Let’s think about this formula as it relates to Stock #1. The formula above is basically asking "What is the rate of return on an investment in which I am outlying $100 today, receiving $2.50 in a year and then $125 in two years?"
Written out that looks like this: $100 = $2.5/(1+r) + $125 (1+r)2
When you do the math, r=13.06%.
Comparing to cash-on-cash return
Cash-on-cash return (CoC) is a simple and easy financial metric investors use to look at a potential investment. CoC is simply the cash flow from an investment divided by the initial cash outlay. If we go back to the example of the two stocks, both actually have the same CoC of 127.5%, even though their timings are different.
CoC is an excellent tool to use when the timing of cash flows is steady and consistent, like with a rental property. For example, if you plan on buying and holding a rental property, CoC probably makes more sense to use than IRR, especially because it's so simple. Let’s say you buy a three-family for $1 million, put $200k down, and your annual cash flow from the property is $16,000. Your annual CoC is then 8% ($16,000/$200,000). There’s no need to get out your financial calculator and calculate IRR.
When is a good time to use IRR?
At the end of the day, you're trying to decide if an investment provides a high enough return to be worth spending money and time on. That being the case, for investments with uneven cash flows, depreciating assets, or when you want to see your return based on the real-time held period, IRR is more appropriate to use than CoC.
Let’s use the example of a three-family home in which you can rent one of the units immediately, but have to do some work in the other two before they can produce cash flow. You expect to rent one of those in year two and the other in year three. To keep it simple, let’s assume the following:
- Purchase price of $1,000,000 with 20% and closing costs of $5,000.
- Rental (gross) income in each unit annual of $30,000.
- Total expenses, including debt service of $75,000 ($25,000 per unit).
- Work to be put into the two units (all in the first year) of $100,000 (consider this an up- front cost to keep things simple).
- You expect to sell the property for $1.5 million in four years with $70,000 of the mortgage paid off.