Following my last post on the flaws of IRR—resulting from the unrealistic assumption that cash inflows get reinvested in projects with identical IRRs, I decided to investigate a formula with which I had not been very familiar, the modified internal rate of return (MIRR). The MIRR overcomes the reinvestment assumption of IRR and serves as a much better metric for ranking projects.

While more complex as a formula, MIRR is not difficult to work with once the concepts are understood. Besides, Excel can do the hard work of crunching the numbers: see http://office.microsoft.com/en-us/excel-help/mirr-HP005209180.aspx and http://www.techonthenet.com/excel/formulas/mirr.php.

The MIRR formula starts by calculating the future value (value in the final period) of all cash inflows generated by the project using the organization’s reinvestment rate, a weighted average of return rates on projects. (This reinvestment rate could be calculated based on historical rates or the rates of recently approved projects.)

The future value of cash inflows is divided by the present value (value at project start) of all project cash outflows discounted by the finance rate, a rate that represents the cost of capital for the organization.

The n in the formula represents the number of periods.

The cons of MIRR are that it requires two inputs not required by IRR: the reinvestment rate and the finance rate. But the result is far more meaningful. It allows comparisons among projects with widely different patterns of cash flows.

This is not to say that organizations should use MIRR as a sole metric for project selection. It still might make more sense to pursue a smaller number of projects with larger Net Present Values (NPV) that many smaller projects with larger MIRRs.

For some reason, IRR is used far more often in project selection than MIRR. Does your organization use IRR or MIRR and why?

Other posts in series: MIRR, IRR, Break-Even Analysis, NPV, ROI

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