IRR Series, Part 5: The Internal Rate of Return

We have now come full circle. You hopefully have stuck with me for the last 4 posts and are finally to the reason we started this journey.

I don’t really like the name, Internal Rate of Return. It confuses people and makes them think it is some kind of Return on Investment, averaged out over the years of ownership. It really is just the discount rate, or risk, that we have to have in the deal to make the deal break even. If our discount rate is lower we will likely make money. If it is higher we likely lose money.

In real estate, we often purchase something for a price, and hope to sell it later for a profit. Each year we receive a little profit from the use of the property as well. We also realize that money returned to us today is worth more than money returned to us in the future. The Internal Rate of Return (IRR) accounts for all of these needs.

Here is a new offer our acquaintance gives us:

He will pay you $100,000 five years from now when he is confident his surgical mask factory will be making a ton of money. He needs an investment today. He won’t be able to make annual payments. How much would you be willing to invest in his factory today to get 100k back in five years?

From what we know about the time value of money, that 100k paid 5 years from now will be worth less to us than it is today, so we must be willing to pay something less than 100k today. We will need to take into account. If we end up making a positive return of even one penny than it technically might be worth it to make the investment. So, what is that value that makes it a wash? In other words, what amount paid today, with returns at different times in the future nets us exactly $0? Any additional return of money nets us a profit, anything less makes this a loss.

Recall that to calculate an NPV we need to estimate a discount rate. We have been using a big 18% for this risky venture. For this scenario, the amount we need to invest turns out to be about $43,711. Probably a lot less than you might have thought. If we want to make a profit on this investment, we either need to pay less at the start or we need to negotiate some monthly payments. If we can do either or both than this may be a good investment for us. But most people looking to get a loan don’t ask you how much you want to pay now, they just ask for a certain amount that they need. This scenario really doesn’t happen much in real life. I use it as a way to start your thinking.

How do I use this to evaluate an investment, then?

Good question. You will need to first calculate a discount rate, as we talked about previously. This is very important because you need to figure this out in order to have a value to benchmark for your deals. Then you will calculate the IRR. You can do an internet search for the equation and it gets very deep in mathematics. Luckily, your favorite spreadsheet can make this calculation. You simply give it the initial investment, then the cash flows, then the money returned to you at the end.

This will then give you the IRR, the discount rate that makes the NPV equal to 0. If you predicted your discount rate to be less than this amount, you probably have a good investment. We need to have a good estimate of how much income we will get each year from the investment. If you are thinking ‘that sounds a lot like the NPV equation’ then you are right. The NPV needs a discount rate, the IRR generates one.

Don’t fall into the trap of thinking that the IRR is just a percentage return you get over the life of the investment and averaged annually. The IRR is just a discount rate and you need to do better than the IRR to make a profit. Doing better means that the estimated risk (your discount rate) needs to be less than the IRR. That is extremely important. Read this paragraph again until you get it.

Back to the Scenarios

Recall the two scenarios from last week where your acquaintance asks for an investment in a factory making surgical masks:

  1. Loan $100,000 and he will pay back $16,000 yearly for five years and pay back the $100,000 at the end of five years. You’ll get a profit of $80,000.
  2. Loan $100,000 and he will pay back $25,000 yearly for three years and pay back the $100,000 at the end of three years. You’ll get a profit of $75,000.

For scenario #1, we have an NPV of $-6,254. For scenario #2, we have an NPV of 15,220. You can plug these into your spreadsheet and you will find that scenario #1 gets an IRR of 16%. Scenario #2 is 25%. Again, I feel the need to caution you, both IRRs seem pretty good if you are looking at them as a return on investment. Don’t do it.

What you need to do is compare the IRR to your discount rate. Recall that we estimated an 18% discount rate in part because we felt that the investment was pretty risky. We would need to calculate an IRR higher than 18% to be interested in the investment. Scenario #2 satisfies this.

When to use the IRR

IRR is a quick way to put the projected return numbers into your spreadsheet and get back a number you can compare across potential investments. The NPV isn’t good for comparisons as each deal usually requires a different initial investment. You need to have a solid handle on your discount rate, though. Go back and read that post if you still feel hazy.

Most investors will have heard of the IRR but won’t completely understand the concept. If you can explain it to them, they will think you are a Rockstar. Keep in mind that the IRR is another tool in your box to evaluate and present deals to potential investors. I realize it is complicated. Let me know your questions in the comments and thanks for reading the IRR Series!

Dr. Equity