Taking a look at Internal Rate of Return

Posted on September 7, 2010

0


After reading “Introduction to Internal Rate of Return (IRR)” by J Scott I decided to take a deeper look into IRR. I have learned the subject in school before, but I have forgotten its definition and purpose.

I happened to come across the following interactive tutorials by Prof. Samuel L. Baker of University of South Carolina: Internal Rate of Return and The Perils of Internal Rate of Return. I wanted to understand what was IRR, how it is used, and the pitfalls of IRR.

After reading the above articles, I understood that IRR is useful for comparing investments and determining which one is more profitable. However, it has its pitfalls.

  1. A higher IRR is appropriate for comparing investments that have their costs first, their positive incomes later and similar initial costs.
  2. IRR does not take into consideration different risks. An investment with lower IRR but less risk may be a better investment.
  3. The Net Present Value and IRR can contradict each other in choosing which investment as more profitable.
  4. The discount rate can change with economic conditions. Thus there is an element of uncertainty with IRR.

Using the IRR, we can compare RE investments to less riskier investments such as the bank and bonds. This allows us to determine whether the single project is worth investing.

Advertisements
Posted in: Analysis, Real Estate