Modified Internal Rate of Return (MIRR)

The internal rate of return (IRR) is a break-even cost of capital - i.e. the discount rate at which
the NPV of a project is zero.
For most projects the decision rule can be stated as follows:
"Accept project if IRR > cost of capital"
One interpretation of this rule is to see the IRR as a project "return" - similar to an accounting
rate of return but incorporating factors such as the time value of money.
However, there are a number of problems with the standard IRR calculation and its interpretation
that can be resolved by calculating the modified internal rate of return (MIRR)

Problems with the standard IRR

The decision rule
For conventional projects (those with a cash outflow at time 0 followed by inflows over the life
of the project), the decision rule states that projects should be accepted if the IRR exceeds the
cost of capital.
However unconventional projects with different cash flow patterns may have no IRR, more than
one IRR, or a single IRR but the project should only be accepted if the cost of capital is greater.
Assumptions
The IRR calculates the discount rate that would cause the project to break-even assuming it:

is the cost of financing the project

is the return that can be earned on all the returns earned by the project.

Since, in practice, these rates are likely to be different, the IRR is unreliable
Choosing between mutually exclusive projects
If choosing between mutually exclusive projects one might believe that picking the one with the
higher IRR would be optimal since this gives the greatest "return".

However, a project with a high IRR is not necessarily the one offering the highest return in NPV
terms at the company's cost of capital and IRR is therefore an unreliable tool for choosing
between mutually exclusive projects.
Modified IRR
This measure has been developed to counter the above problems since it:

is unique

can deal with different borrowing and reinvestment rates

is a simple percentage.

It is therefore more popular with non-financially minded managers, as a simple rule can be
applied:

The interpretation of MIRR

MIRR measures the economic yield of the investment under the assumption that any cash
surpluses are reinvested at the firm's current cost of capital.
Although MIRR, like IRR, cannot replace net present value as the principle evaluation technique
it does give a measure of the maximum cost of finance that the firm could sustain and allow the
project to remain worthwhile. For this reason it gives a useful insight into the margin of error, or
room for negotiation, when considering the financing of particular investment projects.
Calculating the MIRR
Method 1
(1) Find the terminal value of the cash inflows (or "return phase") from the project if invested at
the company's reinvestment rate.
(2) Find the present value of the cash outflows (or "investment phase"), discounted at the
company's cost of finance.
(3) The MIRR is then found by taking the nth root of (TV inflows / PV outflows) and subtracting
1(Note that n is the length of the project in years.)
Method 2

To avoid having to calculate the terminal value of the project inflows, there is an alternative way
of computing MIRR which only uses present value calculations. This approach is only valid if
the cost of capital and reinvestment rate are the same.
1 + MIRR = (1+re) [PVR/PVI]1/n
where
PVR = the present value of the "return phase" of the project
PVI = the present value of the "investment phase" of the project
re = the firm's cost of capital

Modified Internal Rate of Return

Modified internal rate of return (MIRR) is an improved version of the internal rate of return
(IRR) approach to capital budgeting decisions. It does not require the assumption that the project
cash flows are reinvested at the IRR; rather, it factors in a discrete reinvestment rate into the
model.
Decision rule: projects with MIRR greater the project's hurdle rate should be accepted; while in
case of mutually exclusive projects, the project with higher MIRR should be preferred.
Formula
There is built in function in Microsoft Exel which can be used to calculate the MIRR:
MIRR = MIRR(values, finance_rate, reinvest_rate)
Values represent the array of the project's cash flows, finance_rate is the relevant cost of capital,
and reinvest_rate is the rate of return at which the project's cash flows are expected to be
reinvested.
The manual approach to calculation of MIRR involves finding the sum of terminal values of all
the net cash flows (other than initial investment) and then using the following equation to solve
for MIRR:
MIRRnSum of Terminal Cash FlowsInitial Investment1MIRR=Sum of Terminal Cash
FlowsInitial Investmentn-1
Where n is the number of periods.
Example
You are an assistant to Gkhan Erdogan, the corporate finance director at BTC, a Turkish civil
engineering firm. Two of the company's recent bids are accepted. The first relates to construction
of a new airport in Izmir. The second relates to construction of a motorway connecting Izmir

with Ankara, the capital. Both the projects are expected to take 3 years. The applicable finance
rate is 10% and the project's cash flows in Turkish Lira are given below:
Year
0
1
2
3

Airport
(12,000,000)
6,000,000
8,000,000
4,000,000

Motorway
(18,000,000)
8,000,000
10,000,000
10,000,000

The company submitted bids for both projects because both had positive net present values.
Alev Toprak, the CEO, has asked Gkhan to recommend which project the company should
accept. Alev is a fan of the IRR approach. Gokhan, on the other hand, is worried about the
shortcomings of the IRR approach. He believes that the economy might slow down a little in
next few years and a lower reinvestment rate should be factored in. He asked you to calculate
MIRR for both the projects.
You double-check whenever and wherever possible: so you decided to calculate the MIRR using
the manual formula approach and then verify the results using MS Excel MIRR function.
Manual approach
The following table calculates the equivalent terminal cash flow for both projects:
Year
0
1
2
3

Year
0
1
2
3

Cash Flows
(12,000,000)
6,000,000
8,000,000
4,000,000

Cash Flows
(18,000,000)
8,000,000
10,000,000
10,000,000

Airport Project
FV Factor
Formula
1.16640
1.08000
1.00000

=(1+8%)^(3-1)
=(1+8%)^(3-2)
=(1+8%)^(3-3)

Motorway Project
FV Factor
Formula
1.16640
1.08000
1.00000

Terminal Value
6,998,400
8,640,000
4,000,000
19,638,400
Terminal Value

=(1+8%)^(3-1)
=(1+8%)^(3-2)
=(1+8%)^(3-3)

9,331,200
10,800,000
10,000,000
30,131,200
MIRRAirport319,638,40012,000,000117.84%MIRRAirport=19,638,40012,000,0003-1=17.84%
MIRRMotorway330,131,20018,000,000118.74%MIRRMotorway=30,131,20018,000,00031=18.74%
The motorway project should be preferred based on MIRR approach.
Microsoft Excel Function
MIRR function is used to calculate MIRR for both projects as shown in the spreadsheet below. It
uses finance rate of 10% and reinvestment rate of 8%.