A method of analyzing discounted cash
flows in investment properties to arrive at
a rate of return. The FMRR was developed (as
was the modified internal rate of return),
in response to limitations involving the
internal rate of return (IRR ) calculation.
The IRR (while mathematically sound),
can lead to ambiguities if successive
positive and negative cash flows occur
within the investment period. Also, the IRR,
while effective in analyzing individual
properties based on investor expectations,
lacks the facility to analyze alternate
properties based on a pre-determined lump
sum available for investment as these
properties may have differing initial
investments and lengths of holding periods.
The FMRR was developed as a method to
effectively make such comparisons and
eliminate sign change problems (+ and –).
The approach involves four steps:
Adjustments:
Adjust future negative cash flows against
prior positive cash flows with appropriate
discounting as required.
Negative Cash Flows:
Discount remaining negative cash flows back
to Year 0 using an appropriate safe rate.
Positive Cash Flows:
Compound remaining positive cash flows
forward at an appropriate reinvestment rate.
Investment Disparities:
Adjust for initial investment and timing
disparities.
The FMRR applies the principle of
reinvestment and, therefore, considers
external factors in the analysis process. To
fully understand the use of FMRR, the reader
is directed to other references concerning
the internal rate of return (IRR) and the
modified internal rate of return (MIRR).
Considerable debate is associated with MIRR
and FMRR approaches. Critics are quick to
point out that the IRR is strictly an
internal rate of return and performs that
function correctly. Both the MIRR and FMRR,
they assert, introduce external factors and
more importantly inject the profitability of
those external investments into the asset
being analyzed. The introduction of
reinvestment and safe rates, according to
some, does little more than contaminate a
less than perfect, but nevertheless valid,
IRR measure of return.
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