Introduction

The Modified Internal Rate of Return (MIRR) is a financial metric used to evaluate and compare investments with different cash flow structures. It is an extension of the traditional Internal Rate of Return (IRR) that overcomes certain limitations associated with the IRR, such as its inability to account for different borrowing and reinvestment rates. In this article, we’ll walk you through the steps to calculate MIRR for an investment project.

Step 1: Understand MIRR and Its Components

Before jumping into calculating MIRR, it’s essential to understand what it entails and its key components:

1. Cash Flows: Like IRR, MIRR uses the series of cash flows from an investment, including initial investment, periodic cash inflows, and outflows.

2. Financing Rate: The financing rate represents the cost of borrowing funds for an investment project.

3. Reinvestment Rate: The reinvestment rate is the return achieved by reinvesting interim cash flows generated by the investment project.

Step 2: Organize Cash Flow Data

Create a table that lists all cash inflows and outflows for each period of the investment time horizon. Make sure to include both positive and negative cash flows at their respective periods.

Step 3: Apply the Financing Rate

If there are negative cash flows throughout the investment period (such as additional investments like follow-up funding), apply the financing rate to these amounts. Calculate the present value (PV) of these negative cash flows by dividing them by (1 + financing rate) raised to the power of their respective periods.

Step 4: Apply the Reinvestment Rate

For any positive interim cash flows (excluding initial outlay), apply the reinvestment rate to calculate their future values (FV). Multiply each positive cash flow by (1 + reinvestment rate) raised to the power of (n – t), where ‘n’ is the last period of investment and ‘t’ represents the cash flow period.

Step 5: Calculate Terminal Value

Sum the future value (FV) of all positive interim cash flows. Similarly, add the present value (PV) of all negative cash flows and initial investment. This will give you the terminal value which is the net future value of all cash flows.

Step 6: Calculate MIRR

Finally, use the following formula to calculate MIRR:

MIRR = (Terminal Value / Initial Investment) ^ (1 / n) – 1

Using this formula, you can estimate the Modified Internal Rate of Return for a given investment project, which takes into account both financing and reinvestment rates.

Conclusion

The MIRR is a useful metric for evaluating investments with different cash flow structures and addresses some drawbacks of traditional IRR. By following these steps, you can effectively calculate MIRR and make informed decisions on your investment projects. Keep in mind, however, that like any financial metric, MIRR also has its limitations and should be used in conjunction with other metrics for a comprehensive analysis of an investment’s viability.