A few notes and two questions to ask when applying and interpreting IRR.
Internal rate of return (IRR) reflects the compounded return produced by an investment or capital project. IRR is best used in tandem with other measures, such as Net Present Value (NPV), especially in fields such as forestry, timberland investing and other capital projects. As a ‘rate’ of return, IRR is a relative measure, not an absolute one, so it does not tell us anything about investment size or wealth creation. However, it remains a powerful and intuitive tool when properly deployed (like a chainsaw).
IRR does not, per se, provide a “proper” or “appropriate” signal for the risk associated with a given investment. Rather, IRR specifically and by definition simply provides the rate of return that produces an NPV of zero given the assumed cash flows.
IRR does provide a good signal for the returns associated with our cash flow “story”. Assuming we’ve accounted for concerns with the reinvestment rate (see questions below), the IRR gives us a useful measure of investment performance especially when used in conjunction with NPV.
IRR provides a robust, intuitive measure for investments with one cash flow out (your investment) and one cash flow in (your future return), such as when we evaluate enhancements, improvements or specific treatments (e.g. forest management activities such as fertilization).
However, IRR can mislead when the investment generates multiple cash flows over time. To better understand the context and assumptions about a stated IRR for investments with multiple cash flows, ask two questions to confirm the IRR was properly applied:
- “What is the assumed reinvestment rate?” This question alone indicates whether or not the firm or analyst is aware of or considered the reinvestment rate issue. Ideally, the person will respond, “we assumed that interim cash flows were reinvested at the cost of capital” or some other reasonable discount rate. Otherwise, the IRR may overstate, if not directly misstate, the potential returns of the investment.
- “When do interim cash flows occur in the life of the investment?” With an improper reinvestment rate assumption, IRR’s overstatement of potential returns will be worse when cash flows occur sooner in the life of the investment rather than later. Why? Because the assumed reinvestment rate goes into effect sooner – it’s applied early on generated cash flows – and the returns from this overstated IRR accumulate for more years. This reinforces why the ideal application for IRR is a project with one outgoing initial investment and one incoming cash flow at the end of the investment. In those cases, IRR provides a perfect read on annualized returns.
Click here to learn about and register for “Applied Forest Finance” on March 30th in Atlanta, Georgia. The course details necessary skills and common errors associated with the financial analysis of timberland and other forestry-related investments. All students receive a copy of Forest Finance Simplified