Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR): An Overview
When they're considering whether to undertake a new project, business managers consider its internal rate of return (IRR). This metric is an estimate of the potential annual profit of the project after its costs.
The internal rate of return metric is popular among business managers, but the truth is that it tends to overstate the potential profitability of a project and can lead to capital budgeting mistakes based on an overly optimistic estimate.
A variation, the modified internal rate of return, compensates for this flaw and gives managers more control over the assumed reinvestment rate from future cash flows.
- The standard internal rate of return calculation may overstate the potential future value of a project.
- It can distort the cost of reinvested growth from stage to stage in a project.
- Modified internal rate of return allows for adjusting the assumed rate of reinvested growth for different stages of a project.
Internal Rate of Return (IRR)
Calculating the internal rate of return (IRR) can be done for any investment under consideration, whether it's an individual investor's decision or a company's decision on a major project.
It is a calculation of the potential rate of return of an investment. That is, it's the annual percentage of growth that can be expected from the investment. Obviously, the higher the number is, the more desirable the investment is.
The numbers are often used to compare the potential of a number of options or projects. For example, a company that is considering expanding into a new product line might compare the internal rate of return if it accomplishes that expansion by building a new factory, buying a competitor, or importing the products.
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The Drawback to IRR
The IRR calculation does not paint a realistic picture of how cash flows are actually pumped back into future projects.
Cash flows are often reinvested at the cost of capital, not the same rate at which they were generated in the first place. IRR assumes that the growth rate remains constant from project to project.
It is very easy to overstate potential future value with basic IRR figures.
Another major issue with IRR occurs when a project has periods of both positive and negative cash flows. In these cases, the IRR produces more than one number, causing uncertainty and confusion.
Modified Internal Rate of Return (MIRR)
The formula for modified internal rate of return (MIRR) allows analysts to change the assumed rate of reinvested growth from stage to stage in a project.
The most common method is to input the average estimated cost of capital, but there is flexibility to add any specific anticipated reinvestment rate.
The MIRR also is designed to generate one solution, getting rid of the problem of multiple IRRs.
IRR and MIRR are commonly calculated using Microsoft Excel.