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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
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CORPORATE FINANCE
ACCOUNTING
Modified Internal Rate of Return (MIRR)
vs. Regular Internal Rate of Return (IRR)
By SEAN ROSS Updated October 03, 2024
Reviewed by MELODY BELL
Fact checked by DAVID RUBIN
Understanding the rate of return on an investment.
Modified Internal Rate of Return (MIRR) vs. Regular Internal
Rate of Return (IRR): An Overview
Business managers often consider a potential project's internal rate of return
(IRR). This metric is an estimate of the potential annual profit of the project
after its costs. It is commonly used by business and project managers as well as
government agencies to select projects. [1]
IRR tends to overstate the potential profitability of a project and can lead to
capital budgeting mistakes based on an overly optimistic estimate. A variation
of this metric, called the modified internal rate of return (MIRR), compensates
for this flaw and gives managers more control over the assumed reinvestment
rate from future cash flows. Let's compare the two and understand how these
two approaches differ.
Cite
KEY TAKEAWAYS
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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
The standard internal rate of return calculation is widely used to
determine an expected profitability rate for a project.
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IRR calculations may overstate the potential future value of a project as
it may use unrealistic discount rates for all cash flows.
The modified internal rate of return may avoid distorting the cost of
reinvested growth between project stages.
MIRR allows for adjusting the assumed rate of reinvested growth for
different stages of a project.
MIRR can also only return one answer, while IRR may be harder to
analyze when reporting multiple valid calculations for an irregular set
of cash flows.
What Is Internal Rate of Return?
Internal Rate of Return (IRR)
The internal rate of return is often used to analyze cash flow over time. It is
calculated by summing the present value of each cash flow over the life of a
project. The calculation often has an initial cash outlay (the initial investment)
along with subsequent annual cash inflows (resulting in revenue generated
from the initial investment).
The discount rate used to find the present value of the cash flows is set so the
net present value of the series is equal to 0. This discount rate is the IRR; it is the
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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
required investment return rate to break even on a project when considering
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the timing of the cash flow of a project. In general, projects with higher IRRs are
favorable than projects with lower IRRs, as the expected rate of return on
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these projects is greater.
IRR is often used to compare different options or choose between projects. For
example, a company that is considering expanding into a new product line
might compare the IRR if it accomplishes that expansion by building a new
factory, buying a competitor, or importing the products. All else being equal,
the option with the highest IRR is the most favorable.
The Drawback to IRR
There are several disadvantages when using IRR. First, IRR does not give you the
return on investment (ROI) in a dollar figure. A project may yield an IRR of 10%,
but you won't know if the project will generate a cash flow of $10,000 or $10
million. For this reason, larger projects with lower yields but higher net cash
proceeds may be at an analytical disadvantage when using IRR.
IRR does not consider differences in the duration of projects. Imagine a oneyear project with an IRR of 10% and a five-year project with an IRR of 8%. While
the one-year project is more favorable because of its higher IRR, the company
may want to consider a longer-term project that will yield a return over a longer
period.
IRR calculations also assume all cash flow will be reinvested at the same rate
over the term of the entire project. This means the initial cash outlay and
subsequent cash inlays will have the same earning potential, even if these cash
flows span years.
Last, a series of cash flows may end up having two valid IRR calculations. This
problem arises when a project has non-normal cash flow over its life and
generally occurs when the direction of cash flow changes. When this occurs, a
project has more than one internal rate of return and may be more difficult to
analyze.
Modified Internal Rate of Return (MIRR)
To fix the last two issues above related to IRR, a different calculation was
created. The MIRR uses a lot of similar concepts as IRR, but there are slight
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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
differences to help improve the original formula. The MIRR is calculated by
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incorporating the future value of positive cash flows and the present value of
flows taken at different discount rates.
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Similar to IRR, MIRR is used to analyze the profitability of a project. MIRR is
often compared to an internally required rate of return. If a project's MIRR is
higher than this expected return, a project is favorable; if a project's MIRR is
lower, it is often not recommended.
Tip: Both formulas can be difficult to manually calculate. Both can be
calculated in Excel using specific functions (=IRR and =MIRR). [2] [3]
Key Differences
There are several differences between IRR and MIRR, and these differences are
what make the general view that MIRR demonstrates a more realistic picture of
a project. These differences are discussed below.
They use different rates. IRR relies on a single reinvestment rate for all cash
flows. This may not be realistic, especially for projects with a lengthy span.
In addition, a company may have a different rate of return for cash inlays as
opposed to the cost of capital rates for cash outlays.
They consider inflation differently. Because IRR does not factor in the cost of
capital as part of its equation, IRR does not incorporate inflation. Meanwhile,
MIRR can reflect this cost.
They provide a different number of solutions. When a project has irregular
cash flow, it may return multiple IRR results. This makes analysis difficult, as
both percentages can be interpreted as the rate of return. Alternatively,
based on the format of the formula, MIRR will only generate one result. This
often means MIRR is easier to analyze.
They are defined differently. IRR is the discount rate at which the net present
value of a series of cash flows is equal to zero. Alternatively, MIRR is defined
at the ROR where the NPV of the project inflows is equal to the initial
investment. Though these definitions aren't widely different, they do vary as
they use different approaches to the discount rate(s) used.
They vary in accuracy. Because MIRR incorporates more information and
allows for more flexibility, it is often considered the more accurate and more
useful calculation.
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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
IRR
MIRR
Uses a single discount rate for all cash
flows
Uses different discount rate for different
types of cash flows
Does not incorporate a company's cost
of capital
Incorporates a company's cost of
capital
May return more than one result
depending on the sequence and
direction of cash flows
Will always return a single result
regardless of the sequence and
direction of cash flows
Not considered highly accurate
Considered to be highly accurate
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What Is Internal Rate of Return?
IRR is a capital budgeting technique used to calculate the profitability of a
project. It is calculated by finding the present value of a series of cash flows that
equals $0. This discount rate is often compared to a company's required rate of
return, and projects with higher IRR calculations are seen as more favorable.
How Is IRR Different than MIRR?
IRR and MIRR both analyze the cash flow of a project to determine its long-term
profitability rate. However, these two calculations are slightly different. MIRR
uses different discount rates and treats cash outlays differently than IRR. As
MIRR incorporates more information, it is often considered more accurate.
Is MIRR Better than IRR?
In general, MIRR is considered better than IRR. MIRR incorporates more
information and more accurately reflects expected rates of return around cash
outlays. MIRR also incorporates external costs like inflation due to the
incorporation of cost of capital. Because MIRR also only returns one calculated
figure, it is often considered easier to analyze as well. [4]
Why Is MIRR Different Than IRR?
MIRR has several differences to IRR. Most notably, MIRR incorporates different
rates in its calculation. While IRR uses only one expected rate of return for all
cash flows, MIRR incorporates both expected investment growth rates as well as
the cost of capital rates. Based on the setup of the formula, MIRR also only
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Modified Internal Rate of Return (MIRR) vs. Regular Internal Rate of Return (IRR)
yields one calculation every time, whereas IRR might return two results for a
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single project.
Does IRR and MIRR Tell You?
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Both IRR and MIRR result in a calculated percent. This percent represents the
profitability of a project through the analysis of project cash flows over the life
of the project. IRR and MIRR are often used to compare projects and select more
ideal endeavors. They are also used to test the overall profitability of a project.
The Bottom Line
There are different metrics that businesses can use to estimate the profitability
of a future project. These metrics allow business leaders to make more
informed decisions before committing to one. Two common forms of
measurement are the internal rate of return and the modified rate of return.
While both have their benefits, the IRR can be flawed. That's why using the
MIRR is often a better choice as it is a better representation of the rates of
returns when related to cash flows.
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