Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR) is a financial metric used to measure the profitability of an investment. Think of it as the smarter, more worldly cousin of the standard Internal Rate of Return (IRR). The classic IRR calculation has a rather optimistic flaw: it assumes that all the cash profits you receive from a project can be reinvested at the very same high rate of return. If a project has an IRR of 25%, the formula assumes you have a magic pipeline of other 25%-return projects waiting for your cash. MIRR corrects this by allowing you to use a more realistic 'reinvestment rate' for these cash flows—often the company's cost of capital or a safe market rate. It also assumes that any money spent to fund the project is borrowed at the company's 'financing rate'. This provides a much more sober and accurate picture of a project's potential return, making it a favorite tool for savvy investors who prefer realistic expectations over hopeful fantasies.

The regular Internal Rate of Return (IRR) is a popular metric, but it comes with some serious baggage that can lead investors astray. Its biggest sin is the reinvestment rate assumption. Imagine you hit a home run with an investment that yields a 30% IRR. The IRR formula automatically assumes you can take every dividend and cash payout from that investment and immediately reinvest it in another project that also yields 30%. In the real world, finding such consistently high-return opportunities is next to impossible. More likely, you'll reinvest that cash into the company's general operations, which earn a return closer to its Weighted Average Cost of Capital (WACC), or maybe even just a low-risk government bond. This rosy assumption can artificially inflate the attractiveness of projects, especially those with large cash flows early on. Furthermore, for projects with unconventional cash flow patterns (e.g., an initial investment, positive cash flows, then a large negative cash flow for decommissioning costs), the IRR can produce multiple conflicting answers or no answer at all. MIRR elegantly solves both these problems, providing a single, reliable rate that reflects a more plausible reality.

You don't need a PhD in math to grasp how MIRR works. It's a three-step dance that turns messy, multi-year cash flows into a single, understandable percentage.

First, MIRR takes all the cash you pay out for the project (the initial investment and any subsequent costs) and discounts them back to today's value (Year 0). It uses a 'financing rate' for this, which is basically the interest rate the company pays on the money it borrows to fund the project. This gives you one single number representing the total cost in today's money.

Next, MIRR takes all the cash you receive from the project (the positive cash flows) and compounds them forward to the very end of the project's life. Instead of using the pie-in-the-sky IRR, it uses a sensible 'reinvestment rate'. This is the star of the show! As an investor, you can plug in a conservative, realistic rate—like the company's cost of capital or even the return on a safe index fund. This gives you one single number representing the total cash you'll have in hand at the end.

With just two numbers—the total cost today and the total payoff in the future—calculating the return is simple. The MIRR is the single annual growth rate that turns your initial cost into that final future sum. It answers the clean, simple question: “What annual return did I earn on my investment, assuming a realistic growth rate for my profits?”

For a value investing enthusiast, MIRR is a breath of fresh air. It aligns perfectly with the core tenets of prudence and conservatism.

  • A Built-in Margin of Safety: By forcing you to choose a realistic reinvestment rate, MIRR encourages a conservative approach. You're not just hoping for the best; you're planning for a more probable reality. This builds a margin of safety directly into your return calculation. If a project still looks good using a conservative MIRR, you can have much more confidence in its quality.
  • Better Project Rankings: While Net Present Value (NPV) is often hailed as the king for deciding if a project is worthwhile (a positive NPV is good), it can be tricky for comparing projects of different sizes. IRR is often used for this ranking, but its flaws can be misleading. MIRR provides a much better “apples-to-apples” comparison.
  1. Example:
    1. Project A has a high IRR of 30% but generates cash early.
    2. Project B has a lower IRR of 25% but generates cash later.
  2. The IRR for Project A looks better because it assumes that early cash can be reinvested at a whopping 30%. But what if you can only reinvest it at 8% (your WACC)? The MIRR for Project A might drop to 18%. Meanwhile, Project B's MIRR might only fall to 20%. Suddenly, Project B is revealed as the superior long-term wealth creator. MIRR helps you see beyond the flashy IRR headline to the more durable truth underneath.