What is Modified Internal Rate Of Return MIRR?
Definition: Modified Internal Rate of Return or MIRR represents an investment’s internal rate of return when the investment is tailored to factor in the differences between investment return and re-investment rate.
The MIRR operates on the assumption that a company reinvests its positive cash flows and the reinvested resources are provided by its capital. It also assumes that the company’s initial expenditures are financed by the company’s financing costs. It is a slight deviation from the Internal Rate of Return (IRR) which suggests that project cash flows are plowed back at the IRR.
MIRR is considered a better representation of a project’s profitability and costs than IRR. Some might argue that MIRR exists to solve some of the drawbacks of IRR. But we have to first understand those IRR shortcomings in order to fully understand why MIRR is a superior solution. The first drawback is that IRR may provide multiple answers since it is a relative determinant of value creation. Calculating IRR is quite difficult and its reinvestment assumptions are considered unrealistic.
While there are some similarities between IRR and MIRR, the latter has a more viable assumption that a project’s cash inflows will be reinvested at a rate that considers the cost of capital. This is why MIRR calculations usually result in lower figures than would be the case if it was an IRR calculation.
How does the MIRR help project managers?
Remember when we noted that IRR usually results in multiple answers? Well, MIRR was created to solve that problem. MIRR is mostly used as a tool that helps to rank projects or investments that are run by an investor or firm. It is mainly used to rank different-sized projects.
Project managers who use MIRR can adjust the assumed reinvested growth rate at every stage of the project. It is a common approach to use the average estimated cost of capital although project managers can use any predicted reinvestment rate.
MIRR formula
You can use the Modified Internal Rate of Return formula below to calculate MIRR.
In the above formula,
- n is the number of years that the investment will run.
- Terminal Value is the future value of an investment’s net cash inflows when reinvested at the cost of capital rate.
IRR VS MIRR
| IRR | MIRR |
| It tends to overestimate a project’s profitability leading to budget deficits caused by the optimistic estimates. | Managers can control the outcome since the MIRR achieves more accuracy thanks to the future cash flow’s reinvestment rate. |
| The IRR does not present an accurate representation of plowing back cash flows into the project. | The MIRR specifies the cash inflows and cash outflows using the reinvestment rate and the safe rate. |
| IRR makes the assumption that the growth rate is constant from one project to another. This allows for the potential future value to be overstated. | The safe rate makes the assumption that the funds used to adjust for the negative cash flows can be attained easily when needed. |
| The IRR calculations produce more than 1 figure when a project goes through negative and positive cash flow periods. This tends to cause confusion. | The safe rate assumption that liquidity helps to provide cash that is pumped in to counter negative cash flows helps to overcome the issue of multiple answers from the calculations. |
MIRR Drawbacks
One of the problems with MIRR is that it comes across as a difficult topic to grasp especially for individuals that have not gone through financial training. Although MIRR is considered a more accurate approach compared to IRR, it still leaves a significant degree of error and so project managers using this approach might still make some poor decisions that will not lead to an optimal value.
MIRR is still not an accurate method of demonstrating or identifying the various impacts of having a variety of investments. Net present value is a more precise tool when it comes to multiple investments especially if they are completely unrelated investments or if they happen at different times. MIRR is also not very effective when managers try to achieve optimal results especially in situations where capital rationing is involved. MIRR is still not unanimously accepted in the academic community because some scholars dispute its theoretical basis.