If you’re just starting out within project management, there may be a few things that you may not know or even understand. Valuation methods, for instance, are used to measure the profitability of certain projects that you’re company will complete for or come up with. This is called capital budgeting or investment appraisal.
There are several types of methods that help in outlining and detailing whether an investment for a company, whether it be new machinery or taking on a scalable project, is worth doing or purchasing.
Two of these methods are the Internal Rate of Return (IRR) and a Modified Internal Rate of Return (MIRR).
Internal Rate of Return/Modified Internal Rate of Return
The Internal Rate of Return, or IRR, is a measure of an investment that takes into account internal factors, but does not measure interest rates or inflation. It is used to indicate efficiently, quality, and/or the yield of an investment. This is important to a company or business’ investors and owners as they use this to measure whether an investment will be greater than the actual cost or capital that they will put into a project.
The Modified Internal Rate of Return, or MIRR, is just as the name implies - it is a modified type of method that covers the limitations of
the IRR. While the same steps are taken, the MIRR goes a step further by examining the reinvestment of positive cash flows that a company does with the money it receives. This allows for a more accurate account of the budget that a project would bring to a company’s investors and owners.
IRR v. MIRR Valuation Methods
Determining the IRR involves a few mathematical equations in order to see what a projected outcome for say a year would be. The equation for determining IRR is -
(Future value)/(1 + interest rate)^n
The future value would be the amount of profit that a company or business would receive based on the investment and the exponential of ‘n’ represents the number of years or length of time that is projected for the value of the project or item.
The IRR is a very popular method in determining capitol budgeting that is used by many businesses; however, it also has many flaws that skew a company’s projected numbers. The biggest problem is that it does not take into account the risk factors or other costs that could come from a company’s return. This is where the MIRR comes in.
What MIRR does is fill in the limitations that come from the IRR. As seen in the picture above, the calculation for the MIRR combines both future value and that of the present value, allowing for finance rates and money flowing out of the business.
In terms of IRR v. MIRR valuation methods, MIRR is the better choice as it gives a much clearer view on what a company stands to either gain or lose in terms of an upcoming project or purchase. The IRR is more of an optimistic view of returns, while the MIRR is a realistic view. This does not mean that the IRR is obsolete or it cannot be used. In fact, using both in conjecture with a project could be beneficial, as long as you compare and contrast both results.
Image content @ Wikipedia.org