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Financial Modeling – Calculating the Modified Rate of Return

by Jackson B
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An internal rate of return, also called minimum acceptable rate of return (MAPR), is an economic measurement used in investment analysis to compare the performance of different investments. Investors use internal rate of return to determine if an investment will meet their expectations. An example of an internally-rated product is a portfolio of stocks. One’s investments are gauged against an economic benchmark called the market index. The benchmark is updated periodically and investors must adjust their investments accordingly.

The term “Internal Rate of Return” (IRR) became very popular with respect to financial planning and retirement planning in the early 1980s. A key objective of IRR is to provide a standard of what an investor should invest his or her money in based on the expected performance of the chosen investments. The IRR formula was developed by Robert Kaplan and David Norton. These two professionals identified three factors that are necessary in order for any calculation to be valid: expected returns, risk-adjusted returns and a time-comparison value.

Expected Returns is expressed as a percentage over a certain period of time. Some individuals prefer to express this as the effect of compound interest on capital appreciation. It can also be expressed as a maximum and minimum achievable investment target. When these three values are entered into the calculation, the result is an Internal Rate of Return.

In the context of the definition of an IRR, the term “net present value” (NPV) is not used. Kaplan and Norton chose to describe it instead as the excess of current income over the initial cost of capital. Investing today with cash is much less expensive than investing with future capital. When the investment is made today with cash, the expected value of the lump sum is equal to the amount by which the present value of the initial cost exceeds the NPV of the investment at the end of the period of investment.

Risk-adjusted returns are those that are adjusted for risk-free assets. They are often calculated as a ratio of the current market price of a security to the amount of capital invested. All investments come with risk, so there is a measure of relative risk-adjusted return. This is a widely used concept in the world of finance and is widely used in Internal Rate Of Return calculations. Unfortunately, no single model or method exists to calculate the level or standard of return for all investments.

Time-comparison value is the term given to the comparison of the present value of money invested to the total cash inflows over a period of time. The comparison is usually expressed as a ratio. Expense ratio and reinvestment ratio are examples of this calculation. Internal Rate Of Return and Time Value are terms that are often interchanged and are used in the same analysis. For example, the internal rate of return on an equity portfolio is the rate at which an equity portfolio’s present value is equal to or exceeds the replacement rate minus the cost of capital at current market prices.

The modified internal rate of return, also called the MCR, is a financial modeling analyst’s most basic tool. Its purpose is to simulate the effect of changing rates of interest, dividends, capital gains, and other factors on the value of the portfolio. When determining whether to change the discount rate or credit rate, the financial analyst uses the modified internal rate of return to compare the new rate to the existing rates. As long as the comparison is satisfactory, the financial analyst will choose the appropriate discount rate or credit rate. However, the financial analyst must take care to ensure that the new rates and discount rates are not more favorable than the existing rates.

The modified internal rate of return MCR is calculated by dividing the annual income produced by the investment by the total amount of income needed to pay back a debt. The higher the annual income, the lower the annual cost of capital, and the lower the annual payback, the higher the modified internal rate of return will be. The financial modeling analyst should compare the present discounted value of the investment with the earlier discounted value in order to determine whether the present discounted value is greater than or equal to the earlier discounted value. If so, the financial analyst can conclude that the investment is making a profit, and therefore, the modified internal rate of return should be changed to keep the business profitable.

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