developing long-term and stronger relationship with a large potential customer.
When choosing either the Internal Rate of Return or the Modified Internal Rate of Return, the company must decide the appropriate metric through considering the pitfalls that are involved in determining them. Since it's an iterative process in which the reinvestment rate is similar to the IRR itself, the Internal Rate of Return is the most common tool for return analysis that is used in private equity deals, project appraisal, calculating bonds, and LBO analysis. When IRR is evaluated correctly, it's usually equal to the compounded annual growth rate because of the basis of its calculations. On the contrary, the Modified Internal Rate of Return provides a manager with the option to select a more realistic or different rate that is normally the cost of capital. As a result, this valuation method in capital budgeting provide a more reliable and logical conclusion of the project.
In most cases, the Modified Internal Rate of Return is considered as a better valuation method than the Internal…