IRR Question - Looking for feedback
Have an IRR question: See below - both scenarios have the same net cash flow, but delaying net inflows by 6 months produces a better IRR in scenario 1 than scenario 2 which doesn't make sense (i.e. delaying inflows by six months and keeping all else equal produces a better negative IRR). What am i missing - this only happens when there is a negative IRR?
Scenario 1 - (delay cash inflows - total net cash flow of -100) - IRR of -9.97%
-500 -250 -250 -250 -250 50 50 50 50 300 300 300 300
Scenario 2 - (no delay cash inflows - total net cash flow of -100) - IRR of -57%
-500 50 50 50 50 50 50 50 50
Scenario 1 your negative cash flow is spread over a longer period of time. IRR approaches 0 as the period lengthens.
In the case of positive cash flows, scenario 1 would be closer to 0% than scenario 2, so IRR would be relatively worse.
Your intuition is correct, if you delay the CF then it's going to be a lower, if net positive. Because it's net negative it'll go towards 0. You'd want to do something like 12/31/16 is a -250 outflow and 6/30/17 would be a +300 inflow. TVM would say that the $50 net should be less than $50 if it's 6 months apart but IRR says that it's actually bigger because a negative discount rate implies that a dollar today is worth more tomorrow.
Are you using IRR or XIRR? If you're not using XIRR then that may be part of your problem because you've got a bunch of different cash flows. If I'm not mistaken the IRRs should be much closer though still negative but I might be wrong.
Either way, the answer is don't touch this project, deal whatever with a ten foot pole.
First - I'd let everyone know this is on a yearly basis
Second - A positive rate means that the value of a dollar today is worth more than a dollar tomorrow. A negative rate means that a dollar tomorrow is worth more than a dollar today.
A large part of the discrepancy is due to the difference in number of periods. Any time you reduce time periods, you typically magnify returns/losses.
In the first scenario, the rate is very low, but has compounded greatly by the time it reaches the finally cash flows. By the final month the cash flow is worth ~$330 (10% higher)
In the second scenario, the rate has to be a bit higher to diminish the value of the most current and bring NPV to 0 in a shorter time period. The value of the final cash flow is around $68 (30% higher)
Test it out for yourself. Each month the value of the cash flow decreases by 1+IRR^T or increases by 1+(-IRR)^T. I think seeing the PV of the cash flow values will help you understand better.
Could be wrong about this all, just a college student thinking about this logically.
EDIT: Don't forget to divide IRR by 12!
Thanks everyone for the comments, still not sure if it makes logical sense to me. In scenario 2, you are receiving the same total cash flows quicker (you are receiving $400 back on a $500 investment) than scenario 1 yet scenario 2 produces a lower IRR (i.e. more negative).
There are 2 ways to think of IRR... 1. Think of IRR as magnitude of returns on an annualized basis. This helps us compare projects of different lengths, amounts invested and potential returns. Between 2 losing projects of different lengths, if you annualized them, you like the scenario with lower magnitude of losses on an annual basis. Between 2 winning projects of different lengths, if you annualized them, you like the scenario with a higher magnitude of gains on an annual basis.
A $100 loss in 1 year has a greater annual magnitude (-$100) compared to a $100 loss in 10 years (-$10). I prefer the second scenario because if I pursued both projects for 10 years, I wouldn't lose as much (-$100 x 10 years vs -$10 x 10 years)
Similarly, a $100 gain in 1 year has a greater annual magnitude (+$100) compared to a $100 gain in 10 years (+$10). I prefer the first scenario because if I did both projects for 10 years, I would make more ($100 x 10 years vs $10 x 10 years).
What Exlurker said is what I was going to mention. Long and short, IRR is just a formula. Don't take it as the be all and end all, decide if it logically makes any sense given the scenario and choose to consider/ignore it based upon that. I use IRR for most major capital expenditures but in some cases it just doesn't make sense especially when the time period is long and the reinvestment at the presumed return can't be guaranteed.
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