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Modified Internal Rate of returns

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Modified Internal Rate Of Return (MIRR)

As the name suggests, the Modified Internal Rate of Return (MIRR) is an improvised technique used to measure an investment's quality financially. This technique is almost similar to the Internal Rate of Return (IRR) while calculating the estimated profit from potential investors. The only difference in MIRR is that it is used to account for the difference between re-investment rate and investment return. MIRR is a more developed technique of IRR dedicated to allowing the net cash flows to grow at lower re-investment rate. Also, this technique is solely responsible for ranking the alternative investments of equal size in capital budgeting. Apart from all the applications of MIRR, it also plays a crucial role to resolve problems with the IRR.

MIRR works on the principle of re-investing the positive cash flows at the firm's capital cost, funding the initial outlays at the firm's financing cost. Therefore, the use of this technique allows marketers to calculate the profitability of a project more accurately. In this technique, the financial costing is responsible for backing up the initial expenses of the firm. This allows marketers to estimate the cost and profitability of a project more accurately. Do you ever wonder where the idea of MIRR came from? The source that gave rise to the concept of MIRR was nothing but a flaw in the technique of IRR. It worked on the flawed theory that the project net cash flows are reinvested at the IRR. Therefore, to overcome this flaw, the technique of MIRR was introduced to measure the attractiveness of the investment more accurately. So, the method of MIRR believes in the re-investment of positive cash flows at the firm's capital cost.

The Formula to Calculate MIRR

Marketers derived an effective formula to calculate the profitability of a project more accurately. The formula can be given as follows:

Modified Internal Rate of Return (MIRR) = n * under root {Terminal(Future) Value of Cash Inflows / Present Value of Cash Outflows} - 1

where:

n = Number of periods of investment

Example Of MIRR

To understand the calculation of MIRR, first, you need to gain the knowledge required to calculate the IRR. Therefore, to understand the calculation of both IRR and MIRR, refer to the example shown below.

Consider a project with a tenure of 2 years having an initial outlay of $195 and a capital cost of 12%. The return gained in the first year will be $121 and will jump to $131 in the second year. So, first, you need to calculate the IRR of the project keeping the net present value (NPV) = 0.

NPV = 0 = -195 + 121 / (1+ IRR) + 131 / (1 + IRR)^2, when IRR = 18.66%.

Now, to calculate the MIRR of the project, assume that the positive cash flows will be reinvested at 12% of capital cost. Therefore, the terminal(future) value of the positive cash flows can be given as follows 

$121 (1.12) + $131 = $266.52 = Terminal(Future) Value of positive cash flows at t = 2

After this step, divide the terminal value of the cash flows by the present value of the initial outlay, which was $195. After this find the geometric return for the past two periods. Finally, adjust this ratio for the time period using the formula for MIRR, given as follows:

MIRR = ($266.52 / $195) ^ (1 / 2) - 1 = 1.1691 - 1 = 16.91%

Therefore, in the example shown above, you can compare the data provided by both IRR and MIRR. The value of IRR provides us with an excessive optimistic picture of the potential of the project. Contrarily, the data supplied by MIRR gives us a more naturalistic assessment of the project with more accurate data.

The Difference Between MIRR and IRR

Although the technique of IRR has managed to maintain its popularity among the marketers, still it can lead to error in capital budgeting. On the other hand, the method of MIRR compensates for this flaw. It provides business control to marketers allowing them to revise the re-investment rate from future cash flow more accurately.

While calculating the IRR, the compounding growth rate can act inversely in the re-invested cash flows. So, the technique of IRR fails to provide you with a realistic picture regarding the cash flows into future projects. Therefore, cash flows often tend to re-invest at the capital cost of the project. IRR believes that the growth rate remains constant from project to project. To generate revenue for a business, it is crucial to re-invest the cash flows at capital cost rather than at the same rate at which they were re-invested at the rate at which they were generated in the first place.

The most significant difference between the IRR and MIRR is that a project has different periods of positive and negative cash flows. In this case, IRR reflects multiple values in the calculation of profitability of a project contributing to unnecessary chaos. Thus, the technique of MIRR is the perfect solution that provides an accurate value in calculating the profitability of a project.

Problems with the MIRR Technique

The potential conflict between the techniques of MIRR and NPV acts as the biggest drawback of the MIRR method. It can occur due to a difference in project scale or the timing of cash flows. Moreover, the decline in the re-investment rate as compared to the capital cost contradicts with the underlying assumption of the NPV method. This implies that all expected cash inflows are reinvested at the capital cost or discount rate. It is, therefore, possible for the project to have positive NPV and lower MIRR than capital cost simultaneously. This is the reason why numerous studies emphasize that the re-investment rate should be equal to the capital cost earned for a project.

Apart from this, the dependency of the MIRR on an externally supplied discount rate contributes to its drawback. This is because the result obtained by this method is not indeed an “internal” rate of return. Also, numerous methods and types of MIRR contributes to the complexity of the project. Therefore, all the above factors are responsible for the drawbacks of the MIRR technique.

Textbooks On Modified Internal Rate Of Return

Book 1

Investment Analysis for Real Estate Decisions, Volume 1

Published by Dearborn Real Estate in 2003

By Gaylon E. Greer, Phillip T. Kolbe (Authors)

Book 2

Applied Corporate Finance

Published by John Wiley & Sons in 2010

By Aswath Damodaran (Author)

Book 3

CAPITAL BUDGETING DECISIONS: PBP, DPBP, ARR, NPV, PI, IRR & MIRR (Theory & interpretation Book 1)

By Chandra Sekhar (Author)

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