The Modified Internal Rate of Return (MIRR) streamlines investment analysis by assuming positive cash flows are reinvested at the firm’s cost of capital and initial outlays are financed at the firm’s financing cost. This offers a more realistic picture compared to the Internal Rate of Return (IRR) which reinvests cash flows at the IRR itself.
Enhanced Precision with MIRR
MIRR, distinct from IRR, accurately reflects the cost and profitability of a project by incorporating the following formula:
( MIRR = \sqrt[n]{\frac{FV(Positive , cash , flows , imes , Cost , of , capital)}{PV(Initial , outlays , imes , Financing , cost)}} - 1 )
Where:
- FVCF(c) = The future value of positive cash flows at the firm’s cost of capital
- PVCF(fc) = The present value of initial outlays at the firm’s financing cost
- n = Number of periods
Both the MIRR and IRR rely on the Net Present Value (NPV) calculation.
Key Takeaways
- MIRR offers an improved version of IRR by considering that positive cash flows are reinvested at the firm’s cost of capital.
- It helps rank investments or projects a firm may consider.
- MIRR is tailored to deliver a single solution, eliminating the problem of multiple IRRs.
Decoding MIRR: Insights and Application
MIRR is utilized to rank projects of unequal sizes. It is particularly advantageous over IRR as it overcomes dual challenges present in IRR computations, specifically, multiple results and the impractical assumption of reinvestment at the IRR. MIRR’s single results and a more realistic reinvestment rate significant to real-world applications make it highly dependable.
Moreover, project managers benefit from MIRR’s flexibility to adjust the assumed reinvestment growth rate through various project stages, generally using average estimated cost of capital alternatives, or other specified reinvestment rates.
Comparing MIRR and IRR
Despite its popularity, IRR often overstates project profitability, inherently risking capital budgeting inaccuracies. MIRR counteracts this by presenting more control over assumed future cash reinvestment rates, leading to better project evaluations.
For example, IRR assumes a consistent growth rate. However, differing cash flow periods and multiple IRRs can confuse results. MIRR corrects by focusing future values of positive cash flows based on the actual cost of capital.
Differentiating MIRR and FMRR
The Financial Management Rate of Return (FMRR) goes a step further than MIRR for evaluating real estate investments by delineating cash inflows and outflows with “safe rate” and “reinvestment rate”. Combining these yields an extensive analysis for achieving better financial outcomes.
MIRR Limitations
- Subjectivity in Calculating Cost of Capital: Estimating cost of capital can lead to variable and subjective conclusions.
- Potential for Suboptimal Decisions: MIRR might not yield the best outcomes for selecting mutually exclusive investments nor in capital rationed environments.
- Complex Understanding: MIRR’s complexity compared to IRR can alienate those without extensive financial knowledge.
- Theoretical Disputes: MIRR’s theoretical basis often incites academic debate.
Example of MIRR Calculation
Consider a two-year project undertaken with an initial outlay of $195 and anticipated returns of $121 in year one and $131 in year two, calculated at a 12% cost of capital.
IRR Of The Project
To find IRR such that NPV = 0:
( NPV = 0 = -195 + \frac{121}{(1+IRR)} + \frac{131}{(1+IRR)^2} ) IRR = 18.66%
MIRR Of The Project
Assuming cash flows reinvestment at 12%:
( 121 , \times , 1.12 + 131 = 266.52 )
The MIRR, given:
( MIRR = \sqrt[2]{\frac{266.52}{195}} - 1 ) Resulting in MIRR = 16.91%
In this cardinal scenario, IRR overestimates project potential while MIRR delivers a more balanced and equitable evaluation.
By utilizing MIRR, business leaders can attain justified confidence when investing capital, ensuring growth projection paths maximize project and financial triumph.
Related Terms: Net Present Value, IRR, FMRR, Cost of Capital.
References
- Financial Industry Regulatory Authority. “Regulatory Notice”, Page 6.
- Kierulff, Herbert. “MIRR: A Better Measure”. Business Horizons, vol. 51, no 4, 2008, pp. 326-328.
- New York University Stern School of Business. “Chapter 5: Measuring Return on Investments”, Pages 12-13.
- Microsoft. “Go with the Cash Flow: Calculate NPV and IRR in Excel”.
- New York University Stern School of Business. “Chapter 5: Measuring Return on Investments”, Page 67.
- New York University Stern School of Business. “Chapter 5: Measuring Return on Investments”, Pages 62-63.
- New York University Stern School of Business. “Chapter 5: Measuring Return on Investments”, Page 64.
- Cary, David, and Dunn, Michael. “Adjustment of Modified Internal Rate of Return for Scale and Time Span Differences”. Allied Academics International Conference, vol. 2, no 2, 1997, pp. 57.
