Even though the internal rate of return metric is popular among business managers, it tends to overstate the profitability of a project and can lead to capital budgeting mistakes based on an overly optimistic estimate. The modified internal rate of return compensates for this flaw and gives managers more control over the assumed reinvestment rate from future cash flows.
Major Disadvantages of the Internal Rate of Return (IRR)
An IRR calculation acts like an inverted compounding growth rate; it has to discount the growth from the initial investment in addition to reinvested cash flows. However, the IRR does not paint a realistic picture about 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 different periods of positive and negative cash flows. In these cases, the IRR produces more than one number, causing uncertainty and confusion.
Advantage of Modified Internal Rate of Return (MIRR)
The MIRR allows project managers 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.
Additionally, the MIRR is designed to generate one solution, getting rid of the issue of multiple IRRs.