Understanding Modified Internal Rate of Return (MIRR)
Let me explain what the modified internal rate of return, or MIRR, really is. It's a way to measure how profitable a project or investment might be, especially when cash flows are irregular and varied. Unlike the traditional internal rate of return (IRR), which assumes you reinvest cash flows at the IRR itself, MIRR takes a more grounded approach. It assumes positive cash flows get reinvested at your firm's cost of capital, and initial investments are financed at the firm's financing cost. This makes MIRR a better reflection of actual costs and profits for your projects.
Key Aspects of MIRR
You should know that MIRR builds on IRR by using the cost of capital for reinvesting positive cash flows. It's a tool you can use to rank different investments or projects you're considering. Importantly, MIRR is set up to give you just one solution, avoiding the problem of multiple IRRs that can confuse things.
The Formula and How to Calculate MIRR
Here's the formula for MIRR: MIRR = [FV(Positive cash flows × Cost of capital) / PV(Initial outlays × Financing cost)]^(1/n) - 1, where FVCF(c) is the future value of positive cash flows at the cost of capital, PVCF(fc) is the present value of negative cash flows at the financing cost, and n is the number of periods. Both MIRR and IRR use the net present value (NPV) formula at their core, but MIRR adjusts for more realistic assumptions.
How MIRR Functions
MIRR tackles two big issues with IRR. First, IRR can give you multiple solutions for the same project, which isn't helpful. Second, it assumes reinvestment at the IRR rate, which isn't practical. With MIRR, you get one clear solution, and the reinvestment of positive cash flows makes more sense in real scenarios. As a project manager, you can even adjust the reinvestment rate stage by stage—usually using the average cost of capital, but you have flexibility to input specific rates.
Comparing MIRR and IRR
IRR is popular, but it often overstates profitability, leading to bad budgeting decisions. MIRR fixes this by giving you control over reinvestment rates. IRR works like an inverted compound growth rate, discounting initial investments and reinvested flows, but it doesn't show how cash really gets reused in future projects. Cash flows typically reinvest at the cost of capital, not the IRR, and IRR assumes constant growth across projects, which can inflate future value estimates. Plus, with mixed positive and negative cash flows, IRR can produce multiple numbers, creating confusion—MIRR avoids that.
MIRR vs. FMRR
The financial management rate of return (FMRR) is mainly for real estate investments, like in REITs. MIRR adjusts IRR for different reinvestment rates on outlays and inflows. FMRR goes further, using a 'safe rate' for outflows—funds that are liquid and low-risk—and a higher 'reinvestment rate' for inflows into similar investments with more risk.
Limitations You Need to Consider with MIRR
One downside is that MIRR requires estimating the cost of capital, which can be subjective and vary based on your assumptions. It might lead to decisions that don't maximize value when comparing multiple investments. MIRR doesn't quantify impacts in absolute terms; NPV might be better for mutually exclusive choices or capital rationing. It's also tough for non-financial folks to grasp, and academics debate its theoretical foundation.
A Practical Example of MIRR
Take a two-year project with a $195 initial outlay and 12% cost of capital, returning $121 in year one and $131 in year two. The IRR comes out to 18.66%, making NPV zero. For MIRR, reinvest positives at 12%: future value at t=2 is $121 × 1.12 + $131 = $266.52. Then MIRR = ($266.52 / $195)^(1/2) - 1 = 16.91%. See how IRR overstates, while MIRR gives a realistic view?
MIRR Explained Simply
In basic terms, MIRR helps businesses estimate project returns considering variable cash flows. Use it in capital budgeting to pick the best projects, especially with changing cash flows, since you can adjust reinvestment rates per stage. IRR is flawed because it overstates profitability by ignoring cash flow variations.
Other articles for you
A grant deed is a legal document for transferring real estate ownership with limited warranties, offering more buyer protection than a quitclaim deed but less than a general warranty deed.
A revolver is a borrower who maintains a balance on a revolving credit line, making minimum payments while accessing funds as needed.
Marketable securities are liquid financial instruments that can be quickly converted to cash and are used by businesses for short-term investments.
A variable prepaid forward contract lets stockholders cash in shares while deferring capital gains taxes until the deal finalizes.
A statute of limitations sets deadlines for initiating legal actions in civil and criminal cases to ensure timely proceedings and preserve evidence.
Liar's Poker is a bluffing game using dollar bill serial numbers and also the title of Michael Lewis's book on 1980s Wall Street bond trading.
A business exit strategy is a plan for entrepreneurs to sell or liquidate their ownership in a company to realize profits or minimize losses.
A deposit is money transferred to a bank for safekeeping or as security for goods and services.
International finance studies monetary interactions between countries, focusing on investments, exchange rates, and global economic stability.
Price stickiness refers to the tendency of prices to remain constant or adjust slowly despite changes in economic conditions, leading to market inefficiencies.