The five key features will help to calculate the modified internal rate of return (MIRR).
The Internal Rate of Return (IRR) has a conventional method that assumes cash flows arising from a project to be reinvested in the same project. It discounts future cash inflows to net present value. The NPV of total cash is zero when a breakeven sets against the WACC. However, it is risky to invest cash flows in the same project, so IRR has two different calculations for costs of interest rate.
IRR calculates all the cash flows associated with the project. It limits the possibilities of cash flows to different projects. It may not be correct in the cost of financing because many projects require ongoing project activities. So, it may become difficult to predict in advance. When uneven cash flows exist, it becomes difficult for IRR to calculate, resulting in multiple IRRs. However, higher IRR is the best investment option because other IRR projects offer higher NPV.
The MIRR is the different cost of returns from the project’s initial investment rate and subsequent cash flows. The reinvestment is from the company’s capital. The current value is the adjusted terminal value of cash inflows with WACC. MIRR is much more flexible compared to IRR in the management of reinvestment.
The MIRR is calculated from the account for the time value of money. There are two simple steps to calculate MIRR.
The formula for Calculating MIRR:
Here n = number of years for the project
Terminal value = Future reinvested value of cash inflows at the cost of capital
Here PVR = PV of return phase (PV of cash inflow)
PVI = PV of investment phase (PV of cash outflow)
Re = Cost of capital
Suppose a project with an initial investment of $ 1,000 uses a WACC of 10% to be completed in three years with cash inflows as below. However, the MIRR cash inflows calculation can be reinvested in the project. The WACC cash inflows compound rate gives modified returns. To calculate the MIRR, the total cash inflows are adjusted with WACC at the end-of-year.
|Year||Cash flow||Multiplier @ 10%||Re-Invested Amount|
As the cash outflow is at $ 1,000, we use:
MIRR = (Terminal Cash Inflows / PV of Cash Outflows) ^n-1
MIRR = (1444/1000) ^3-1
MIRR = 13%
However, if we use the second formula, we will the following present value:
|Year||Cash flow||Discount factor @ 10%||Present value|
As the initial investment is $ 1,000, we use:
MIRR = (PVR/PVI) ^ (1/n) x (1+re)-1
PVR = $ 1,085
PVI = $ 1,000
Re = 10%
MIRR = [(1,085/1,000)] ^ (⅓) x (1+0.10)-1
MIRR = 13%
Both formulas will give the same MIRR result.
INTERPRETATION OF THE MIRR METHOD
According to MIRR, the cost of capital is reinvested in the form of cash inflows. However, if the project returns are less than expected, the margin of error occurs. Therefore, a higher MIRR is expected than the WACC. Even if the WACC rate changes, the MIRR can be adjusted.
MODIFIED IRR WITH DIFFERENT RATES FOR RETURN AND INVESTMENT PHASES
With different discount rates, we use a different formula for calculating the MIRR.
MIRR = (-FV/PV) ^ [1/ (n-1)] -1
FV = Future values of cash inflow (at return phase)
PV = Present value of cash flow (at investment phase)
n = Number of people
A project with initial cost of investment of $ 130,000. The project returns are as follows:
1 year = $ 50,000
2 years = $ 45,000
4 years = $ 47,000
5 years = $ 50,000
6 years = $ 42,000
(With additional investment of $ 30,000 in year 3).
Following discount rate for investment phase at 13% and return phase at 11%.
Required: Calculate MIRR for this project.
Separating the table into investment and return phases:
Present value of investment phase:
|Year||Cash flow||Discount factor @ 13%||Present value|
The reinvested amount for the return phase:
|Year||Cash flow||Factor @ 11%||Compound rate||Value|
We’ll use the formula:
MIRR = (-FV/PV) ^ [1/ (n-1)] -1
FV = $ 307,975
PV = – $ 150,790
n = 6 years
MIRR = (-307,975/-150,790) ^ (⅕)-1
MIRR = 15.35%
Thus, MIRR at different rates of return and investment phase is 15.35%.
ADVANTAGES OF MIRR
LIMITATIONS OF MIRR
MIRR VS IRR
Both calculate the cost of capital employed in a project, value of cash inflows, and assume basic cash inflows for reinvestment purposes. However, the following are the differences between MIRR and IRR:
MIRR is much superior and flexible than IRR in absolute terms of profitability. The average weighted cost of capital for project reinvestment cash inflow is much better to measure accurate appraisals. As MIRR is closer to the company WACC, the project ranking increases with a better appraisal of the rate of return.