what it the difference between internal rate of return and interest rate?

Question

When comparing investment in a bank account versus investment in a property (for example), one would like to compare the property investment with the interest rate obtainable from a bank account. When calculating the Internal Rate of Return for a property investment, if one recalculates the same investement amount as if it were in a bank account earning an interest rate equivalent to the IRR, the results are different. Why is that?
Is there a way of generating a percentage rate from IRR which is comparable with other forms of investment?

Answer 1

I was going to say

"IRR is the bank interest rate that you have to beat to make your investment worth the risk"

but then I read on and it looks like you got that far already, further in fact, because it looks like my explanation doesn't hold good.

Another way of looking at it is to say you're going to borrow for your investment at a certain rate. IRR is the borrowing rate at which your project is breakeven in Net Present Value terms - i.e., it generates no returns; the NPV is zero.

I think the problem with the calcs could be one of two things

(1) the way the interest rate is expressed in banking is very important - how often the interest is calculated, where it's paid, is it compounding, etc

(2) MS Excel has (I believe) a bug in the IRR function. It's possible to calculate an IRR, then use that IRR to calculate an NPV, and for that NPV to not be equal to zero - which it should be if the IRR is calculated correctly.

Always do your IRR/NPV calcs explicitly and don't trust Excel. Note, no-one else thinks that, just me. So maybe I'm wrong about that too...

With all this depreciation, what's the NPV of my ten points now?

Answer 2

Probably because of compounding in the bank account. In Excel the IRR of cashflows for a 3 year investment like (-1000, 100, 100, 1100) will be 10%. However on a bankaccount calculation the value after 3 year would be 1331. This takes into account interest earned on interest, while the IRR does not do that.

Answer 3

You can calculate IRR & Return rates for both the property as well as the bank account.

1) Calculate the amount of returns you are going to get from each of them seperately. like maybe u get 9%/yr and 6%/yr compunded. on this case, you can see thatu have to choose 9% since it gives higher returns

2) IRR is the rate of inflation at which your present value of investment becomes zero. so if the IRR of the bank investment is 12% and the IRR of the property is 14%, so that means that if inflation goes upto 12%, your bank account will yield no returns while your property investment gives you 2%

there is a possibility that both methods may give you different decisions..you have to decide in that case, wether to go for higher returns with higher risk of inflation or vice versa.

now, USUALLY, banks always cover the inflation rate so u are always covered by the bank in that case...

Answer 4

Interest rates generally are IRRs, but not all IRRs are interest rates.

When we talk about interest rates, we usually mean the yields of Treasury Bonds. A yield is the rate that equates the price of a bond with the present value of the future flows. In other words, if you find the present value of each future cash flow -- discounting at the yield, then add them together, it gives you the value of the bond.

An IRR is also an interest rate that gives you the proper price. But IRRs are used for other things as well -- such as finding the return of a corporate project or a loan.

Answer 5

The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. In more specific terms, the IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first. A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects. In layman's language, when you invest $100,000 and you are promised to received $1000 per month, then we will discount the value of $1000 for next "X" period and find out, the value of $100,000

Answer 6

I would not recommend that you compare alternative investments using IRR. This is because the implied discount rate would be different for each of the investments, which makes no sense. It is better to decide on your personal discount rate, then compare the NPVs of the alternative investments at that rate.

Answer 7

Interest rates are usually annualised numbers. Have you done the same with the IRR?

Answer 8

IRR is the interest rate applicable only in the instance when NPV(net present value) would equal "zero".

Otherwise, Interest rate can be anything.

Answer 9

dunno