The modified internal rate of return (MIRR) calculates the return earned on an investment while taking into consideration that you may not be able to re-invest the money you earn at the same rate the investment provides. The weighted average cost of capital (WACC) is the weighted average of a firm's cost of debt and equity financing. Therefore, a firm's WACC is the minimum return it must earn on investments and represents the firm's minimum re-investment rate in the MIRR calculation.
MIRR = (FV of the cash inflows discounted at the WACC / PV of cash outflows discounted at the firm's financing cost for the project) (1/n) -1
Calculate the future value of the cash inflows by discounting them at the firm's WACC. For example, consider a project that will earn $50,000 in the first year, $100,000 in the second year, and $200,000 in the third year. If the firm's WACC is 10 percent, the value of these cash flows at the end of the third year would be calculated as follows:
FV = (50,000 x 1.132) + (100,000 x 1.13) + 200,000
FV = 376,845
Calculate the present value of the cash outflows discounted at the firms's cost of financing for the project. Consider that the project in the previous example would require cash outflows of $75,000 at the beginning of the project and another $75,000 in year 1. If the cost of financing the project is 11 percent, the present value of the cash outflows would be calculated as follows:
PV = 75,000 + 75,000/1.11
PV = 142,568
Solve for the MIRR using the FV from step 1 and the PV from step 2. Since the project in this example provided cash flows for three years, n is equal to three in the MIRR equation.
MIRR = (FV/PV)^(1/n) - 1
MIRR = (376,845/142,568) ^ (1/3) -1
MIRR = .3827
In this example the firm would accept this project because the MIRR exceeds the WACC.