Modified Internal Rate Of Return (MIRR) Method

By: EconomyWatch   Date: 30 June 2010

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Modified internal rate of return (MIRR) method is one of the methods used for capital budgeting. The Modified internal rate of return has been implemented to carry out certain calculations, not taken into consideration by the IRR method or the internal rate of return method.

Modified internal rate of return (MIRR) is a rating tool, which helps in making investment decisions. The modified internal rate of return (MIRR) method is a modification of the internal rate of return method, also known as the IRR method.

Modified internal rate of return (MIRR) and its difference with internal rate of return (IRR)method:

Main difference between the modified internal rate of return(MIRR) and internal rate of return (IRR) methods lie in the fact that while internal rate of return (IRR) method does not take into consideration (in details) the investment rate pertaining to positive cash flow while the former method takes into account cash flows.

While carrying out the process of capital budgeting, the internal rate of return (IRR) method presumes that positive cash flows in any investment are, as per the IRR rates, reinvested. On the contrary, the modified internal rate of return presumes that this re investment is usually done at WACC or weighted average cost of capital. With regard to the cash flows, which are negative these are usually discounted at the beginning of the investment (initial outlay). The profitability calculated as per modified internal rate of return (MIRR) method is more appropriate because it delves into details of re investments and considers positive as well as negative cash flows more accurately. The Internal rate of return(IRR) method has many drawback which are overcome by using the modified internal rate of return(MIRR) method.

The modified internal rate of return can be better understood with the help of the following example:

Problem:

Let us assume, that a project has been undertaken for a period of two years. The cost of capital is 12 percent. The project has an initial outlay of USD$200. It is expected that in the first year, it will return USD$150. In the second year, the project will return USD$160. We are required to find the internal rate of return for the NPV to be zero.

Solution:

NPV=0= -200+150/(1+IRR) + 160/(1+IRR)2      NPV=0 when IRR=32.8%we know the cost of capital is 15 percent.

On substituting MIRR with IRR, which is equal to the cost of capital, 15%.

NPV= -200+150/(1+.15) + 160/(1+.15)2

NPV=51.43 when MIRR=15%.

Therefore, in the event when IRR gives a positive net present value, the project is considered to be one, which will give good returns. On the other hand, if the net present value or the NPV is negative, the project is not worth being pursued.


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