What is Modified Internal Rate Of Return ?

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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.

Definition

The Modified Internal Rate of Return (MIRR) is a financial metric used to assess the profitability of an investment project. It assumes that positive cash flows are reinvested at the company's cost of capital, while initial expenditures are financed at the company's financing cost. Unlike the traditional Internal Rate of Return (IRR), MIRR more accurately reflects the project's costs and profitability.

Origin

The concept of MIRR was developed in the late 20th century as an improvement over the traditional IRR method. Since IRR can produce multiple values when dealing with non-normal cash flow patterns, MIRR was introduced to provide a more stable and realistic estimate of investment returns.

Categories and Features

MIRR is primarily used to overcome the limitations of IRR, especially regarding reinvestment assumptions. MIRR assumes all positive cash flows are reinvested at the company's cost of capital, unlike IRR, which assumes cash flows are reinvested at the IRR itself. The formula for calculating MIRR is: MIRR = [(Terminal Value/Present Value)^(1/n)] - 1, where Terminal Value is the future value of positive cash flows at the cost of capital, Present Value is the initial investment cost, and n is the project duration in years.

Case Studies

Case 1: Suppose Company A 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. With a cost of capital of 10%, the MIRR for this project is 12.1%, indicating feasibility as it exceeds the cost of capital. Case 2: Company B invests in a project with an initial cost of $2 million, expecting annual cash flows of $700,000 over five years. With a cost of capital of 8%, the MIRR is calculated to be 9.5%, demonstrating the project's profitability.

Common Issues

Common issues investors face when using MIRR include misunderstandings about the reinvestment rate and confusion between MIRR and IRR. MIRR assumes the reinvestment rate is the company's cost of capital, not the IRR itself, making MIRR more conservative and realistic in project evaluation.

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