Internal Rate of Return (IRR) for an investment plan is the rate that corresponds the present value of anticipated cash inflows with the initial cash outflows. On the other hand, Modified Internal Rate of Return, or MIRR is the actual IRR, wherein the reinvestment rate does not correspond to the IRR.
Every business makes a long-term investment, on various projects with the aim of reaping benefits in future years. Out of various plan, the business has to choose one that generates the best outcome, and returns are also as per investors needs. In this way, capital budgeting is used which is a process of estimating and selecting long-term investment projects which are in alignment with the basic objective of investors, i.e. value maximization.
IRR and MIRR are two capital budgeting techniques that measure the investment attractiveness. These are commonly confused, but there is a fine line of difference between them, which is presented in the article below.
Content: IRR Vs MIRR
|Basis for Comparison||IRR||MIRR|
|Meaning||IRR is a method of computing the rate of return considering internal factors, i.e. excluding cost of capital and inflation.||MIRR is a capital budgeting technique, that calculate rate of return using cost of capital and is used to rank various investments of equal size.|
|What is it?||It is the rate at which NPV is equal to zero.||It is the rate at which NPV of terminal inflows is equal to the outflow, i.e. investment.|
|Assumption||Project cash flows are reinvested at the project's own IRR.||Project cash flows are reinvested at the cost of capital.|
Definition of IRR
The internal rate of return, or otherwise known as IRR, is the discount rate that brings about equality between the present value of expected cash flows and initial capital outlay. It is based on the assumption that interim cash flows are at a rate, similar to the project which generated it. At IRR, the net present value of the cash flows is equal to zero and profitability index is equal to one.
Under this method, discounted cash flow technique is followed, which considers the time value of money. It is a tool used in capital budgeting that determines the cost and profitability of the project. It is used to ascertain the viability of the project and is a primary guiding factor to investors and financial institutions.
Trial and Error method is used to determine the internal rate of return. It is mainly used to evaluate the investment proposal, wherein a comparison is made between IRR and cut off rate. When IRR is greater than the cut-off rate, the proposal is accepted, whereas, when IRR is lower than the cut-off rate, the proposal is rejected.
Definition of MIRR
MIRR expands to Modified Internal Rate of Return, is the rate that equalizes the present value of final cash inflows to the initial (zeroth year) cash outflow. It is nothing but an improvement over the conventional IRR and overcomes various deficiencies such as multiple IRR is eliminated and addresses reinvestment rate issue and generates outcomes, which are in reconciliation with net present value method.
In this technique, interim cash flows, i.e. all cash flows except the initial one, are brought to the terminal value with the help of an appropriate rate of return (typically cost of capital). It amounts to a specific stream of cash inflow in the last year.
In MIRR, the investment proposal is accepted, if the MIRR is greater than the required rate of return, i.e. the cut-off rate and rejected if the rate is lower than the cut-off rate.
Key Differences Between IRR and MIRR
The points given below are substantial so far as the difference between IRR and MIRR is concerned:
- Internal Rate of Return or IRR implies a method of reckoning the discount rate considering internal factors, i.e. excluding the cost of capital and inflation. On the other hand, MIRR alludes to the method of capital budgeting, which calculates the rate of return taking into account cost of capital. It is used to rank various investments of the same size.
- The internal rate of return is an interest rate at which NPV is equal to zero. Conversely, MIRR is the rate of return at which NPV of terminal inflows is equal to the outflow, i.e. investment.
- IRR is based on the principle that interim cash flows are reinvested at the project’s IRR. Unlike, under MIRR, cash flows apart from initial cash flows are reinvested at firm’s rate of return.
- The accuracy of MIRR is more than IRR, as MIRR measures the true rate of return.
The decision criterion of both the capital budgeting methods is same, but MIRR delineates better profit as compared to the IRR, because of two major reasons, i.e. firstly, reinvestment of the cash flows at the cost of capital is practically possible, and secondly, multiple rates of return don’t exist in the case of MIRR. Therefore, MIRR is better regarding measurement of the true rate of return.
Olufemi Omotayo says
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