Calculating IRR of an Annuity Plus Single Amount Received

If an investment requiring a $20,000 initial investment is forecasted to produce income of $3,000/year for 5 years & will be sold at the end of Year 5 for $24,000, what is its projected IRR?

The answer is 17.81% and I understand how to get that number.

The second part of the answer states "The sale proceeds of $24,000 > initial investment amount of $20,000 which means the entire return of the initial investment ($20,000) & part of the return on the investment (what return the investment gives us) comes from the sale proceeds of $24,000. The annual cash flows contain only a partial return on the investment with the other part of return on investment in the sale proceeds of $24,000 (the extra $4,000). With this configuration of cash flows, part of the interest being earned each year is left in the investment, increasing the amount that earns interest each year at the rate of 17.81%."

Question: What does it mean by part of interest being earned each year is left in investment - why isn't it all of the interest being earned each year reinvested? Comparing this to if sold at end of Year 5 for $20,000 (IRR is 15%) - if we don't get sale proceeds until the end and annual cash flow is the same in both examples, why would the IRR here be higher?

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Comments (2)

Sep 16, 2021 - 8:34am

1. This isn't homework help, go ask your teacher

2. I understand it to mean that part of the interest is accumulative (investment compounds) and part is distribution-based (the annual cash flow). A simple way to think about this is a stock that appreciates and pays dividends. Both the appreciation and dividend contribute to your annualised total return (IRR) but only the appreciation is accumulative (i.e. part of the "interest"/return is left in the investment => compounds your return) whereas the dividend is just a fixed return.

  • Analyst 1 in IB-M&A
Sep 16, 2021 - 8:46am

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