Internal Rate of Return and the Cultural Divide of Cash Flows
Plus how John D. Rockefeller Jr. continues to exemplify success.
Here’s an analysis I developed to help a young couple considering the purchase of their first residence. The working assumptions were as follows:
Remember, agreeing or disagreeing with the assumptions has nothing to do with the validity of the math, but it has everything to do with the validity of the analysis. That’s why I always gather the assumptions first, and make them variable. You’ll also notice that there are two tiers of assumptions in this analysis; the second tier derives from calculations based on the first tier.
Here’s what the analysis yielded:
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What did the IRR analysis conclude?
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Bottom line, without the “use value” (the assumed rental value of the house), this investment yielded a compound annual IRR of 3.07% over the 10-year life of the ownership including the net cash gain in sale year 10. With the “use value” folded in (stated with quotation marks, since they intended to occupy, sometimes known as an “imputed [or implied] value”), the IRR rose to 11.50%. These calculations could be compared and contrasted with conventional even-cash-flow annuities in the context of comparative risk.
In a riskier investment, such as an apartment house with varying expenses and income, including the inevitable prospect of vacancies, seesawing energy costs, and volatile market conditions for rent, the comparisons to annuities become increasingly esoteric. With a start-up business in a cutting-edge market, such as technology, almost anything can happen -- “sure-thing” markets disappear, proprietary technologies suddenly become obsolete, key people croak -- which is why venture capitalists rely so heavily on adequate capitalization and largely nonfigurative appraisals such as “management quality.”
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