The companies use capital budgeting techniques to analyze different investment options and choose the best one. There are different techniques for this purpose, each having its own benefits and limitations.
Therefore, it’s recommended in most cases to use a combination of two or more techniques to analyze all aspects of any investment project.
Internal Rate of Return or IRR is also a capital budgeting technique that is often criticized by academic bodies. The drawbacks of the technique include that it’s only a relative measure of value and multiple answers make it difficult to calculate.
In principle, IRR is the discounting rate where the NPV of a given project is zero, and that’s why IRR is called the reinvestment rate of any investment.
However, financial managers often like IRR if we talk about the practical side of the measure. They consider it a useful tool for measuring headroom to help further negotiate with the fund suppliers.
Financial scientists have invented the modified IRR that is similar to the IRR but has different essence, calculation method, and uses.
This article will discuss the modified internal rate of return and how it is calculated. We will also discuss the different uses and limitations of MIRR. So let’s get into it.
What Is Modified Internal Rate of Return?
Modified Internal Rate of Return can be defined as,
It’s a financial metric or capital budgeting technique that analyzes a prospective investment project’s precise value and profitability. Companies and investors can rely on the MIRR to choose the best investment considering the expected returns.
How is it a modified form of Internal Rate of Return?
Unlike the IRR, MIRR gives a more accurate measure of any investment or project attractiveness. It compares the viability of one investment with others to give more realistic expectations.
In fact, MIRR fixes the problem that is associated with the formula of IRR. To explain it, understand this as if a project’s expected return is lower than the MIRR; such an investment is considered attractive and viable.
The modified internal rate of return will also use the WACC adjusted terminal value of cash inflows and compare it to the present value. In short, it can be said that MIRR provides the flexibility to calculate the reinvestment rate from time to time, which is not possible for IRR.
We can say that MIRR is a form of IRR that is adapted to consider the difference between investment rate and reinvestment rate. There are three different approaches to MIRR:
- Discounted approach – All cash outflows are discounted to the current investment and added to the initial investment cost.
- Reinvestment method – You will compound all the positive and negative cash flows to the end of the project time and then calculate the IRR of the amount.
- Combination approach –The third approach is a hybrid one that merges the above two by discounting the negative cash flows to the current investment and compounding the positive cash flows to the investment end. Finally, the IRR is calculated on the amounts.
Formula For Modified Internal Rate of Return?
The most commonly used formula to calculate the MIRR in capital budgeting is as follows:
In the formula, the explanation of calculations is as follows:
- FVCF = Positive cashflows compounded to the future value after subtracting the reinvestment rate or cost of capital.
- PVCF = Present value of negative cash flows after subtracting the finance cost of the company
- n = Number of the years
You can also calculate the MIRR using Excel Spreadsheet. The function of the MIRR is:
MIRR(value_range, finance_rate, reinvestment_rate)
- Value range describes the range of excel cells having cash flow value in each period
- The finance rate represents the cost of capital or interest expense for negative cash flows
- The reinvestment rate is the compounding rate of return on reinvested positive cash flow
How To Calculate Modified Internal Rate of Return?
Let’s understand the modified internal rate of return calculation using an example.
Let’s say a company has a project with an initial investment of $1,000. The company’s finance manager must calculate the MIRR by assuming the project will last for three years. The weighted average cost of capital of the company is 10%.
The company’s cash inflows for the project are 400, 600, and 300 each year, respectively. The conditions imply that the cash inflows at the end of every year can be reinvested to get the return.
We will make calculations with all approaches.
- Compounding cash inflows
- Discounting cash outflows
- MIRR Calculation
Compounding Positive Cash Flows
|Year||Cash Flow||Multiplier = (1 +WACC)^n||Reinvested Amount|
The present value of the initial investment is $1000.
The MIRR formula will be as follows:
MIRR = (Terminal cash inflows/ PV of cash outflows)^n – 1
MIRR = (1444/1000)^3 -1
MIRR = 13%
Present Value Formula
In this method, the cash inflows are discounted to the present value and compared to find the MIRR. This method signifies that no cash inflow is not invested back into the project.
|Year||Cash Flow||Discount Factor = 10%||Reinvested Amount|
The present value in this case will also be $1000 for the initial investment.
The MIRR Formula will be as follows:
MIRR = (PVR/PVI) ^(1/n) X (1+re) – 1
If we put the values in the formula, it will be as follows:
MIRR =(1085/1000)^(1/3) X (1+0.10) – 1
MIRR = 13%
So we can conclude that the answer with both formulas will be the same for a given project.
Interpretation of MIRR
It’s important to understand the interpretation of MIRR to select or reject an investment or project.
When we have calculated the MIRR for any investment or project, it also factors in the company’s cost of capital.
That means there can be an error If the actual returns are less than expected. General practice is that if the MIRR is higher than WACC, the project is accepted and vice versa.
Modified Internal Rate of Return Vs. Internal Rate of Return
They are very similar if we have to choose between the Modified Internal Rate of Return versus Internal Rate of Return.
The MIRR is preferable to measure as it addresses some of the problems in the IRR. As we have already discussed, the IRR ignores reinvestment of cash inflows, and the MIRR addresses the issue.
Another issue faced in the IRR is more than one value for a single investment project. It can lead to ambiguity in the finance department about the project. When MIRR is employed, a realistic view improves the decision-making process.
We can say that MIRR is better than IRR in choosing a project. Another thing to know here is that MIRR is often lower than the IRR. That’s why it’s a realistic measure.
Uses of Modified Internal Rate of Return
5As already mentioned, MIRR is lower than IRR; it provides a conservative view that saves investors from false hopes. Since the measure is similar to IRR in many aspects, the uses will be the same. However, additional uses or benefits of using MIRR as a capital budgeting technique are as follows:
- You can rank different investment projects of similar characteristics, making it easier to choose the best one
- The attractiveness of a project can be accessed based on the expected returns. When MIRR is higher than the expected return, the project is recommended.
- The modified IRR of any investment project helps to calculate the difference between the investment and reinvestment rate.
- Multiple answers in IRR for the same period are solved by using MIRR.
- The rate of return can be adjusted based on the investment phases. Even if the WACC changes in the future, MIRR can be accurately recalculated.
Unlike the traditional methods of NPV and IRR, MIRR is a more realistic measure considering the reinvestment strategy. Therefore, we can easily say that MIRR can quickly be calculated and does not raise ambiguity by giving multiple answers.