What is the modified internal rate of return (MIRR) and how is it calculated?

The modified internal rate of return (MIRR) is a financial metric used in capital budgeting to evaluate the profitability of an investment project. It addresses some of the limitations of the traditional internal rate of return (IRR) by considering both the reinvestment rate and the financing rate.

To calculate the MIRR, the following steps are typically followed:

1. Determine the cash inflows and outflows associated with the investment project over its lifespan. These cash flows should include the initial investment, any interim cash flows, and the final cash flow from the project's termination or sale.

2. Identify the reinvestment rate, which represents the rate of return that can be earned on the cash flows generated by the project during its lifespan. This rate is usually based on the cost of capital or the expected return on alternative investment opportunities.

3. Calculate the future value (FV) of all positive cash inflows using the reinvestment rate. This involves compounding the cash flows to their respective future values at the end of the project's lifespan.

4. Calculate the present value (PV) of all negative cash outflows using the financing rate. The financing rate represents the cost of capital or the rate of return required by the investors or the company.

5. Determine the terminal value (TV) of the project, which represents the future value of the final cash flow at the end of the project's lifespan.

6. Calculate the MIRR by finding the discount rate that equates the present value of the negative cash outflows (PV) with the future value of the positive cash inflows (FV) and the terminal value (TV). This is typically done using trial and error or by utilizing financial software or calculators.

The MIRR provides a more realistic measure of the project's profitability as it considers both the reinvestment rate and the financing rate. It helps decision-makers compare different investment projects and choose the one with the highest MIRR, indicating the highest potential return on investment.