can anyone explain to me what the Internal Rate of Return (IRR) is?

Z

z106

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Excuse my ignorance but can anyone explain to me what the Internal Rate of Return is?
 
i still don't get it.

Can someone explain it in lay mans terms in 3 sentences please ?
 
The rate of return that equals the individual's weighted average cost of capital, i.e. breakeven.
 
um, given your occupation qwertyuiop, how could you not know what that was?
 
And in fact - i still don't really get it.

"
The rate of return that equals the individual's weighted average cost of capital, i.e. breakeven."

Can someone give me a basic example.
 
Yep - imagine (for simplicity) my investment choice is a building that will cost 5,000 and yield a payment of 500 in one year, 500 in three years and 6,000 on sale of property in five years, then the IRR i is the solution of this equation:

5,000 = [500 * (1+i)^-1] + [500 * (1+i)^-3] + [6,000 * (1+i)^-5]

The solution of this equation is i (the internal rate of return) = 7.725%...hope this helps!
 
Still don't get it.
In your example, what's so special about year 1 and year 3 - as opposed to say,year 2 and 4 ?
Why doesn't your example look at all years?

And ultimately - even if your calculated IRR is correct - (and I'm not suggesting it's not) - then what does it actually represent?

Your 7% odd (or whatever it is) of €5,000 is €350 or so.

So what? What information does that give me about anything ?

I don't understand this still.
 
As I understand it, IRR is used to evaluate a potential capital investment.

The IRR is basically the return or yield on an investment (e.g. buying new equipment).

If the expected benefit exceeds the return on alternative forms of investment (e.g. buying different equipment, putting the money in the bank, etc,), then the business would obviously be positively disposed towards pursuing that option.
 
That was just an example, you could have payoffs at any time, i (the IRR) would be the solution of a similar equation.

The higher i is, the more attractive the investment proposition is.
 
The wikipedia article is as good an explanation as any. IRR is basic finance for investment decisions. It doesn't really get much simpler than what has been explained so far by the various posters above-extopia's is as simple as it gets in my view.
 
Ok CCOVICH - so you're saying so that,according to extopia, it is the same as ROI (Return on investment) ?

extopia said:
.
The IRR is basically the return or yield on an investment (e.g. buying new equipment).
Click to expand...
So - if I put in 10k on a 100k property and the property rises in value by 10% to 110k then the IRR is 100% ? i.e. 10k gain on a 10k investment.
Is this what it is?

Because that is what a ROI is anyway.

So basically it's just another term for ROI so ya ?
 
No.

From the wikipedia article

Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cash flows

ROI is the actual earned return on a project.

To work out the IRR, you need to know what your (opportunity) cost of capital is-i.e. is it 5%, 6%, 7% etc. The cost of capital is then used to work out the relevant discount rate.

Interpolation is then used to get the rate/yield that gives a NPV of zero. Excel has an IRR function.
 
ok - I STILL don't get it !!

Again - can anyone use a very simple example to illustrate.

In fact - what is the IRR on my example of 10K down on a property of 100K ?
Assume an interest rate of 5% on the borrowed 90k for teh sake of argument (Not even sure if the interest rate is relevant in calculating the IRR)
ANd ccovich - I don't know how you can say it has been really simply explained already.
Below is one of the explanations so far.

Liek - hardly lay mans terms.

South said:
Yep - imagine (for simplicity) my investment choice is a building that will cost 5,000 and yield a payment of 500 in one year, 500 in three years and 6,000 on sale of property in five years, then the IRR i is the solution of this equation:

5,000 = [500 * (1+i)^-1] + [500 * (1+i)^-3] + [6,000 * (1+i)^-5]

The solution of this equation is i (the internal rate of return) = 7.725%...hope this helps!
Click to expand...
 
South's equation is simple-are you aware that ^ means "to the power of"?
You need to define a timeframe and expected cash flows (discounted at 5%) before someone can give you an IRR.

If nothing that has been said so far (or the wikipedia link) makes sense, buy a book called Principles of Corporate Finance (Brealy and Myers) or some other basic finance text that would be used at undergraduate level.
 
Yes - I am aware it means to the power of.

But as I said in an earlier post - the 7% odd works out at €350 of teh €5,000.

Yes - the IRR is €350.
So - what does this tell me about anything ?
What is teh significance of that figure in souths example ?

Like - Am I the only one not getting this here?
 
The IRR is not a monetary amount-it is a %-a % return that gives a NPV of zero at the relevant discount rate.

South's equation looks at the amount invested (on the left of the =) and the future cash flows (on the right). The "i" is the yield that ensures the investor recovers their investment. So any rate of return greater than "i" means that the investment is probably a good idea.
 
Another way to look at it is to turn South's example upside down: If I was to put 5,000 into the bank, take out 500 after 1 year, take out another 500 after 3 years and have 6,000 in my account after 5 years, what interest rate was the bank paying me? The answer is the same.
 
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