IRR vs Cash-on-Cash: What's Better For Evaluating an Investment?

 Internal Rate of Return (IRR) and Cash-on-Cash Return are both metrics used in the world of finance and investing to gauge the performance of an investment. However, they measure different things and are best used in different contexts. Here's how they compare and contrast:

 Relevant Templates:

Both of these metrics are often used in real estate investment evaluation and are the first calculations I learned when I started building financial model templates.

Internal Rate of Return (IRR):

IRR is a comprehensive way to calculate the annualized rate of return for an investment. It takes into account the present value of money and accounts for the timing of cash flows - so it's especially useful in scenarios where cash flows may vary year to year. It considers all cash inflows and outflows over the entire life span of the investment.

Advantages of IRR:

  • IRR takes into account the time value of money, providing a more complete picture of an investment’s potential return.
  • It accounts for all cash flows over the life of an investment, making it ideal for investments with varying returns over time.
Disadvantages of IRR:
  • It can be more complex and difficult to calculate, particularly for investments with irregular cash flow. The XIRR function in Excel can help normalize the rate when you want to calculate this based on specific dates that have irregular period lengths.
  • IRR assumes that interim cash flows are reinvested at the IRR itself which may not be realistic.

When you calculate the Internal Rate of Return (IRR) for an investment, you're finding the discount rate that makes the net present value (NPV) of all cash flows (both inflow and outflow) from a particular project or investment equal to zero. In other words, it's the rate at which the present values of cash inflow and cash outflow are equal.

A key underlying assumption when using IRR is that any cash flows received during the course of the investment are reinvested at the IRR itself. This is known as the "reinvestment assumption."

Here's an example to illustrate the point: Let's say you invest in a project that is expected to generate a positive cash flow at the end of each year for the next five years. If you calculate the IRR for this investment, and it turns out to be 10%, this assumes that the cash received at the end of each year is reinvested at a 10% rate of return.

The assumption can be unrealistic because it may not always be possible to reinvest the intermediate cash flows at the same rate as the IRR. Market conditions can change, and other investments with the same rate of return might not be available. Hence, the actual returns may be less than the calculated IRR if the reinvestment rate is lower than the calculated IRR. This can potentially lead to overestimating the attractiveness of the project or investment when making the investment decision based only on the IRR.

In the real world, the rate of return for reinvesting intermediate cash flows often differs from the project's IRR, which is why some investors prefer to use the Modified Internal Rate of Return (MIRR). The MIRR allows the investor to assume a different reinvestment rate, which can provide a more accurate picture of the potential profitability of a project or investment. 

Note, Excel does have an MIRR function as well.

Cash-on-Cash Return:

Cash-on-Cash Return is a simpler calculation that compares the cash income earned on an investment to the amount of cash invested. It does not take into account the time value of money, but gives a clear, understandable measure of an investment's immediate yield.

Advantages of Cash-on-Cash Return:

  • It's straightforward and easy to calculate, ideal for quick assessments and comparisons.
  • It provides an accurate depiction of the annual cash yield an investor may expect, making it good for cash flow-focused investments (real estate).

Disadvantages of Cash-on-Cash Return:

  • It does not take into account the time value of money.
  • It only focuses on annual return, so it may not fully represent an investment’s overall potential.

In summary, IRR and Cash-on-Cash Return are both useful, but they serve different purposes. IRR is best for a holistic view of the investment over its entire lifetime, while Cash-on-Cash Return is a good indicator of an investment's immediate or short-term annual yield.