

Help Internal Rate of Return Internal Rate of Return This can be illustrated by looking at outgoing and and outgoing cash flows separately. The above table illustrates a hypothetical investment property which is bought for $1,000,000 and attracts an interest rate on mortgage repayments. In this example the IRR would equate to the effective interest rate which is 10%. The IRR discounts the cumulative NPV until it become zero. In other words each mortgage repayment reduces the balance unitl the mortgage is repaid which in this case take 5 years. Note that in this case, since only outgoing cash flows are being considered, a lower IRR means that the property attracts less costs and is more desirable than a comparable property with a higher IRR. The above table illustrates an investment property which is already owned and thus has no mortgage. The property is valued at $1,000,000, split into shops and then leased out. However, in the first two years the property is vacant and thus does not attract rental income. Hence there is no positive cash flows for the period.This risk factor and time value is reflected in the discounted cash flow whereby in the first year the projected value of the property of $1,100,757 has been discounted to $1,000,000. The same applies to the second year where the projected value of property of $1,211,666 has been discounted to $1,100,757. The cumulative difference in values is the cost of the property to the owner over the original selling price. In the remaining years, the property does attract income in the form of rent, albeit at staggered levels. This rental income represents the positive cash flow to the investment property and is used to offset the discounted cash flows in the first two years. At the end of the five year period the NPV is again zero. That is it takes five years to breakeven on this investment. For properties only generating ingoing cash flows, a higher IRR means greater profitability making the property more desirable as an investment. Now we will consider both ingoing and outgoing cash flows. In the beginning of the first year a property is bought and it attracts an annual mortgage interest rate of 10%. This is the outgoing discounted cash flow. However, the property also produces a rental income of $265,605 per annum which is the ingoing cash flow. This income is used to pay off the mortgage until at the end of the fifth year the NPV is again nil. That is, it takes five years for the property to pay for itself. Since the IRR is amortised at a constant rate it can be understood as a summary figure of the profitability of an investment property. As noted this allows comparison with other investment properties by their respective IRR values. This is illustrated by the following example: There are two prospective investment properties: The purchase price of both properties is $1,000,000. If the IRR only represented outgoing cash flows which in both cases is the effective interest rate of mortgage repayments then one would choose the lower IRR. However in the above examples, there are additional ingoing cash flows in terms of rental income. Hence the respective IRRs of both properties do not only represent the respective effective interest rates on their associated mortgages but also the ingoing cash flows from their rental incomes. The IRR is how quickly these ingoing cash flows repay the mortgage for each property. On this basis the more profitable investment is property A even though it has a higher interest rate for its mortgage than property B. This is because property A attracts greater incoming cash flows that pay off its associated mortgage quicker. It takes 3 years to pay off the mortgage for property A instead of 5 years for property B. IRR Limitations Since the Modified Internal Rate of Return (MIRR) address these problems it maybe an alternative method of assessing the profitability of investment projects.
