What is Internal Rate of Return?
Internal Rate of Return (IRR) is the annualized rate of return based on when cash is received or paid.
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What is the formula for IRR to adjust for any inflow or outflow of value between the future value and present value amount?
Hi,
Will the IRR be the same if we set up different shares% in the joint venture company? For example, I’m not sure whether IRR is equivalent with the whole project’s IRR when you account for 51% or 67% in the JV company. Thanks
Hi Ace,
The different share ownership % would not alter IRR so long as the different shareholders of the JV receive cash distributions proportional to their respective ownership at the same time. So for example, suppose there are two parties to a JV: Company A and Company B. So long as Company B receives cash the same time Company A receives cash from the JV, and both receive cash proceeds proportional to their respective ownership, then IRR will be the same.
If Company A can receive distributions every quarter but Company B can only receive distributions every year, then IRR will not be the same.
If Company A owns 40% of the company and Company B owns 60% of the company, but Company A is entitled to 45% of the cash flow while Company B is entitled to 55% of the cash flow, then the IRR will not be the same.
Thanks a lot for the explanation!
Would you mind tell me more about second and third situation? As I’m not quite clear about why the IRR would not be the same when they receive distribution with different frequency and entitle to different shares of the cash flow.
Furthermore, if we calculate IRR in the primary market, should we use (intrinsic equity value/how much we need to pay)^(1/n)-1
Thanks again!
IRR is influenced by cash flow. If Party A invests $100 and receives $20 in one year, that’s 20% IRR. If Party B invests the same $100 but only receives $10 in one year, that’s 10% IRR. So if the parties are entitled to share of cash flow disproportional to their share of investment, then IRR will naturally be different.
IRR is influenced by time. Thus, if the two parties receive cash distributions at different points in time, then they’ll naturally have different IRR. You can test this in Excel using the XIRR formula.
IRR’s formula is (how much you’ll get back / how much you need to pay) ^ (1/n)-1. This assumes that you pay in a single payment upfront and that you get all your money back also in a single payment. If you get multiple cash distributions over a period of time, you need to use the XIRR formula in Excel.
Isn’t the IRR on this investment actually 52%? This is assuming t0 = -$14, t1=$1, t2=$1+$29.75.
Hi Julian,
Yes, technically, it should be calculated based on the time of cash inflow. However, we didn’t want to introduce that calculation here for two reasons:
1) We want to introduce the concepts in the Foundation curriculum and provide a framework for how you’d think about it in an interview. You won’t be expected to figure out the exact IRR %, but you would need to be able to estimate it. We’ll have future courses where we focus on modeling that calculate IRR based on the XIRR formula in Excel that address this.
2) Doing it based on exact timing of cash flow actually isn’t always applied for hedge fund investors. Many HFs just add total dividends to the Future Share Price and calculate IRR based on that, ignoring the impact of time on the dividends. Page 40 of Pershing Square’s Starbucks presentation provide an example: https://assets.pershingsquareholdings.com/2014/09/09140753/Doppio.pdf
We’ll go over this more precise way of calculating IRR in an Advanced course.
Thanks. Interesting to learn about the way HFs approach this topic.