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Modified internal rate of return (MIRR) is used to assess the cost and profitability of a future project for a company. Unlike the standard internal rate of return (IRR), MIRR assumes that positive cashflows are reinvested at the cost of capital, and that cash outlays are funded at the current financing cost.

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MIRR adjusts for differences in the perceived reinvestment rates of positive cashflows (the money a company receives) and cash outflows (the money a company spends) derived from the net present value (NPV) of the project. For reference, NPV is defined as the difference between the present value of cash inflows and the present value of cash outflows over time.

If the NPV is zero – as is the case in an IRR calculation – it will likely result in an overly-optimistic forecast of the profitability of a future project.

The MIRR formula is complex and few traders calculate it without the use of computer software. To calculate MIRR manually, you will need to know the future value of a company’s positive cash flows discounted at the current reinvestment rate, as well as the present value of a firm’s negative cash flows discounted at the financing cost.

The future value and present value are represented by FV and PV in the formula below:

Where:

FV = the future value (at the end of the last period)

PV = the present value (at the beginning of the first period)

n = number of equal periods in which the cash flows occur (not the number of cash flows)

MIRR tells a trader what that company’s stock price might do in the future, so it is used as part of a trader’s fundamental analysis. If the project is expected to produce a profit, traders might rally on this news and buy into a company’s stock. Conversely, if the profitability estimate is conservative or has been overestimated, then traders might take short positions on the expectation that the company’s stock value will fall.

The IRR is a discount rate which is used in capital budgeting to calculate an investment’s profitability. Because it makes the NPV of all cash flows from a project or investment equal to zero, IRR can overestimate profitability.

MIRR compensates for this by accounting for any differences in the assumed reinvestment rates of the positive cashflows and the financing cost of the cash outlays.

As a more accurate indicator of the profitability of a future project, MIRR can be used by traders to assess whether or not any predictions made by IRR are overly optimistic.

MIRR resolves an inherent problem of the IRR calculation as it assumes that all cashflows are reinvested at the reinvestment rate, which is more accurate than cashflows being reinvested at the IRR.

A limitation of MIRR is that a trader will need to work from an estimate of the cost of capital in order to make a decision.

MIRR is also a difficult concept for those without a financial background to grasp, and there is dispute over the theoretical background for the MIRR calculation within academic circles. However, MIRR is often thought to be more accurate than IRR and other similar calculations.

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