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What is Modified Internal Rate of Return (MIRR)?
Modified Internal Rate of Return, commonly known as MIRR, is an investment evaluation technique. It is a modified version of the internal rate of return (IRR) that overcomes some of the drawbacks of IRR.
MIRR is normally used in capital budgeting decisions to check the feasibility of an investment project.
For example, when the MIRR of a project is higher than its expected return, the investment is considered to be attractive.
Conversely, it would be unwise to take up a project if the MIRR of the project is lower than the expected return of the project.
How to Calculate Modified ARR?
The formula to calculate MIRR is a complex one. One needs to know the future value of a company’s positive cash flows discounted at the present reinvestment rate, and the present value of a firm’s negative cash flows discounted at the financial cost.
The formula to calculate MIRR is −
$$\mathrm{MIRR =\sqrt[n]{\frac{FV\:(positive \:cash\: flows \:and \:reinvestment \:rate)}{−PV (negative \:cash \:flows\: and\: financen \:rate}}− 1}$$
Where −
FV = the future value (at the end of the last period)
PV = the present value (at the beginning of the first period)
n = number of equal periods in which the cash flows occur (not the number of cash flows)
MIRR vs. IRR
Internal rate of return (IRR) and Modified internal rate of return (MIRR) are two closely related concepts. MIRR resolves a few problems associated with the IRR. For example, one of the major problems with IRR is that it assumes that the obtained positive cash flows are reinvested at the same rate at which they were obtained. MIRR, instead, considers that the proceeds from the positive cash flows of a project should be reinvested at the external rate of return. Generally, the external rate of return is equal to the cost of capital.
The calculations of IRR may provide two solutions in some cases. This fact is ambiguous and has unnecessary confusion regarding the correct outcome. The MIRR calculations on the other hand always have a single solution.
The common idea is that the MIRR provides a more realistic and clearer picture of the return on the investment project compared to the standard IRR. The MIRR is usually found lower than the IRR.
Pros and Cons of MIRR
Following are the advantages of using MIRR −
It is a more accurate indicator of the profitability of a future project. So, MIRR can be used by traders to check whether or not predictions made by IRR are too optimistic.
MIRR assumes that all cash flows are reinvested at the reinvestment rate, which is more accurate than cashflows being reinvested at the IRR.
Following are the drawbacks of using MIRR −
An estimation of the cost of capital has to be made in order to make a decision.
There is a dispute over the theoretical background for the MIRR calculation within academic circles. Moreover, it is complex for non-financial managers.
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