MIRR (Modified Internal Rate of Return)
MIRR, short for Modified Internal Rate of Return, is a financial metric used to evaluate the profitability and performance of an investment, especially in the context of private equity. It is an improvement over the traditional Internal Rate of Return (IRR) method, addressing some of its shortcomings and providing a more accurate assessment of investment returns.
What is MIRR?
MIRR is a financial metric that takes into account both the cost of investment and the reinvestment of cash flows at a predetermined rate. Unlike the IRR, which assumes reinvestment at the original rate, MIRR assumes reinvestment at a rate consistent with the cost of capital or other relevant rates of return.
MIRR in private equity: Why is it relevant?
In private equity, MIRR is relevant due to its ability to consider the impact of reinvestment at a rate that better reflects the investment’s cost and expected returns. This makes it a more realistic and appropriate metric for evaluating the performance of private equity investments with their unique cash flow characteristics.
Why is MIRR calculated?
MIRR is calculated to provide a more accurate measure of investment performance by addressing the shortcomings of the traditional IRR method. It accounts for the fact that cash flows generated by an investment are typically reinvested at different rates than the original investment’s rate of return.
What MIRR Can Tell You
MIRR can provide valuable insights into an investment’s true rate of return, considering the cost of capital and reinvestment rates. It helps investors assess the attractiveness of an investment opportunity and make more informed decisions about allocating their capital.
How To Calculate MIRR?
Calculating MIRR involves the following steps:
- Identify and sum all cash inflows and outflows associated with the investment.
- Determine the rate at which future cash flows will be reinvested (usually the cost of capital).
- Use the MIRR formula to compute the modified internal rate of return.
MIRR Formula
The MIRR formula is as follows:
MIRR = (FV of positive cash flows / PV of initial investment)^(1/n) – 1
Where n is the number of periods, FV is the future value of cash inflows reinvested at the reinvestment rate, and PV is the present value of cash outflows.
2 Examples
Let’s consider two examples to illustrate MIRR calculations and compare them with traditional IRR results.
IRR vs MIRR – Which Is Better?
While both IRR and MIRR provide insights into investment returns, MIRR is generally considered better for evaluating investments with irregular cash flows and those that require different reinvestment rates.
Comparison Table: IRR vs MIRR
| Metric | IRR | MIRR |
|---|---|---|
| Assumption | Reinvestment at IRR | Reinvestment at cost of capital or other relevant rate |
| Advantage | Simple to calculate | Accounts for realistic reinvestment assumptions |
| Limitation | May overestimate returns | More complex calculation |
Limitations of Using MIRR
While MIRR addresses some of the limitations of IRR, it also has its own limitations. It assumes a constant reinvestment rate, which may not accurately reflect real-world scenarios.
Problems associated with the IRR
The IRR method can lead to unrealistic reinvestment rate assumptions, potentially overestimating investment returns. It does not consider the cost of capital or the actual reinvestment opportunities available.
Uses Of MIRR
MIRR is widely used in financial analysis and investment decision-making. It helps investors and analysts make better-informed choices by providing a more realistic measure of investment returns.
What is FMRR?
FMRR stands for “Fund-Level Modified Rate of Return.” It is an extension of MIRR, but instead of evaluating individual investment opportunities, FMRR calculates the overall rate of return for an entire private equity fund, taking into account multiple investments and cash flow streams.
