MOIC vs. IRR - Interview Question
Let's say you have two investment opportunities. One has a higher MOIC, one has a higher IRR. Which do you prefer?
Investment Banking Interview: MOIC and IRR
The question above tests your understating of two similar principles in finance. These principles are "Multiple on Invested Capital" and "Internal Rate of Return." It is important to understand the differences between the two because an interviewer could easily ask a variation of this question.
MOIC in Finance
Multiple on invested capital is a phrase that is defined by its name. If you invest 100$ and your return is $1,000 in 2 years, then your MOIC is 10x. Additionally, if you invest 100$ and your return is $1,000 dollars in 10 years your MOIC will remain at 10x. Therefore, time does not affect the multiple.
IRR in Finance
It is important to note that time is used in the calculation of IRR. The inclusion of time means we are accounting for the opportunity cost of the dollars locked into the investment. Consequently, internal rate of returns can be seen as a more useful metric to prospective investors.
MOIC and IRR Example
Above, we listed the basic definitions of each term. Next, let's take a look at the original interview question.
Interview Question: Let's say you have two investment opportunities. One has a higher MOIC, and one has a higher IRR. Which do you prefer?
This solution was originally posted by certified user Marcus_Halberstram.
Key thing you need to zero in on in comparison questions is what the third variable that needs to be considered. In most comparison questions, there is an indifference point at a given third variable.
In this case, the third variable is time.
There are 3 things to keep in mind when answering this question:
- Given 2 cash flows, MOIC will be the same, regardless of time.
- IRR will change for the same exact cash flows depending on when they are paid.
- Most solid candidates get these 2 quantitative points, what some people miss is the qualitative one... which why do you care in the real world? That's because a 40% IRR
across a 3-month investment is useless. You want a dollar value of proceeds that is meaningful to both you and the LPs. Similarly, a MOIC of 3x across 11 years is similarly unattractive, because the actual returns are not compelling (~10%).
So the answer is it depends. What is the time horizon. With that third variable answered, you can properly make a decision.
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Thanks Marcus.
So let's say you have two investment opportunities, both with 5 year horizons. One has higher MOIC, one has higher IRR. Would you always prefer the one with higher IRR, all else equal?
I think the key to these questions is not to memorize answers to certain scenarios but to understand the fundamentals so you can think through all the variants of the same question.
If you have Investment A and Investment B, both have 5 year horizons, one has higher IRR and the other has higher MOIC... think about that. At first blush it doesn't seem possible, because if your time horizon is the same... how can the IRR be higher in one investment and MOIC be higher in the other? Again... whats the third variable... time. If IRR1 > IRR2 but MOIC2 > MOIC1, but TIME1 = TIME2... that tells me there is some funky stuff going on with the CFs. Like dividends.
Investment A and Investment B each require a $100m investment. A demonstrates an MOIC of 2.5x and B demonstrates an MOIC of 2.3x. What would make the returns of B higher than A? The timing. If A consists of investment on day one and full proceeds at exit, but B consists of investment on day 1, div recap of 80% of investment after year 1, and remaining proceeds at exit... B is more attractive from an IRR perspective.
Again, most of the solid candidates will breeze through this question also. But top candidates will be able to take it one step further and discuss its application in a practical setting... i.e., B is not only more attractive from a returns perspective but is also more compelling from a risk standpoint since you get an earlier return of capital, you get to take money off the table sooner and have less capital at risk through the life of the investment.
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