IRR vs. Compound Return Rate
Does IRR assume the interim cash flows are reinvested? Various sources say yes and others say no. Investopedia's IRR article says "One of the disadvantages of using IRR is that all cash flows are assumed to be reinvested at the same discount rate". I was also taught this in my Corp Finance class as well.
But this link says otherwise:
http://www.propertymetrics.com/blog/2014/06/09/what-is-irr/
"The internal rate of return measures the return on the outstanding “internal” investment amount remaining in an investment for each period it is invested. The outstanding internal investment, as demonstrated above, can increase or decrease over the holding period. It says nothing about what happens to capital taken out of the investment. And contrary to popular belief, the IRR does not always measure the return on your initial investment."
Would you guys say the above link is technically correct? I tried an example in Excel where I invest $100 for 5 years and make a 5% return in year 1, then compound the return by 5% through year 5 where I also receive the principle. Discounting all these cash flows gives a positive NPV and an IRR of 5.5% even though the investment has a compounded return rate of 5%.
Is it accurate to say that IRR does not necessarily represent the annual (or periodic) return on an investment, but as " the percentage rate earned on each dollar invested for each period it is invested."?
I have no idea what math you did, but reinvesting proceeds at 5% every year gets you a 5% IRR / CAGR. $100 outflow in Year 0, $127.628 inflow in Year 5.
CAGR = (127.628 / 100) ^ (1/5) - 1 = 5.00%
NPV ( 0.05, {-100,0,0,0,0,127.628} ) = $0
IRR ( {-100,0,0,0,0,127.628} ) = 5.00%
These are just three different ways of saying the exact same thing: compounded annually, the rate of return on this investment is 5%.
I did IRR ( {-100,5,5,5,5,105} ) = 4.56%
But now I realize this wouldn't be accurate because the 5's should be 0 to represent the reinvestment of the $5. If I'm building a DCF, how would I capture the reinvestment of the free cash flows each year? i.e. your terminal value includes the cash flow reinvestments with their annual gains, I'm wondering where in the DCF you would fit in the reinvestment so that the FCF line would show {-100,0,0,0,0,127.628}?
Your sources are not at odds with each other.
In summary: IRR means the interim cash flows are reinvested at the same rate.
The source, "And contrary to popular belief, the IRR does not always measure the return on your initial investment", simply means that you can achieve the IRR returns ONLY IF YOU CAN GET THE DESIRED CASH FLOW bAND[/b] REINVEST AT THE SAME RATE.
Most of the time, you cannot - customers miss or delay payments, projects generate more cash flows than projected etc.
This explains the sentence: "The outstanding internal investment, as demonstrated above, can increase or decrease over the holding period".
For practical purpose, IRR = true return when there are no interim cash flows (only beginning and ending cash flows; like a zero coupon bond).
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