Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)

Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR): An Overview

When determining whether to undertake a new project, business managers often 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 and project managers. It is also used by government agencies like the United States Environmental Protection Agency to select projects.

Unfortunately, IRR 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.

This variation, called the modified internal rate of return (MIRR) strives to improve the original formula. Let's compare the two and understand how these two approaches differ.

Internal Rate of Return (IRR)

IRR is often used to analyze cash flow over a period of time. It is calculated by summing the present value of each cash flow over the life of a project. The calculation often has an initial cash outlay (the initial investment) along with subsequent annual cash inflows (resulting revenue generated from the initial investment).

The discount rate used to find the present value of the cash flows is set so the net present value of the series is equal to 0. This discount rate is the internal rate of return; it is the required investment return rate to break even on a project when considering the timing of the cash flow of a project. In general, projects with higher IRRs are more favorable than projects with lower IRRs, as the expected rate of return on these projects is greater.

IRR is often used to compare different options or choose between 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. All else being equal, the option with the highest IRR is most favorable.

The Drawback to IRR

There are several disadvantages when using IRR. First, IRR does not give you the return on investment in terms of dollars. A project may yield an IRR of 10%; however, you won't know if the project will generate $10,000 or $10 million of cash flow. For this reason, larger projects with lower yields but higher net cash proceeds may be put at an analytical disadvantage when using IRR.

IRR does not consider differences in the duration of projects. Imagine a one-year project with an IRR of 10% and a five-year project with an IRR of 8%. While the one-year project is more favorable because of its higher IRR, the company may want to consider a longer-term project that will yield a return over a longer period of time.

IRR calculations also assume all cash flow will be reinvested at the same rate over the term of the entire project. This means the initial cash outlay and subsequent cash inlays will have the same earning potential, even if these cash flow span years.

Last, a series of cash flow may end up having two valid IRR calculations. This problem arises when a project has non-normal cash flow over its life and generally occurs when the direction of cash flow changes. When this occurs, a project has more than one internal rate of return and may be more difficult to analyze.

Modified Internal Rate of Return (MIRR)

To fix the last two issues above related to IRR, a different calculation was created. The MIRR uses a lot of similar concepts as IRR, but there are slightly differences to help improve the original formula. The MIRR is calculated by incorporating the future value of positive cash flows and the present value of cash flows taken at different discount rates.

Similar to IRR, MIRR is used to analyze the profitability of a project. MIRR is often compared to an internally required rate of return. If a project's MIRR is higher than this expected return, a project is favorable; if a project's MIRR is lower, it is often not recommended.

Key Differences

There are several differences between IRR and MIRR, and these differences are what make the general view that MIRR demonstrates a more realistic picture of a project. These differences are discussed below.

• They use different rates. IRR relies on a single reinvestment rate for all cash flows. This may not be realistic, especially for projects with a long timespan. In addition, a company may have a different rate of return for cash inlays as opposed to cost of capital rates for cash outlays.
• They consider inflation differently. Because IRR does not factor in the cost of capital as part of its equation, IRR does not incorporate inflation. Meanwhile, MIRR can reflect this cost.
• They provide a different number of solutions. When a project has irregular cash flow, it may return multiple IRR results. This makes analysis difficult, as both percentages can be interpreted as the rate of return. Alternatively, based on the format of the formula, MIRR will only generate one result. This often means MIRR is easier to analyze.
• They are defined differently. IRR is the discount rate at which the net present value of a series of cash flow is equal to zero. Alternatively, MIRR is defined at the rate of return where the NPV of the project inflows is equal to the initial investment. Though these definitions aren't widely different, they do vary as they use different approaches to the discount rate(s) used.
• They vary in accuracy. Because MIRR incorporates more information and allows for more flexibility, it is often considered the more accurate and more useful calculation.