1

This is a simple question but I just wanted to be sure. Say I have an IRR of 5%. Does this mean that I have an actual return of (1.05)^3 - 1 = 15.7%?

2

Yes, if your IRR is 5% per annum after three years then the total return (I prefer total rather than your use of actual) over those three years is 15.76%.

Note that if you have other cashflows in and out, it gets a bit more complicated (e.g. using the XIRR function in Excel), but the idea is to find an effective annual percentage return that you're getting for your money.

1

IRR is not subjective, this is a response to @Laythesmack, to his remark that IRR is subjective. Not that I feel a need to defend my position, but rather, I'm going to explain his.

My company offered stock at a 15% discount. We would have money withheld from pay, and twice per year buy at that discount. Coworkers said it was a 15% gain. I offered some math. I started by saying that 100/85 was 17.6%, and that was in fact, the gain. But, the funds were held by the company for an average of 3 months, not 6, so that gain occurred in 3 months and I did the math 1.176^4 and resulted in 91.5% annual return. This is IRR.

It's not that it's subjective, but it assumes the funds continue to be invested fully during the time. In our case the 91.5% was real in one sense, yet no one doubled their money in just over a year.

Was the 91% useless? Not quite. It simply meant to me that coworkers who didn't participate were overlooking the fact that if they borrowed money at a reasonable rate, they'd exceed that rate, especially for the fact that credit lines are charged day to day. Even if they borrowed that money on a credit card, they'd come out ahead.

IRR is a metric. It has no emotion, no personality, no goals. It's a number we can calculate. It's up to you to use it correctly.

-1

Yes, assuming that your cash flow is constantly of size 5 and initial investment is 100, the following applies:

IRR of 5% over 3 years: Value of CashFlows: 4.7619 + 4.5351 + 4.3192 = 13.6162 NPV: 100 - 13.6162 = 86.3838

Continuous compounding: 86.3838 * (1.05^3) = 100

  • This doesn't make much sense to me. Why did you introduce the cashflow of size 5? The IRR of 5% can be explained without it very simply: it just means what the OP suggests: that the total return (rather than their "actual") is 15.7% over the three years. No cashflows needed. -1 – Peter K. Jul 22 '16 at 8:57
-7

IRR is subjective, if you could provide another metric instead of the IRR; then this would make sense. You can't spend IRR. For example, you purchase a property with a down payment; and the property provides cash-flow; you could show that your internal rate of return is 35%, but your actual rate of importance could be the RoR, or Cap Rate. I feel that IRR is very subjective. IRR is hardly looked at top MBA programs. It's studied, but other metrics are used, such as ROI, ROR, etc. IRR should be a tool that you visually compare to another metric. IRR can be very misleading, for example it's like the cash on cash return on an investment.

  • 1
    "IRR is subjective" What? Perhaps the MBA program I attended was sub-par? – JTP - Apologise to Monica Jun 8 '16 at 18:28
  • Maybe. Answer me this, Can you spend the IRR? – Laythesmack Jun 8 '16 at 21:20
  • 2
    How does that relate to the question? I can't spend P/E. And I can't spend PV=nrT, but thank God it keeps me cool at night . – JTP - Apologise to Monica Jun 8 '16 at 22:00
  • The irr is worthless. Look I can't sit and teach you an entire MBA program in finance with 500 characters left. So read this for now. boundless.com/finance/textbooks/boundless-finance-textbook/… – Laythesmack Jun 8 '16 at 22:13
  • 3
    I don't need you to. I have one (MBA in finance). You linked to its application, and misuse. That's fine, and I'd agree. But that's unrelated to the question. It's a number. We can calculate it. And we can use IRR in spreadsheets, hopefully, for good, not evil. – JTP - Apologise to Monica Jun 8 '16 at 22:17

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