Understanding IRR - is this scenario correct?
Hey guys,
Was with a friend who explained IRR as below:
Scenario: 20% IRR (return over life of the investment), so you'd get your initial investment plus 20% back. Ie over a 5 year hold you as an LP investing $1 million, you would get initial $1mm + $200k back.
Refinancing Year 2 to give money back, to keep it simple just showing IRR and this 20% IRR can be paid out:
Year 1: 15% (or any combination to get paid out over life of investment based on cash flows and return to principal, i.e. Year 2 no income so no payout)
Year 2-4: 0%
Year 5: 5%
Is this correct? Person who explained this to me is somewhat new so I wanted to make sure this was right.
IRR is an annualized rate of return, sounds like he maybe was confusing IRR with multiple (or MOIC - Multiple on Invested Capital). In the scenario(s) above, your IRR is going to be less, because you are generating the 20% profit over 5 years and returning capital 2 years out (which gets discounted).
Also, moving around the cash flows will affect your IRR given that money returned sooner is inherently more valuable than money returned later (time value of money). However, a multiple will stay the same as it is time agnostic.
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