Interview question.
Period 0: -110
Period 1: 10
Period 2: 10
Period 3: 10
Period 4: 110
Calculate IRR
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Very high level using rounding:
IRR = (MOIC - 1) / Hold Period + a little bit to account for compounding
IRR = (1.27 - 1) / 4 + a little bit
IRR = 6.75% + a little bit
Actual IRR = 7.04%
I initally read that the inital investment was 100, in which case you could have simply derived IRR by thinking of it as a a YoY compound metric (10% in this case) that returns the inital investment in the last year (100+10) for a total IRR of 10%. However, after reading it again and seeing the initial investment is 110, it is a bit more tricky.
As mentioned above, you can calculate the total MOIC (140/110) = 1.27x = 27% and divide it by the holding period (four years) to get the annual yield (c. 6.8% in this case). Generally, you need to discount this arithmetic return a bit to account for the compounding effect of IRR, e.g. to 6%. Additionally, IRR is time-weighted, hence having early cashflows in year 1-3 in this example will boost IRR a bit, yielding to the c. 7% result.
Hope this helps.
Thank you for your response.
I'm confused about first decreasing IRR to 6% (discounting arithmetic return to account for the compounding effect) and then increasing it to 7% (early cashflows boost IRR).
If you want to discount cash flows more, don't you have to increase the discount rate, in this case the IRR? Why are we lowering closer to 6% instead of bumping to 7%? The first comment to this post says "+ a little bit to account for compounding", that's why I'm confused.
Can you recommend any resources to better understand IRR and such questions? I need to improve.
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