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Never heard of Effective Rate IRR (nor can I find a definition for it).
Presuming you mean the formula in your header, it looks clunky and is not commonly used in my experience. In the absence of a reason not too, just use XIRR.
Given the question, I think it would be worthwhile to invest some time into better understanding the mathematics behind and the functional purpose of calculating an IRR.
The more explicit answer to your question is, it depends on your cash flows. If you have a monthly model, (1+IRR())^12-1 is the more accurate function. Likewise, if you have a quarterly model, (1+IRR())^4-1 is the more accurate function.
XIRR is the most accurate when you have known dates, which generally isn't until the investment is substantially realized. Final returns are always ran on an XIRR basis, but underwriting and asset management returns are ran on a "Effective Rate IRR" basis.
At the end of the day, there's a minimal difference between the functions. But someone that always uses XIRR illustrates they don't fully understand the math and/or point of measuring an IRR.
Hey - Can you provide a simple explanation of the logic of that formula: (1+IRR())^12-1
What do you do 1 + IRR, to the power of 12, then subtract 1?
Thanks!
XIRR vs Effective Rate IRR (Originally Posted: 01/26/2018)
Any thoughts/preferences on using the XIRR function vs Effective Rate IRR when modeling development projects?
Both account more time value - is one more accurate than another?
If you XIRR for monthly, your returns are higher cause the money comes in sooner. But this can give you a false sense of huge upside. Lets say you got an IRR of 9, with a target return of 11 and an XIRR of 13, would you pull the trigger on the acquisition?
XIRR is good to look at, but it tends to inflate peoples perception of how good the deal is.
I have never encountered this. XIRR should return ~ same value as (1+IRR(values))^12-1 or however you are compounding. Should be within like 5 bps or less. XIRR can be finicky since the data series must start with a negative value, which in some cases doesn't happen (construction loan origination comes to mind where you receive a fee upfront but the loan doesn't start funding until borrower's equity is fully committed).
XIRR is the most accurate. If your proforma has time intervals that are spaced EXACTLY the same distance apart (monthly, annual, etc) then IRR with compounding is fine otherwise use XIRR.
Just had a partner send us a model where they were calculating returns using a nominal irr calc instead of an effective basis. Honestly didn’t even know there was a difference before then
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