The internal rate of return, or IRR, is a single rate that summarizes the merits of a project. It is the rate of return that a project generates to cover its costs -- taking into account the time value of money. IRR, as a methodology, has limitations that modified IRR attempts to address. The acceptance rule is the same for basic and modified: Accept the project if IRR is greater than the required return on the project. A modified IRR of 25 percent or greater is often acceptable.
Relation to Capital Budgeting and NPV
Modified IRR is a common investment criterion in capital budgeting decisions (e.g., which fixed assets to buy, products to launch or markets to enter). The most effective investment criterion, however, is the net present value approach, or NPV. In essence, NPV is the difference between a project's market value and its cost; thus, acceptable projects are those with positive NPV. A project's market value is the sum of its discounted future cash flows. IRR relates to NPV in that it is the rate of return at which a project's NPV is zero.
IRR Problem No. 1: Negative Cash Flows
When a project has negative future cash flows, solving for the rate at which NPV is zero yields multiple IRRs; this is also known as the multiple rates of return problem. You cannot tell which rate is the correct IRR -- perhaps both or neither. To address this, compute the present value of negative future cash flows at first and add it to the cost of the project. Next, set NPV to zero and solve for the "modified" IRR.
IRR Problem No. 2: Comparing Mutually Exclusive Projects
Modified IRR and the NPV approach produce conflicting recommendations when comparing mutually exclusive projects. This often occurs for projects with low required rates of return. The reason is timing of cash flows: At low discount rates, deferred cash flows are more valuable. A project with significant cash flows around the end of its life yields a lower modified IRR compared to a similar project with significant cash flows around the beginning of its life. Ultimately, the project with the highest NPV is always the value-maximizing choice.
Do not forget to consider the strategic implications of undertaking a project. A seemingly profitable project can destroy value over the long run as a company loses its competitive advantage in the market. This calls for a wider assessment of a project, taking into account potential changes in the business environment, strategic position relative to the competition, and real options (i.e. options embedded in the project). Examples of real options include the option to delay, expand or abandon a project.