Modified Internal Rate Of Return
The modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. By contrast, the traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR itself. The MIRR, therefore, more accurately reflects the cost and profitability of a project.
Modified Internal Rate of Return (MIRR)
Definition
The Modified Internal Rate of Return (MIRR) assumes that positive cash flows are reinvested at the company's cost of capital, while the initial outlays are financed at the company's financing cost. In contrast, the traditional Internal Rate of Return (IRR) assumes that project cash flows are reinvested at the IRR itself. Therefore, MIRR more accurately reflects the cost and profitability of a project.
Origin
The concept of MIRR was introduced in the late 20th century to address the limitations of traditional IRR in terms of reinvestment assumptions. As financial theory evolved, scholars found that IRR could produce multiple solutions when dealing with varying cash flows, whereas MIRR resolves this issue with more realistic reinvestment assumptions.
Categories and Characteristics
MIRR has the following key characteristics:
- Reinvestment Assumption: Assumes positive cash flows are reinvested at the company's cost of capital, rather than at the IRR.
- Financing Cost: Initial outlays are financed at the company's financing cost, making MIRR more reflective of actual financing costs.
- Single Solution: Unlike IRR, which can produce multiple solutions, MIRR typically has a single solution, making it more stable and reliable.
Specific Cases
Case 1: Suppose a company invests in a project with an initial investment of $1 million, expecting cash flows of $400,000, $500,000, and $600,000 over the next three years. The company's cost of capital is 10%, and the financing cost is 8%. By calculation, the MIRR is 12%, indicating that the project remains highly profitable after considering actual financing and reinvestment costs.
Case 2: Another company invests in a project with an initial investment of $2 million, expecting cash flows of $700,000, $800,000, $900,000, $1 million, and $1.1 million over the next five years. The company's cost of capital is 12%, and the financing cost is 9%. The calculated MIRR is 14%, indicating that the project remains highly profitable after considering actual financing and reinvestment costs.
Common Questions
Question 1: Why is MIRR more accurate than IRR?
Answer: MIRR considers more realistic reinvestment and financing assumptions, thus better reflecting the actual profitability of a project.
Question 2: Is MIRR always better than IRR?
Answer: While MIRR is more accurate in many cases, IRR can still be an effective evaluation tool for simpler projects.
