In the world of investment, there has never been less room for risk. Investors need to use every tool at their disposal to ensure they are making wise investments that will provide the best returns. The modified internal rate of return (or MIRR) is just one of these tools – a financial measure used to help investors compare investments and make more informed decisions. As its name suggests, the MIRR is a modification of the internal rate of return (IRR) formula and aims to be a more reliable version of that measure.
Generally speaking, when making a capital investment, if a project’s MIRR is higher than the expected ROI then it’s a solid investment. If the inverse is true, then it’s not a good investment. When comparing potential investment projects, the project with the highest MIRR is the one you should consider the more attractive prospect.
How to calculate MIRR
There are three variables to take into account when calculating MIRR – the positive cash flows, the initial outlay, and the number of periods. The MIRR formula is as follows:
Positive cash flows x the cost of capital ÷ by the initial outlays x the financing cost.
It’s a tedious and complicated equation that, thankfully, can be automated in most financing software, including Microsoft Excel. So, if you want to know how to calculate MIRR, it’s really as simple as clicking the right button.
MIRR or IRR?
The IRR was always a flawed assumption that needed some course correction. MIRR represents that correction. The main problem of IRR is that it always assumes the positive cash flows will be reinvested at the same rate, whereas the MIRR formula takes the external rate of return into account, offering a far more reliable figure.
The IRR formula also frequently provides two solutions, creating a certain amount of ambiguity that is never welcomed by investors. MIRR, meanwhile, offers just one solution that is a more considered and realistic picture of the ROI on the project. It’s often lower than the IRR, of course, but would you not rather a lower figure that’s more realistic than a higher figure that’s overshooting the mark?
How to find MIRR
Let’s take an investment example. Say you have a £200,000 investment that you expect to generate revenue of £50,000 in the first year, £100,000 in the second year and then continues to increase by £50,000 every year up to the end of year 5. If the financing rate is 10%, the reinvestment rate is also 10% and the negative cash flow is £200,000 (as it’s just one lump sum investment in this case) then the MIRR will be 33.8% – a pretty sound investment.
The IRR for this scenario would be an inflated 48.6%, as it doesn’t take into account the reinvestment rate. This larger figure might look better on paper, but it could lead to unwise investment decisions as you’re essentially playing with money that you don’t have.
What is FMRR?
The financial management rate of return metric is generally used in real estate investment. It takes things a step further by taking into account the safe rate and the reinvestment rate of cash inflows and outflows.
Why is MIRR Useful?
MIRR is an incredibly powerful formula for helping investors choose between unequal investments. It also allows them to alter the assumed rate of reinvestment growth at every stage in an investment project. Of course, some might argue that there are some inherent limitations in the formula, such as the fact it requires you to use estimates and assumptions, but in that regard, there are no 100% definites in the investment world. If there were, surely everyone would be doing it?
We can help
If you’re interested in the possibilities and implications of MIRR and would like to find out more then get in touch with the financial experts at GoCardless. Visit our website today to find out how GOCardless can help you with ad hoc payments or recurring payments.