Determining whether potential gains outweigh possible losses is critical to any type of investment. “What is the internal rate of return?” is a common question asked when evaluating such investment decisions. Numerous entrepreneurs throughout the world find it difficult to make decisions about differing opportunities and projects. For example, it is reasonable to wonder whether purchasing a new piece of equipment is more advantageous than a cash deposit at the bank.
Financial tools are designed to answer these types of questions. The Internal Rate of Return (IRR) and the Modified Internal Rate of Return (MIRR) are two of the more significant tools.
These metrics are commonly used in business decision-making and are a core part of business analytics.
This is an IRR guide designed for novices, in particular, for investors. And it also considers the possibility that, in certain situations, opting for MIRR may make more sense.
So, What is the Internal Rate of Return (IRR)?
Let’s consider IRR a gauge for the profitability of an investment. It gives you the expected annual rate of growth an investment will produce. More specifically, IRR is the rate of interest (or discount rate) that results in the net present value (NPV) of all the cash flows for a given project being equal to zero.
Let’s break that down a bit. Let’s say you invested today. Over the following years, that investment should hopefully produce (cash) returns for you. The IRR is that one rate for a series of future cash flows that tells you the return it’s generating vis-a-vis your cash outlay.
Investments are generally considered worthwhile if their IRR is greater than the company’s cost of capital (cost of debt or return investors expect). If the IRR is lower, the investment is questionable.
These return metrics often guide capital allocation decisions within a broader business growth plan.
Why Do People Use IRR?
Analysts rely on IRR due to several factors.
- It’s a Simple Percentage: IRR breaks large, complicated endeavors down to a single percentage. Financial analysts can easily compare different investments. A project with a 20% IRR is clearly superior to one with a 15% IRR.
- It Values Money Correctly: A dollar today is worth more than a dollar next year. IRR discounts future cash outflows so you can describe your return better.
- It is versatile: you can use the IRR calculation for virtually any investment opportunity, including purchasing a new factory, investing in a technology startup, or assessing a stock buyback program.
The Big Problem with IRR’s Assumption
The IRR calculation assumes that all of the cash flows the project produces can be reinvested at the same rate that the project produces the cash flows. In other words, all of the cash flows can be reinvested at the IRR.
Suppose that after analyzing a project, you determine the project will yield an IRR of 30 percent. This is spectacular! However, the way the IRR is computed assumes that the cash flows coming in during the first couple of years can be reinvested at 30 percent. In the real world, you will have a hard time finding anything that will pay you 30 percent. You will probably have to settle for a money market or a bond fund that yields 5 or 10 percent.
It falsely provides a way of looking at things that is not in line with reality. It can make the project appear to be more financially viable than it really is. It can lead to suboptimal financial decisions.
MIRR: A More Realistic View of Returns
For instance, the Modified Internal Rate of Return (MIRR) has practical applications in project management, as it solves one of the major problems with IRR.
MIRR uses two different rates. Firstly, it considers that all project-related borrowings will be at the firm’s financing rate. Secondly, and more importantly, it considers that all positive cash flows from the project will be reinvested at a more reasonable rate. This rate could be the firm’s cost of capital or a safe rate, such as a high-yield savings account.
MIRR gives a more realistic and conservative estimate of a project’s cash inflows.
Key Differences: IRR vs. MIRR
1. The Reinvestment Rate
- IRR: Cash flows are assumed to be reinvested at the project’s own IRR. This may be considered an unrealistic rate, as it is too high.
- MIRR: Cash flows are assumed to be reinvested at a more reasonable rate (for instance, the company’s cost of capital).
2. Accuracy and Realism
- IRR: Overly optimistic and may not reflect the realistic potential return of a long-term project.
- MIRR: More realistic and provides a more accurate forecast on the return of the investment.
3. The Problem of Multiple Answers
- IRR: With unconventional cash flows, such as negative cash flows mid-project, the IRR formula can be confusing, as it can produce more than one answer.
- MIRR: Provides one clear answer every time.
A Practical Example for US Investors
To deeply understand what is the internal rate of revenue is, we will figure it out through an example. Let’s assume you own a small manufacturing company located in Texas. You are considering purchasing a new machine for $100,000.
Analysis with IRR:
After completing the calculations, you realize the project has an IRR of 22%. You have stated that your cost to borrow money is 8%. Therefore, the project appears to be a big win. You could be extremely confident about making this investment.
Analysis with MIRR:
You decide to look into this more deeply with MIRR. You understand that profits resulting from the new machine are likely to be reinvested at a 10% return (the average return on capital for your company). When calculating MIRR at a 10% reinvestment rate, the answer is 15%.
The project remains a favorable investment, since 15% is well above your 8% cost of capital. Nonetheless, the MIRR offers you a more realistic point of view. The project is good, but the 22% IRR suggests that it is more than it actually is. This allows you to adjust your expectations and make a better decision.
When to Use IRR vs. MIRR
Does this mean you should stop using IRR? No. It is still useful as a basic screening mechanism.
Use IRR when:
- You need a basic, preliminary assessment of the possible profitability of a project.
- You are considering a few very short-term and homogeneous projects.
- You are in a case where the reinvestment rate is expected to be around the IRR.
Use MIRR when:
- You are making a major, final investment decision.
- You are evaluating multi-year projects.
- You are dealing with unconventional cash flows (both inflows and outflows).
- You need to present a more conservative and more defensible case to your business partners or to your financiers.
Thinking Beyond the Formula
Use IRR and MIRR to inform your decision, not substitute it. If a project shows a favorable MIRR but seems to carry too much risk, you are right to be concerned. Good business decisions are always a combination of solid information and good risk assessment.
Frequently Asked Questions (FAQs)
1. Is a greater IRR always positive?
A greater IRR is usually positive, but a high IRR sometimes raises a caution flag because the forecast may be too aggressive, or the reinvestment rate is a flawed assumption distorting the measure.
2. Why is the MIRR value usually less than the IRR?
MIRR is more realistic because it assumes that profits could be reinvested at the company’s cost of capital, which is usually lower than the project’s IRR. Therefore, MIRR is a lower value.
3. Do I need specific software to perform IRR and MIRR calculations?
Although you could calculate by hand, the problem is that it is extremely laborious. Spreadsheet applications like Excel or Google Sheets have built-in functions that do the calculations very easily.
4. Could I apply these metrics to personal finance, such as a rental property?
Yes, indeed. You can apply the IRR and MIRR metrics to a rental property, assuming you have the purchase price, rental income, and expenses to assess the annual potential return.
