Full 46.1 - Royal Institution of Surveyors Malaysia

THE MALAYSIAN SURVEYOR | Vol.46 | No.1 | 2011
INTERNAL RATE OF RETURN:
UNDERSTANDING THE
DIFFERENCE BETWEEN
IRR, MIRR AND FMRR
James Kobzeff
Internal rate of return (IRR), modified internal rate of return (MIRR), and financial
management rate of return (FMRR) are three returns used to measure the profitability
of investment property. Each method arrives at a percentage rate based upon an initial
investment amount and future cash flows, and in each case (of course) the higher the
better, but the procedure for making the calculation varies significantly as do the results.
By definition, internal rate of return is
the discount rate at which the present value of
all future cash flows is exactly equal to the initial
capital investment. To make the calculation,
negative cash flows are discounted at the same rate (i.e.,
the IRR) as positive cash flows.
Let’s consider the following investment with the initial
investment as CF0 (always a negative number because it
is cash outflow) and subsequent cash flows as CF1, CF2,
etc., with some negative and some positive.
CF0 -10,000
CF1 -100,000
CF2 50,000
CF3 -60,000
CF4 50,000
CF5 249,300
IRR = 30%
Seems all well and good, but the problem here is that the
calculation assumes that the cash generated during an
investment will be reinvested at the rate calculated by the
IRR, which may be unrealistically high and therefore will
overstate the return on initial investment. Likewise, since
negative cash flows are also discounted at the IRR, if that
rate is fairly high, the investor might not accurately
estimate the cash required to meet those future negative
cash flows.
To deal with this shortcoming many real estate analysts
use a method known as MIRR (i.e., modified internal rate
of return). In this approach, the assumption is that
positive cash flows the investment generates during its
life can be reinvested and earns interest at a
“reinvestment rate”, and negative cash flows must be
financed at a “finance rate” during the life of the
investment. In other words, rather than simply using one
rate (i.e., IRR) to deal with both negative and positive
cash flows, MIRR introduces the option to use two
different rates.
By applying a finance rate of 5% and a reinvestment rate
of 10% here’s the result using the same investment
criteria as we did earlier.
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