IRR.....What is it?

5 Replies

I’m currently reading “What Every Real Estate Investor Needs to Know About Cash Flow...” and just finished the section about the relationship between IRR & NPV. I don’t feel I have a good grasp on this concept and have been looking online for other explanations, but it still has yet to click. Could anyone who understands this concept please help me out? Cheers!

Logan, 

I'll take a stab at this. 

NPV is the current value of all future cashflows discounted to the WACC ( weighted average cost of capital,  or the interest rate that you borrow at). NPV gives you a dollar figure that represents the increase  (or decrease ) in cashflow for the term of the investment. 

IRR is the percentage expression if that cashflow. It's done by setting the NPV to zero and solving for the WACC.

If the IRR exceeds the WACC, accept the project as NPV > 0, i.e. positive cashflow. If the NPV > 0 i.e. (NPV - acquisition cost) is positive, then the project should be accepted.

Hope that helps. 

Good luck, 

Jim 

James C. Thanks, that helped a lot! I must have read over the part about WACC. With that factored in, I understand the relationship much better. In the book, it talked about how there can be better years than others to “cash out”. How is that possible?

@Logan Jorns , basically, as well as literal "cash flow" estimations, guesses are also made of the assets' future appreciation in value, and how that value is expected to be impacted by the future (lower) buying power of each dollar.

ie. It's not enough to know that over the next 5 years, your purchase of an investment is likely to generate say, one and a half million dollars in actual net cash flow.

You also want to know: how much will that asset be worth (vs now)?

Then, you can compare how that asset is likely to perform - vs alternative purchase/s!

But remember, that's a lot of guessing/estimating/expecting...

Originally posted by @Logan Jorns :

James C. Thanks, that helped a lot! I must have read over the part about WACC. With that factored in, I understand the relationship much better. In the book, it talked about how there can be better years than others to “cash out”. How is that possible?

Investments don't go up in value in a linear fashion like an IRR/NPV formula might suggest.

Take bitcoin for example. When might a good time have been to "cash out", vs right now?...

Originally posted by @Logan Jorns :

James C. Thanks, that helped a lot! I must have read over the part about WACC. With that factored in, I understand the relationship much better. In the book, it talked about how there can be better years than others to “cash out”. How is that possible?

The timing of the cash flows matters for the IRR calculation (and for you personally). If you are adding value, the IRR is higher if you cash out in the early years because you have that cash inflow in hand to reinvest (rather than sitting in equity). The IRR formula assumes that cash inflow is reinvested (at 10% using Excel if you don't enter anything in the "guess" part of the formula).

It's great that you are taking the time to figure this out. Many investors don't understand IRR and the real return on their personal capital.

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