How to do capital budgeting

After you enter these numbers the calculator will entertain you by blinking for a few seconds as it determines the IRR, in this case 12.02%. It's fun, isn't it!

Ah, yes, but there are problems.

• Sometimes it gets confusing putting all the numbers in, especially if you have alternate between a lot of negative and positive numbers.
• IRR assumes that the all cash flows from the project are invested back into the project. Sometimes, that simply isn't possible. Let's say you have a sailboat that you give rides on, and you charge people money for it. Well you have a large initial expense (the cost of the boat) but after that, you have almost no expenses, so there is no way to re-invest the money back into the project. Fortunately for you, there is the MIRR.

Modified Internal Rate of Return - MIRR - Is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.

WHAT?

OK, MIRR assumes that the revenue is not invested back into the same

project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.

Why use the Cost of Capital?

Because we know the company wouldn't do a project which earned profits below the cost of capital. That would be stupid. The company would lose money. Hopefully the company would do projects which earn much more than the cost of capital, but, to play it safe, we just use the cost of capital instead. (We also use this number because sometimes the cash flows in some years might be negative, and we would need to 'borrow'. That would be done at our cost of capital.)

How to get MIRR - OK, we've got these cash flows coming in, right? The money is going to be invested back into the company, and we assume it will then get at least the company's-cost-of-capital's interest on it. So we have to figure out the future value (not the present value) of the sum of all the cash flows. This, by the way is called the Terminal Value. Assume, again, that the company's cost of capital is 10%. Here goes.

Source: www.teachmefinance.com

Category: Bank