In an effort to solve some of the shortcomings of the IRR method, financial analysts have devised an alternate evaluation procedure that is comparable to the IRR but modified.
The modified internal rate of return (MIRR) is a monetary indicator of an investment’s appeal.
The IRR has a number of issues, but MIRR fixes two of them. First off, IRR makes the assumption that positive interim cash flows are reinvested at the same rate of return as the project that produced them. This is typically a fanciful scenario, and it is more likely that the money will be reinvested at a rate that is more in line with the firm’s cost of capital.
As a result, the IRR frequently paints an overly positive picture of the projects under consideration. The interim cash flows should typically be reinvested using the weighted average cost of capital to compare projects more fairly. Second, projects with alternating positive and negative cash flows can have more than one IRR, which causes uncertainty and confusion.
The following steps are used to determine this modified internal rate of return (MIRR):
- Find the present value of the cash outflows using the firm’s cost of attracting capital as the discount rate.
- Find the future value of all cash inflows using the firm’s cost of attracting capital as the discount rate. All cash inflows are compounded to the point when the last cash inflow will be received. The sum of the future value of cash inflows is known as the project terminal value.
- Compute the yield that sets the inflows’ future value equal to the outflows’ present value. This yield is the modified internal rate of return.
Limitations of MIRR Method
Because all cash flows are compounded at the cost of capital, the MIRR method fixes the IRR method’s reinvestment rate assumption issue. Additionally, there is only one solution for MIRR, as opposed to the IRR, which may have several different mathematical solutions. The MIRR method, like the IRR method, has the drawback of not being able to differentiate between large- and small-scale projects. Due to this restriction, the MIRR can only be used to accept or reject projects; it cannot be used to rank projects.