Meaning of Modified internal rate of return (MIRR): MIRR or the Modified internal rate of return is the measure of the attractiveness of the financial investment. This measure is employed in ranking the different investments of equal size in the field of capital budgeting. As its name implies, it is the modification of IRR or internal rate of return. There were many problems in the IRR method, which led to the development of MIRR.
What MIRR Can Tell You?
The MIRR is used to arrange projects and investments of unequal size. It allows the manager of the project head to vary the estimated rate of reinvestment growth from one phase to another level in the project. The most basic method is to input the mean predicted cost of capital, but it provides the flexibility to add any particular expected reinvestment rate.
Problems with the IIR
Among the various issues in IIR, MIIR resolved two of its significant problem:
The first problem associated with it is that it is not applied correctly and works under the assumption that positive cash flow (interim) is spent with the same rate of return as that of the plan that generated them. It is generally not a realistic scenario, and a possible condition is that the assets will be invested at a value closer to the company’s cost of capital.
Thus IIR method generally gives an extremely positive picture of the plans under study. Typically, for the interim cash flows reinvesting, the weighted average cost of an asset is used to compare plans more fairly.
Second, IRR results in more than one plan with alternating negative and positive cash flow, leading to ambiguity and confusion, whereas MIRR provides just one value for this.
Calculation For MIRR
The formula for MIRR calculation is as follows:
MIIR = {square root n [FV (positive cash flows, reinvestment rate)] / [-PV (negative cash flows, finance rate)]} – 1
Where:
n= the number of equal periods occurred at the end of cash flows (not the number of cash streams)
PV= It is the current value at the starting of the first period.
FV= It is the future value taken at the end of the final period.
This formula sum ups the negative cash flows after discounting these to zero time using the cost of capital (external). It also sums up the positive flows including returns of reinvestment (at external reinvestment rate) to the final period.
Comparing Projects of various sizes
Like the IIR, the modified internal rate of return is not valid or suitable for ranking the plans of various sizes. It is because a large project with a low MIRR may have higher net current value. However, other variants of MIRR can be used in such cases.
