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Summary
- The modified internal rate of return or MIRR refers to a measure that determines the attractiveness of an investment.
- MIRR is a modification of internal rate of return (IRR) formula and identifies the viability of a project.
- MIRR is generally said to give a more realistic picture of the return on the investment project compared to the standard IRR.
The modified internal rate of return or MIRR refers to a measure that determines the attractiveness of an investment. The financial measure is used to compare different investments. MIRR is a modification of internal rate of return (IRR) formula and identifies the viability of a project.
In case the MIRR of a project is higher compared to its expected return, the investment is expected to be attractive. Experts generally disapprove undertaking a project if its MIRR is negative. A project’s attractiveness increases with a rise in MIRR.
The financial measure is used to rank projects of unequal size.
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How does MIRR address the challenges of IRR?
While IRR is a popular measure of investment, its tendency to overstate the profitability of a project can result in capital budgeting mistakes. However, MIRR gives more realistic assumed reinvestment rate from future cash flow.
Thus, MIRR comes into the picture to address a few problems associated with IRR. The major problem with IRR is that it assumes the obtained cash flows are reinvested at the same rate they were generated.
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On the other hand, MIRR assumes that the positive cash flows of a project will be reinvested at the external rate of return, which is generally fixed equal to the cost of capital of the company.
IRR also attracts confusion in case of a project with different periods of positive and negative cash flows. In such cases, the IRR calculate more than one number, leading to uncertainty. But MIRR always leads to a single solution.
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MIRR is generally said to give a more realistic picture of the return on the investment project compared to the standard IRR. Also, the MIRR is commonly lower than the IRR.
What are the limitations of using MIRR?
The calculation of an MIRR requires you to estimate the cost of capital to reach a decision. Such a computation can vary based on the assumptions made.
Just like IRR, the MIRR results in sub-optimal decisions. These decisions do not maximise value when several investment options are being considered at once. Also, MIRR does not actually quantify the different impacts of investments in absolute terms.
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In addition, MIRR does not produce optimal results in the case of capital rationing. MIRR is a challenging subject for people on non-financial background to understand.
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However, MIRR may not be much useful in raking projects of different sizes. The reason is that a larger project with a smaller MIRR may have a higher net present value. But there are variants of MIRR which can be used in such cases.
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