MIRR: How It Fixes IRR’s Reinvestment Rate Problem

The traditional Internal Rate of Return, often called IRR, is a popular tool for evaluating potential investments. Think of it as figuring out the percentage return you’d get on a project, much like calculating the interest rate on a loan or the return on a stock. It helps answer the crucial question: is this project a good use of our money?

However, the traditional IRR method has a hidden assumption that can sometimes lead to unrealistic results. This assumption is about what happens to the cash flows generated by the project after they come in. Imagine you invest in a new ice cream truck. It starts generating profits each summer. What does IRR assume you do with those profits?

The traditional IRR implicitly assumes that you can reinvest those incoming cash flows at the same rate as the IRR itself. Let’s say the IRR for your ice cream truck project is calculated to be a whopping 25 percent. The IRR calculation operates as if you can take every dollar of profit from the ice cream truck and immediately find another investment that also yields a 25 percent return. Year after year. This is the reinvestment rate assumption.

Now, think about the real world. Is it always possible to reinvest money at the same high rate of return as a successful project? Probably not. Finding consistently high-return investments is challenging. If your ice cream truck project truly generates a 25 percent IRR, it’s unlikely you’ll find another investment as easily accessible and equally profitable to reinvest those earnings at another 25 percent. You might have to settle for a more realistic reinvestment rate, perhaps closer to what your bank offers for savings or the average return on a less risky investment.

This is where the Modified Internal Rate of Return, or MIRR, comes into play. MIRR is designed to address this flaw in the traditional IRR. It acknowledges that reinvesting at the IRR itself is often an unrealistic assumption. Instead of assuming reinvestment at the IRR, MIRR allows you to specify a more realistic reinvestment rate. This rate is typically based on your company’s cost of capital, which represents the average return your company needs to earn on its investments to satisfy its investors, or perhaps a safe, readily achievable rate like a government bond yield.

To calculate MIRR, we take a slightly different approach. First, we consider all the cash outflows, the money you spend on the project. We bring these outflows back to their present value using a discount rate, usually the cost of capital. This is like figuring out the true cost of the investment in today’s dollars, considering the opportunity cost of using that money elsewhere.

Next, we look at all the cash inflows, the money the project brings in. We project these inflows forward to the end of the project’s life, but this time, we compound them using the specified reinvestment rate, not the IRR. Imagine you’re putting those ice cream truck profits into a savings account that earns a more realistic interest rate, say 5 percent. MIRR uses this 5 percent rate to grow those future cash flows.

Finally, MIRR is the discount rate that makes the present value of all the outflows equal to the present value of the future value of all the inflows. Essentially, it’s the effective return rate when you acknowledge that reinvestments will happen at a more realistic rate than the project’s own IRR.

By using a more realistic reinvestment rate, MIRR provides a more accurate picture of a project’s true profitability. It avoids the potentially inflated returns that the traditional IRR can sometimes suggest due to its optimistic reinvestment assumption. This makes MIRR a valuable tool for making sound investment decisions, especially when comparing projects with different risk profiles or when realistic reinvestment opportunities are limited. It gives a more grounded and dependable measure of return, helping businesses make wiser choices about where to allocate their resources.