A modified internal rate of return is one way of assessing an asset. It allows investors to make comparisons between various investment opportunities on the basis of their expected returns. It is one of several measures that manipulate the same data in different ways. Others include the net present value and the internal rate of return. Analysts choose which measure to use based on their own beliefs about the accuracy and relevance of each.
The net present value of a project is the sum of the discounted values of the investment into the project and the payments that it generates. If this is positive, the project is profitable; if it is negative, the project costs more than it returns. The internal rate of return is the maximum discount rate at which the project will still be profitable. The modified internal rate of return has the same meaning, but it is calculated using a modified cash flow: all of the anticipated payments are added together and treated as a lump sum received during the last period.
The simplest way to calculate the modified internal rate of return is by using the formula MIRR = (Terminal Payment/Outlay)1/n - 1. The terminal payment is the sum of all of the undiscounted cash payments that are expected to come from the project. For this formula, there must be one lump investment into the project: the outlay.
If there are multiple periods of payment, the formula is given by MIRR = [(Present Value of Return Phase)/(Present Value of Investment Phase)]1/n * (1+i) – 1, where n is the number of periods and i is the discount rate. The investment phase consists of the periods during which the investor lays out funds. The return phase is the time over which he receives the proceeds of his investment. When calculating the modified internal rate of return, the return phase includes only a terminal payment.
The formulas for the modified internal rate of return yield answers in the form of percentages. Essentially, they set the net present value equal to zero and solve for the discount rate. Investors can observe the modified internal rate of return and compare it to the discount rate that they think is appropriate for the project. As long as the proposed discount rate is lower than the modified internal rate of return, the project will be profitable.
The modified internal rate of return is easier to calculate than the net present value or the internal rate of return, and some analysts prefer it for this reason. It is also less demanding than the internal rate of return, which assumes that all proceeds from a project are reinvested directly into the project. Relaxing this assumption reflects actual investment practices more accurately.