Cash Flows From Investing Do Not Include Cash Flows From Alternatives to IRR and NPV

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Alternatives to IRR and NPV

In a previous article, I discussed the disadvantages associated with using the internal rate of return (IRR) or net present value (NPV) as a measure of return for income-producing assets.

I also stated in that article that there are several other return measures that I prefer and they will be the subject of discussion here. Note that these measures are not perfect, but in my experience, I have found them to be stronger and more reliable indicators than IRR or NPV.

As noted in my previous article, the primary drawback of the IRR is that it assumes that all positive cash outflows will be reinvested at the same rate as the IRR. Because this is rarely the case, IRR figures are often skewed, sometimes significantly.

The modified internal rate of return (MIRR) mitigates this problem by assuming that the present values ​​of cash outflows are calculated using the financing rate, while the future value of cash inflows is calculated using the actual reinvestment rate.

Without getting too technical, the formula used to calculate MIRR can be described as “the nth root of the future value of positive cash flows divided by the present value of negative cash flows minus 1.0, where “n” is the number of time periods.

Calculations like the above can be bypassed by simply using the MIRR formula found in Excel. For the case where the cash flows are detailed in cells A2 through A8, using a reinvestment rate of 7.0% and a financing rate of 5.0%, the formula would be: =MIRR (A2:A8, 0.05, 0.07)

However, for this formula to work, there must be at least one negative cash outflow. For examples without negative cash flows, the above “long arm” formula must be used.

In essence, the MIRR formula is simply a geometric mean, identical to the formula used to calculate the cumulative average growth rate for numbers that grow exponentially, such as compound interest earnings.

Since many real estate investments (hopefully) do not have periods of negative cash outflows, the above calculation can be cumbersome, especially in situations involving an investment horizon that spans many time periods. Regardless, since the final calculation is likely to be more accurate than a similar IRR figure, it’s worth the extra time to do it.

There are two other investment metrics that I rely on, perhaps more than any other. This includes the net return on capital and that old reserve, the capitalization rate. If you’re reading this article, chances are you’re very familiar with both metrics, but in case you’re not, the formula used to calculate net return assumes after-tax cash flow + depreciation (principal reduction) divided by initial capital, while the capitalization rate simply net operating income divided by total investment cost.

While none of the above factors in the “time value of money” (such as IRR, NPV and MIRR), the underlying assumptions that go into the calculation of both are very reliable, and as such, the return figures generated by any of them can be used with confidence that they are not distorted by problematic variables.

Analyzing investment properties is not rocket science, and I see no reason to complicate the analysis, when simpler, time-tested indicators are readily available. This is especially true when using more complex measures of return (ie, IRR and NPV) that can distort actual returns.

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