This article will explain the basic formula and then will describe how it is mistakenly used in the world of business. For you, you need to primarily understand the formula and why it is a poor or insignificant determinant of value in the small business world.
- 1 Understanding the Basic Formula
- 2 Mistaken Application of IRR
- 3 Summary – Internal Rate of Return
Understanding the Basic Formula
There are three basic rules to follow when exercising this formula. First, the investment for all the projects must be equal, secondly, the time periods for the projects must be similar in duration and finally, the risks must be alike. The following sections describe these basic rules.
Rule #1 – Equal Level of Investment
The first key to this formula is that it is used to compare two or more projects of a similar investment. So you cannot use this formula to compare an investment into a hot dog cart and the investment into building a hot dog restaurant. It is obvious the restaurant will require a higher significant investment than the hot dog cart. Think of it more in the neighborhood of comparing a hot dog cart to a sausage stand. The two investments must be of equal nature.
So what would be an example of an equal level of investment for the small business owner? Answer: Sticking to the same hot dog cart, suppose you as the operator live in an area where you can serve two different cities. Both require a license to operate a curb based food stand. Both cities have a license cost of $100. So the investment is $100 and it is easy to compare now. Two different locations, same investment required. Now you can determine which one will be the better investment because you actually have an equal level ($100) of investment.
Rule #2 – Same Time Period for Investment
Ironically, both cities allow the vendor to operate for a period of one year with the license. Now we can compare the return on the investment. However, if City A is one time cost of $100 and City B requires a renewal each year; you can’t compare the initial investment of $100. The two time periods for the return on the investment must be equal.
Rule #3 – Risks Must be Similar
This is important to understand, the conditions and inherent risks for the projects under comparison need to be similar in nature. The formula is designed to exclude external factors such as inflation. These external factors are at the macro level of economics and not at the micro level. The risk factors I explain here are at the micro level. For a better understanding of business risks, please read: Business Risk
If one project has a unique factor that can affect the cash flows, then you can’t compare the projects. Let me illustrate using some extreme comparisons. Continuing with my hot dog cart example, suppose we are now comparing the fact the City ‘A’ is on a beach in Florida, and City ‘B’ is located in some remote location in Canada. It’s apples and oranges. For this to work, both locations need to be similar. City ‘A’ is on a beach and City ‘B’ is on a beach. Some examples of primary risks that should be similar include: 1)location, 2)access to labor pool, 3)weather conditions and 4)access to resources (hot dogs and supplies).
OK, for those of you who are really into the science of this, below is the technical formula. Yes I know, ‘What on Earth does it mean?’ Simply put, it is the discount rate (the letter r for ‘Rate’ in the formula) that makes net present value (NPV) of the number of cash receipts (C) equal the initial investment; the higher the discount rate, the better the return on the investment. Think of it as which would you rather have, an 11% rate of return or a 7% rate of return on your investment?
So to compare the two investments, the ‘N’ (time period) and the initial investment must be equal. What ends up not being equal is the actual amount of cash return depicted by ‘C’ which then changes the value of ‘R’. Remember, the higher the ‘R’ the better the investment.
So let’s go back to the hot dog cart. Again, both licenses are for one year. If you know that City ‘A’ will generate a $37,000 profit and City ‘B’ will generate a $39,500 profit. Then obviously, the cash flow is higher in City ‘B’ and therefore the ‘R’ must be higher in order to bring the NPV of the investment back to $100.
Mistaken Application of IRR
In my introduction above, I said that the formula has little if any value in the small business world. This is due to the inherent nature of the small business world. The reality is that there will rarely if ever exist two or more projects requiring the same initial investment, the same time period for the investment and often more importantly, the same risk. The following sections elaborate in more detail about these respective elements using the formula in determining the Internal Rate of Return.
Equal Initial Capital Investment
For any small business owner, there is rarely an opportunity to compare two or more investments of an equal nature. But I’m going to try to explain one here. Let’s suppose you are residential contractor. You have an opportunity to build a spec house on three different lots. You must purchase the lots and the bank will finance the construction of the house. Each lot is $50,000.
I’ve never seen this, EVER! What ends up happening is that the three lots are $50,000, but lot number 1 requires some type of site development to get it ready to build a house; which means more investment. Lot number 2 can’t pass a perk test or doesn’t have the sewer hookup fee paid, or lot number 3 is perfect, that is all the essential issues are addressed. It has a perk test or the sewer fee paid, it doesn’t require clearing or site work for drainage and so on. So at the end of the day, the three lots are not truly equal in the initial investment.
As a small business owner, you have to be realistic in determining this initial investment. The key is to fully understand ALL OF THE COSTS in the initial outlay of capital to compare the projects. Do you really think that the initial investment is going to be exactly equal? This is the most common mistake in comparing the projects in determining the IRR. They are rarely if ever equal.
I know, most of you are saying, ‘So what’; I mean seriously, is there that much of a difference over a few thousand dollars of cost (initial investment). In a large scale situation such as the recent Tesla Gigafactory whereby a $5 BILLION investment is being made, the answer is ‘NO’. A few thousand or even tens of thousands of dollars isn’t going to make a difference. But in our example, you bet your wallet it will make a difference. I’ll illustrate:
Let’s assume the following initial investment for the three lots:
Lot # 1 – $53,000
Lot # 2 – $52,200
Lot # 3 – $50,000 (remember, this one is perfect)
OK, the rest of the facts are exactly the same, the house is built on the three lots for the same price, sold in the same amount of time, and sold for the same price. So, the gross margin from the sale is $60,000. So let’s determine the IRR for the three projects; to keep it easy, I’m going with exactly one year from start to finish. The following identifies the net margin (gross margin less the capital investment on the project) and the corresponding Internal Rate of Return.
Lot Number Initial Investment Net Margin ($60,000 Gross Margin) IRR
# 1 $53,000 $7,000 13.21%
# 2 $52,200 $7,800 14.94%
# 3 $50,000 $10,000 20.00%
The IRR is significantly different between the three projects. This is because of the low net margin (Gross Margin less Initial Investment) associated with the project. But let’s see what happens if the margin were to increase about $20,000 for each lot.
Lot Number Initial Investment Net Margin ($80,000 Gross Margin) IRR
# 1 $53,000 $27,000 50.94%
# 2 $52,200 $27,800 53.26%
# 3 $50,000 $30,000 60.00%
OK, now we are talking. The variance is actually getting higher for the Internal Rate of Return. In order for the variance to decrease, the final net margin must be relatively smaller and financially less valuable to the small business owner. Let’s take a look if the gross margin is $54,000.
Lot Number Initial Investment Net Margin ($54,000 Gross Margin) IRR
# 1 $53,000 $1,000 1.89%
# 2 $52,200 $1,800 3.45%
# 3 $50,000 $4,000 8.00%
What the above three examples illustrate is how difficult it is to compare rates of return for projects with dissimilar initial investments. You must have similar initial investments to properly compare the projects.
Now, let’s illustrate a comparison with similar initial investments. Let’s assume that all three projects have the exact same initial cost of $50,000. Instead of an equal Gross Margin, let’s change the gross margin on the respective projects because the house models are different. Please take note, the initial investments are equal. What changes is some other factor that affects the final cash flow. In this case, we changed the model of the home which then affected the Gross Margin. Let’s take a look:
Lot Initial Investment Style Gross Margin Net Margin IRR
# 1 $50,000 2-Story $67,000 $17,000 34.00%
# 2 $50,000 Ranch $71,800 $21,800 43.60%
# 3 $50,000 Split-Level $70,000 $20,000 40.00%
From this information, it is easy to determine which project the contractor will invest with his $50,000. It is Lot #2, the ranch style home. This project generated $71,800 of gross margin which is equal to a 43.60% rate of return. Assuming all other factors are equal (amount of time to sell the project, similar neighborhoods, school systems and access to labor and resources) then the builder would indeed select Lot #2 for his project. It has the best opportunity to maximize the return on the investment because all other factors are equal. IRR is used to compare projects of similar investment with similar risk factors and a similar time period.
Comparison to Net Present Value
This is an important aspect of the formula folks need to actually understand. If you look back at the formula, it uses NPV (Net Present Value) of ZERO. This means the cash flows are discounted at a certain rate to bring the entire cash flow from the future back to the initial investment. So there is a relationship that exists between the two phrases. Net Present Value measures the magnitude of dollars at a certain discount rate and Internal Rate of Return is the discount rate used to bring the future cash flows back to the original investment. For the small business owner, it is usually better and easier to calculate Net Present Value. In my example of above whereby the initial investment is equal between the projects, the Net Present Value for the Ranch style house is $21,800. This means that this project will generate the maximum return of physical dollars for the project. In the world of business, many managers/owners/investors don’t want to know the magnitude of dollars but they desire to know the IRR. This is because this value is used compare opportunities against a desired level or against the cost of capital. If the investors can borrow the money for 10%, then all three projects as describe in the Example 4 are good projects to invest with (naturally Lot #2 is the best). If the cost of capital is 37%, then only Lots 2 and 3 can be considered.
In effect, it is easier to compare rates of return than the net present values.
Other Inherent Flaws
There are other flaws with the formula. One of the more interesting ones relates to the future cash flows. In my examples above, there are only two cash flows, one out and one inflow at the end of the project (sale of the house). But what happens if there is a series of negative and positive cash flows over time? A good example in the small business world is the purchase of an annuity over time. The individual buys the annuity with several cash outflows over several years and then receives the inflows over several years. This changes the formula significantly. The formula has its derived result based on a single initial outflow and then a series (or just one) inflow of cash.
Another flaw with the formula deals with the return on the investment for the initial inflows of cash or earlier years of inflow. The formula assumes the initial inflows are reinvested at the same rate as the overall Internal Rate of Return. This is highly unlikely. Often the reinvestment of the initial cash inflows is at the cost of capital. Thus the overall Internal Rate of Return is actually less and for those projects with high initial cash inflows, the effect is substantial.
The last example of an inherent risk relates to the time of the investment. The longer the investment period, the more likely the return will not unfold as initially thought. This is one of the basic principles of economics and business. It is extremely difficult if not impossible to predict what is going to happen several years from now. So, the shorter the time period for the investment, the more accurate and reliable is the IRR calculated.
Summary – Internal Rate of Return
For the small business owner, the Internal Rate of Return (IRR) is not a very valuable tool. IRR is used to compare similar initial investments over a similar time period with similar risks. This just doesn’t happen in the real world for small business. The better financial tool for comparison purposes is the Net Present Value function to determine the magnitude of the return on the investment. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.