Modified Internal Rate of Return

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Modified Internal Rate of Return (MIRR) is a financial measure used to determine the attractiveness of an investment. It is generally used as part of a capital budgeting process to rank various alternative choices. As the name implies, MIRR is a modification of the financial measure Internal Rate of Return (IRR). The main difference is that it is a measure for the rate of return on the whole capital during the whole duration of the project.

The modified internal rate of return assumes all positive cash flows are re-invested (usually at the WACC) for the remaining duration of the project. All negative cash flows are discounted and included in the initial investment outlay. MIRR ranks project efficiency consistent with the present worth ratio (variant of NPV/Discounted Negative Cash Flow), considered the gold standard in many finance textbooks. [1][2]

Contents

Problems with IRR

A problem of the IRR is that it ignores the reinvestment potential of intermediate positive cash flows. Unless a better number is known, the firm's cost of capital is a reasonable proxy for the return to be expected.

In the case of a project with an unusually high IRR, the cash spun off from it will probably be reinvested at a moderate rate of return rather than in another unusually high-return investment. This mitigates the attractiveness of the project, which is reflected in the MIRR. Conversely, this reinvestment also mitigates the unattractiveness of an unsuccessful project, which is also reflected in the MIRR.

Similarly, money reserved for negative cash flows after the start of the project cannot be expected to have the same unusually high or low rate of return as the project itself perhaps has, so a normal rate of return is assumed for this money until it goes into the project.

Formula

MIRR is calculated as follows:

\mbox{MIRR} = q^{\frac{1}{n-1}} - 1

where n is the number of cash flows (at evenly spaced times), q is the value at the time of the last cash flow of the positive cash flows, computed according to the reinvest rate, divided by the net present value of the negative cash flows, computed according to the finance rate.

References

  1. ^ Principles of Corporate Finance, Brealey, Myers, and Allen
  2. ^ Economic Evaluation and Investment Decision Methods, Stermole and Stermole

External links

Retrieved from "http://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Return"

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