Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (I𝓀RR): An Overview

Business managers often consider a potential project's internal rate of return (IRR). This metric is an estimate of the potential annual profit of the project after its costs. It is commonly used by business and project managers as well as government agencies to select projects.

IRR tends to overstate the potential profitability of a project and can lead to capital budgeting mistakes based on an overly optimistic estimate. A variation of this metric, called the 澳洲幸运5官方开奖结果♔体彩网:m🦂odified internal rate of return (MIRR), compensates for this flaw and gives managers more control over the assumed reinvestment rate from future cash flows. Let's compare the two and ꧙understand how these two approaches differ.

Internal Rate of Return (IRR)

The internal rate of return is often used to analyze cash flow over time. It is calculated by summing the 澳洲幸运5官方开奖结果体彩网:present value of each cash flow over the life of a project. The calculation often has an initial cash outlay🤪 (the initial investment) along with subsequent annual cash inflows (resulting in revenue ge𒐪nerated from the initial investment).

The discount rate used to find the present value of the cash flows is set so the net present value of the series i꧃s equal to 0. This discount rate is the IRR; it is the required investment return rate to break even on a project when considering the timing of the cash flow of a project. In general, proje▨cts with higher IRRs are more favorable than projects with lower IRRs, as the expected rate of return on these projects is greater.

IRR is often used to compare different options or choose between projects. For 🐓example, a company that is considering expanding into a new product line might compare the IRR i💫f it accomplishes that expansion by building a new factory, buying a competitor, or importing the products. All else being equal, the option with the highest IRR is the most favorable.

The Drawback to IRR

There are several disadvantages when using IRR. First, IRR does not give you the 澳洲幸运5官方开奖结果体彩网:return on investment (ROI) in a dollar figure. A project may yield an IRR of 10%, but you won't know if the project will generate a cash flow of $10,000 or $10 million. For this reason, larger projects with lower yields but h𝐆igher net cash proceeds may be at an analytical disadvantage when using IRR.

IRR does not consider differences in the duration of projects. Imagine a one-year project with an🐎 IRR of 10% and a five-year project with an IRR of 8%. While the one-year project is more favor🌌able because of its higher IRR, the company may want to consider a longer-term project that will yield a return over a longer period.

IRR calculations also assume all cash flow will be 澳洲幸运5官方开奖结果体彩网:reinvested at the same rate over the term of the entire project. This ꦕmeans the initial cash outlay and subsequent cash inlays will have the same earning potential, even if these cash flows span years.

Last, a series of cash flows may end up having two valid IRR calculations. This problem arises when a project has non-normal cash fl𒅌ow over its life and generally occurs when the direction of cash flow changes. When this occurs, a project has more than one internal rate of return and may be more difficult to analyze.

Modified Internal Rate of Return (MIRR)

To fix the last two issues above related to IRR, a different calculation was created. The MIRR uses a lot of similar concepts as IRR, but there are slight differences to help improve the original formula. The MIRR is calculated by incorporating the 澳洲幸运5官方开奖结果体彩网:future value of positive cash flows and the📖 present value of cash flows taken at 💃different discount rates.

Similar to IRR, MIRR is used to analyze the profitability of a project. MIRR is often compared to an internally required rate of return. If a project's MIRR is higher than this expected return, a project is favorable; if a project's MIRR is lower, it is often not recommended.

Key Differences

There are🥀 several differences between IRR and MIRR, and these differences are what make the general view that MIRR demonstrates a more realistic picture of a project. These differences are discussed below.

• They use different rates. IRR relies on a single reinvestment rate for all cash flows. This may not be realistic, especially for projects with a lengthy span. In addition, a company may have a different rate of return for cash inlays as opposed to the cost of capital rates for cash outlays.
• They consider 澳洲幸运5官方开奖结果体彩网:inflation differently. Because IRR does not factor in the cost of capital as part of its equation, IRR does not incorporate inflation. Meanwhile, MIRR can reflect this cost.
• They provide a different number of solutions. When a project has irregular cash flow, it may return multiple IRR results. This makes analysis difficult, as both percentages can be interpreted as the rate of return. Alternatively, based on the format of the formula, MIRR will only generate one result. This often means MIRR is easier to analyze.
• They are defined differently. IRR is the discount rate at which the net present value of a series of cash flows is equal to zero. Alternatively, MIRR is defined at the ROR where the NPV of the project inflows is equal to the initial investment. Though these definitions aren't widely different, they do vary as they use different approaches to the 澳洲幸运5官方开奖结果体彩网:discount rate(s) used.
• They vary in accuracy. Because MIRR incorporates more information and allows for more flexibility, it is often considered the more accurate and more useful calculation.

The Bottom Line

There are different metrics that businesses can use to estimate the profitability of a future project. These metrics allow business leaders to make more informed decisions before committing to one. Two common forms of measurement are the internal rate of return and the modified rate of return. While both have their benefits, the IRR can be flawed. That's why using the MIRR is often a better choice as it is a better representation of the rates of returns when related to cash flows.