IRR (Internal Rate of Return) is a breakeven point at which the NPV of the project equals to 0. While constructing the NPV profile of a project, it’s the point where the horizontal and vertical axis intersect (Martin, 1997). On the other hand, MIRR (Modified Internal Rate of Return) is also a similar concept but assumes that the cash flow the project generates over the time is actually reinvested at the cost of capital (Akpan, 1999). As most of the companies and startup do the same to amplify the rate of their growth, this is also considered to be more realistic compared to IRR.
Companies make use of IRR for various different reasons but one of it is that it makes the calculation of net return or profitability easier. As the rate of return is in percentage, the calculation and comparizations of the return (profit) along with the cost (expense) are easier to find. It makes the interpretation easier. Justifying this with an example, given a project has its cost of capital at 10% and IRR at 15%. From that, we can make out that the net return rate would be 5%. In any given case if the IRR is greater than the cost of capital the project is profitable. In the same scenario, if IRR was 5% instead of 15%, the project would have rather been at a 5% loss.
IRR is easy to calculate and even simpler for any stakeholder to understand. Given that I’ve no financial background before this, it wasn’t hard for me to grasp the concept and get on board. So, this easy to use feature added to it making easier to compare multiple projects in the selection process of a mutually exclusive project makes it more appealing. As the project with the highest IRR would be selected if there are two such projects and only one is to be selected. In case of selecting a project among mutually exclusive projects, let’s consider the company’s cost of capital to be 10%. Project A’s IRR value is 12% while project B’s IRR value is at 17%. So, this brings in the question, as both the project has IRR above the cost of capital, meaning both are to give a positive return to the business. In this case, the project with the highest IRR is to be selected, making the company in the decision making the stage of undertaking projects.
MIRR allows business to make changes to the stage by stage assumed rate of growth in a project. When a company makes an investment in a project, they make an investment to start the project (negative cash flow). As the project progresses over time, the company would start to make a return on the investment. This gives a positive cash flow to the business. When cash flow changes over the lifetime of the project within negative parameters or into the positive, one can observe multiple IRR for every change from positive to negative. The MIRR addresses this issue by accounting for both positive and negative cash flow separately (Mieila, 2017). Let’s take an example for this scenario, consider that a company makes an investment of NRs. 99,000 into a project, another company thought it would be interesting and funded NRs. 1,50,000 for the project. The main company again made an investment of NRs. 1,25,000 in the project. The project’s cash flow in this scenario moved from negative, positive and back to negative. The MIRR accounts for this change in cash flow while determining the return on investment. MIRR is also useful to a company in the decision making as it provides the company’s profit to be reinvested at a more realistic rate while also allowing the user to set the reinvestment rate. Companies can also make use of MIRR to compare projects with non-conventional cash flow methods to aid their decision making with regard to the selection of the project.
References
Akpan, E. (1999). A modified internal rate of return model for capital rationing in project selection. Production Planning & Control , 10 (8), 809-814.
Martin, R. (1997). Internal Rate Of Return Revisited. SSRN Electronic Journal , 1-3.
Mieila, M. (2017). Modified Internal Rate of Return. International Journal Of Sustainable Economies Management , 6 (4), 35-42.
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IRR (Internal Rate of Return) is a breakeven point at which the NPV of the project equals to 0. While constructing the NPV profile of a project, it’s the point where the horizontal and vertical axis intersect (Martin, 1997). On the other hand, MIRR (Modified Internal Rate of Return) is also a similar concept but assumes that the cash flow the project generates over the time is actually reinvested at the cost of capital (Akpan, 1999). As most of the companies and startup do the same to amplify the rate of their growth, this is also considered to be more realistic compared to IRR.
Companies make use of IRR for various different reasons but one of it is that it makes the calculation of net return or profitability easier. As the rate of return is in percentage, the calculation and comparizations of the return (profit) along with the cost (expense) are easier to find. It makes the interpretation easier. Justifying this with an example, given a project has its cost of capital at 10% and IRR at 15%. From that, we can make out that the net return rate would be 5%. In any given case if the IRR is greater than the cost of capital the project is profitable. In the same scenario, if IRR was 5% instead of 15%, the project would have rather been at a 5% loss.
IRR is easy to calculate and even simpler for any stakeholder to understand. Given that I’ve no financial background before this, it wasn’t hard for me to grasp the concept and get on board. So, this easy to use feature added to it making easier to compare multiple projects in the selection process of a mutually exclusive project makes it more appealing. As the project with the highest IRR would be selected if there are two such projects and only one is to be selected. In case of selecting a project among mutually exclusive projects, let’s consider the company’s cost of capital to be 10%. Project A’s IRR value is 12% while project B’s IRR value is at 17%. So, this brings in the question, as both the project has IRR above the cost of capital, meaning both are to give a positive return to the business. In this case, the project with the highest IRR is to be selected, making the company in the decision making the stage of undertaking projects.
MIRR allows business to make changes to the stage by stage assumed rate of growth in a project. When a company makes an investment in a project, they make an investment to start the project (negative cash flow). As the project progresses over time, the company would start to make a return on the investment. This gives a positive cash flow to the business. When cash flow changes over the lifetime of the project within negative parameters or into the positive, one can observe multiple IRR for every change from positive to negative. The MIRR addresses this issue by accounting for both positive and negative cash flow separately (Mieila, 2017). Let’s take an example for this scenario, consider that a company makes an investment of NRs. 99,000 into a project, another company thought it would be interesting and funded NRs. 1,50,000 for the project. The main company again made an investment of NRs. 1,25,000 in the project. The project’s cash flow in this scenario moved from negative, positive and back to negative. The MIRR accounts for this change in cash flow while determining the return on investment. MIRR is also useful to a company in the decision making as it provides the company’s profit to be reinvested at a more realistic rate while also allowing the user to set the reinvestment rate. Companies can also make use of MIRR to compare projects with non-conventional cash flow methods to aid their decision making with regard to the selection of the project.
References
Akpan, E. (1999). A modified internal rate of return model for capital rationing in project selection. Production Planning & Control , 10 (8), 809-814.
Martin, R. (1997). Internal Rate Of Return Revisited. SSRN Electronic Journal , 1-3.
Mieila, M. (2017). Modified Internal Rate of Return. International Journal Of Sustainable Economies Management , 6 (4), 35-42.