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Internal Rate of Return (IRR) (Discounted Cash Flow Measure) article

Internal Rate of Return (IRR) (Discounted Cash Flow Measure)

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Video Title: Learn about the Internal Rate of Return (IRR) (Discounted Cash Flow Measure)

Video Publication_Date: Friday, February 17, 2017

Video Duration: 6:30

Video Description:
Shows how the Internal Rate of Return (IRR) is calculated, what factors are important, and how to use planEASe Sensitivity Analysis to investigate which assumptions the Internal Rate of Return (IRR) is sensitive to.

201020112012201320142015
IRR Before Debt1.5%9.0%9.9%9.0%9.5%8.0%
IRR Before Tax9.2%12.1%9.5%11.0%7.0%
IRR After Tax6.5%8.8%6.6%7.8%4.6%
NPV Before Debt @10.00%($246,299)($54,097)($8,769)($106,089)($66,107)($273,216)
NPV Before Tax @10.00%($236,599)($16,136)$56,761($17,540)$42,716($146,603)
NPV After Tax @10.00%($233,929)($68,875)($32,053)($121,655)($95,859)($265,158)
You may think of the IRR as the annual Interest Rate or Yield (compounded annually) that the investment is paying you over the Holding Period. Naturally, the higher the yield, the better the investment.
Monthly Calculations
Of course IRR's took forever before computers, and even took a very long time on those old computers with no mouse. These days the computers are so fast that monthly IRR's are done almost instantly. In the world of commercial real estate, cash flows occur monthly and the dollar amounts of the revenue and expense cash flows are almost always irregular. In the past there were mathematical games that were played to get the IRR to reflect the monthly irregular cash flow, and you might still hear some of the old ways spoken of today, like "beginning or end of period" or "mid year convention" (Monthly vs Yearly IRR Discounted Cash Flow Measure Comparison). These tricks were necessary in a world where you typed individual cash flows into a calculator or spreadsheet. However, in the modern computing world there is no need for these mathematical tricks, because computers are now fast enough to handle the present value discounting process on a monthly basis. The initial process for computing IRR in Excel and other spreadsheets made the assumption that the cash flows occurred annually and at the end of the year. With the new speed of computers, it became feasible to compute IRR more accurately by including the date of the cash flow as well as the amount. This new (and much more accurate) method of computation is known within Excel (and other spreadsheets) as the XIRR function. Here are links to descriptions of the XIRR process:
XIRR Verification
If you are interested how to verify the monthly NPV look to this page Verify Monthly IRR and NPV Using Excel or Google Spreadsheets XIRR and XNPV. Also there is an "IRR Verification Report" shown at the end of this article that has all the monthly information to use for the verification for the last IRR After Tax.
Internal Rate of Return (IRR) Considers:
  • All assumptions entered such as: Scheduled Income, Purchase Price, Down Payment, Current Debt Payment, Vacancies, Expenses, Property Taxes, Lease terms, Revenue Growth, Rent Control, Expense Growth, Property Tax Growth, Deferred Maintenance, Debt Amount (Ratio), Interest Rate, Interest Rate Changes, Payment Changes, Points, Prepayment Penalties, Depreciation, Capital Expenditures, Income Taxes, $25,000 Exemption, Passive Losses, Appreciation, Capital Gains Tax ... and all other entered assumptions.
Internal Rate of Return (IRR) Ignores:
  • Only assumptions not entered
Why is Internal Rate of Return IRR useful?
The nature of the NPV is that it takes everything into account that made up the cash flow. The only weakness is that it is hard to calculate (not with planEASe of course), and that it uses all the assumption values (so, in turn, you are required to enter these assumptions, which means more work on your part).
The Internal Rate of Return IRR is shown in these planEASe reports:
IRR Verification Report
Retail - Office

These cash flows and dates are those on which the Rate of Return After Tax in the planEASe analysis of the Retail - Office are based.'

planEASe Software plans operating cash flows monthly, and assumes that cash flows occuring during the month all occur at the middle of the month.Calculators and Spreadsheets typically schedule these cash flows at the end of the year (year-end convention).Since cash flows do actually occur unevenly during the year, the mid-month convention is more accurate.

The Internal Rate of Return (IRR) is defined as the Present Value Discount Rate which makes the Net Present Value of the Cash Flows involved equal to zero. The Net Present Value of ($0.16) shown below demonstrates that the Net Present Value of these Cash Flows is very close to zero when discounted at 4.5752% and, in turn, the IRR of the Cash Flows is very close to 4.5752%.



Date

Years

Cash Flow
Present Value
Discount Factor
Present Value
at 4.5752%
1 Jan 20100.00($1,023,344.00)1.0000000($1,023,344.00)
15 Jan 20100.041,691.000.99828561,688.10
15 Feb 20100.121,680.000.99449971,670.76
15 Mar 20100.201,669.000.99109261,654.13
15 Apr 20100.281,658.000.98733411,637.00
15 May 20100.371,647.000.98371041,620.17
15 Jun 20100.451,636.000.97997981,603.25
15 Jul 20100.53(11,578.00)0.9763831(11,304.56)
15 Aug 20100.623,579.000.97268043,481.22
15 Sep 20100.703,568.000.96899163,457.36
15 Oct 20100.793,556.000.96543523,433.09
15 Nov 20100.873,545.000.96177403,409.49
15 Dec 20100.953,533.000.95824413,385.48
15 Jan 20111.043,796.000.95461013,623.70
15 Feb 20111.123,785.000.95099003,599.50
15 Mar 20111.203,773.000.94773193,575.79
15 Apr 20111.283,761.000.94413783,550.90
15 May 20111.373,749.000.94067263,526.58
15 Jun 20111.453,737.000.93710533,501.96
15 Jul 20111.533,772.000.93366593,521.79
15 Aug 20111.623,760.000.93012523,497.27
15 Sep 20111.703,748.000.92659783,472.89
15 Oct 20111.793,736.000.92319703,449.06
15 Nov 20111.872,001.000.91969601,840.31
15 Dec 20111.95779.000.9163205713.81
15 Jan 20122.04(3,586.00)0.9128455(3,273.46)
15 Feb 20122.12(108,832.00)0.9093837(98,970.05)
15 Mar 20122.203,454.000.90615723,129.87
15 Apr 20122.293,441.000.90272073,106.26
15 May 20122.373,428.000.89940763,083.17
15 Jun 20122.453,415.000.89599673,059.83
15 Jul 20122.543,548.000.89270823,167.33
15 Aug 20122.623,535.000.88932283,143.76
15 Sep 20122.713,522.000.88595023,120.32
15 Oct 20122.793,508.000.88269863,096.51
15 Nov 20122.873,495.000.87935113,073.33
15 Dec 20122.963,528.000.87612373,090.96
15 Jan 20133.043,670.000.87280123,203.18
15 Feb 20133.133,863.000.86949123,358.84
15 Mar 20133.203,850.000.86651243,336.07
15 Apr 20133.293,836.000.86322633,311.34
15 May 20133.373,822.000.86005813,287.14
15 Jun 20133.453,808.000.85679653,262.68
15 Jul 20133.54763.000.8536519651.34
15 Aug 20133.62(1,168.00)0.8504145(993.28)
15 Sep 20133.713,720.000.84718953,151.54
15 Oct 20133.793,706.000.84408013,128.16
15 Nov 20133.873,691.000.84087913,103.68
15 Dec 20133.963,725.000.83779293,120.78
15 Jan 20144.043,724.000.83461573,108.11
15 Feb 20144.133,922.000.83145063,260.95
15 Mar 20144.203,907.000.82860213,237.35
15 Apr 20144.293,892.000.82545983,212.69
15 May 20144.373,877.000.82243023,188.56
15 Jun 20144.453,862.000.81931133,164.18
15 Jul 20144.543,846.000.81630423,139.51
15 Aug 20144.623,905.000.81320853,175.58
15 Sep 20144.713,889.000.81012463,150.57
15 Oct 20144.793,874.000.80715133,126.90
15 Nov 20144.873,858.000.80409033,102.18
15 Dec 20144.961,833.000.80113911,468.49
15 Jan 20155.04(6,170.00)0.7981009(4,924.28)
15 Feb 20155.13(2,559.00)0.7950743(2,034.60)
15 Mar 20155.20(2,575.00)0.7923504(2,040.30)
15 Apr 20155.29(2,592.00)0.7893456(2,045.98)
15 May 20155.37(78,787.00)0.7864485(61,961.92)
15 Jun 20155.455,014.000.78346603,928.30
15 Jul 20155.544,998.000.78059063,901.39
15 Aug 20155.625,057.000.77763033,932.48
15 Sep 20155.715,041.000.77468133,905.17
15 Oct 20155.795,024.000.77183813,877.71
15 Nov 20155.875,007.000.76891103,849.94
15 Dec 20155.964,989.000.76608893,822.02
31 Dec 20156.001,332,012.000.76458811,018,440.49
TOTALS$311,827.00($0.16)



Written by
Michael Feakins, CCIM
of planEASe Software