Internal Rate of Return (IRR) seems to befuddle many investors, but if you understand Discounted Cash Flow and Net Present Value, then you already understand IRR. That’s because it is really the same process, but one where you are solving for a different unknown.
In Discounted Cash Flow (DCF), you believe you know what the future cash flows will be, and you believe you know the rate at which those cash flows should be discounted. Your mission is to figure the Present Value of the cash flows.
With IRR, you still believe you know what the future cash flows will be, but now you know the Present Value (PV) and want to find the discount rate. How is it that you know the Present Value? This is a deal happening in the real world. The PV is the amount of cash you are paying for those future cash flow. When you solve for the IRR, you are looking for the discount rate that accurately describes the relationship between those future cash flows and the money you put on the table on Day One.
When you’ve found the discount rate that makes the PVs of the future cash flow equal to your initial investment, you’ve found the IRR. You can express this another way:
When you’ve found the discount rate that makes the NPV equal zero, you’ve found the IRR
Admittedly, the math to find the IRR is ugly, but if you’re reading this then you probably have a computer (or a highly sensitive gold filling that also picks up the BBC); there are plenty of tools, including Microsoft Excel and our own RealData software that will do the job for you.
IRR is the measurement of choice for many investors because it takes into account both the timing and the magnitude of your cash flows
IRR is indeed sensitive to both the timing and amount of cash flow. Receipt of cash flows early in the investment cycle are especially valuable because you didn’t have to wait long to receive them and therefore you didn’t have to discount their values so greatly. This makes for a higher IRR, a higher yield on invested dollars.
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Reprinted with permission of RealData — software for real estate investors and developers — www.realdata.com