February 2, 1998 in Nation/World

Irr Often Is Difficult To Figure Out

Paul Willax The Spokesman-Revie
 

A number that’s of great significance to most entrepreneurs and investors is the return they are realizing on their monetary investments. There’s no point in putting in 26-hour days if the payback isn’t adequate. But calculating that return isn’t always easy.

Q. I’m about to make an investment in my brother-in-law’s business venture, and my accountant tells me I should be looking for an internal rate of return of between 15 and 20 percent. Does that make sense? And how do you calculate such a return?

A. The calculation of internal rate of return is best done with a financial calculator or PC program designed to crank out such numbers.

Since it’s partially a trial and error process to find the right percentage number that fits the circumstances, trying to derive the IRR by hand is out of the question for mere mortals. Most of the instruction books that accompany financial calculators will provide a step-by-step description of how to enter the required numbers and produce the output you are looking for.

What you are trying to determine is a percentage figure that relates to the money you’ve put into the investment and the cash flows you will receive from it. The purpose is to determine if the resulting number is greater than your cost of capital.

If it isn’t, it would obviously be unwise to make the investment. It would be costing you more to make the money available to the venture than you would be receiving in return.

The higher the IRR, the greater are the cumulative cash flows generated by the business in comparison to the cash invested. Your accountant is suggesting that your acceptable floor should be in the 15-20 percent range.

Since, presumably, you could probably borrow money at less than that rate range, he is probably taking into account your alternative investment opportunities, i.e. the other places you could put your money and get a better return. For example, if you put your money in publicly traded securities during the past year you could have outperformed that rate of return with just beginner’s luck.

Furthermore, you’ve got to consider that money devoted to a private investment is illiquid, meaning you can’t just call a broker and ask him to sell it to get your cash back. This liquidity disadvantage should also be taken into account when establishing the “hurdle rate,” or minimum rate of return, you are seeking.

Its a tough concept to simplify in a few words. Suffice it to say, the IRR is the discount rate which, if applied to cash flows into the investment and cash flows from the investment - including the proceeds of any sale of the investment in the future - will cause the present value of both flows to be equal.

If you are interested in more confusing technical details about what the IRR number you are calculating really, really reflects, I’d advise grabbing a strong cup of coffee and checking out a college level financial management textbook.

Whether the percentage target your accountant suggested makes sense or not, is a judgment call. For a risky, illiquid, start-up venture, it might be a bit on the low side. Moreover, cash flows are difficult to accurately predict in such a new venture, so your precise calculations with “iffy” info might very well produce irrelevant answers. However, since the entrepreneur in this case is a relative, it wouldn’t be unreasonable to lower your sights somewhat.

Herewith is a challenge to our readers. If anyone can explain this statistical gobbledygook better than this article has done, send it on and we’ll share it with all those we’ve confused with the paragraphs above.

Q. What’s the best accounting or bookkeeping software to use in start-up?

A. There’s a ton of good software on the market today, so, not knowing your exact situation or the sophistication of the outputs and controls you desire, it’s difficult to grade any the “best.”

However, based on the feedback from the entrepreneurs I meet with regularly, the hands-down favorite seems to be Quicken, a PC product produced by Intuit.

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