Subsequent Rates of Return

The concept of initial rate of return (IRR) is fairly straight forward and easy to understand.  Related, but not so straight forward, to the initial rate of return, is the subsequent rates of return (no particular acronym) that apply in the periods following the initial rate of return.

Initial Rate of Return

Let's say there is an investment opportunity that has an internal rate of return of 10%.  Note that that was an internal rate of return of 10% and not an initial rate of return.  To provide some figures for this investment opportunity, let's say that this opportunity is a company that has $100,000 in the bank, in an ultra-long term deposit rate of 10%.

This company is for sale.  We know that next years earnings will be $10,000, so we know what our return will be, but the rate of return will be determined by the price that we pay.  Should we pay $100,000 for this company then our initial rate of return will be 10%.  Should we only pay $80,000 then our initial rate of return will be 12.5%.  The lower the initial outlay, the higher the rate of return, and vice versa.

That's all pretty straight forward so far.  The subsequent rates of return get a little more interesting though...


Subsequent Rates of Return

If we continue along the scenario where we purchased the company for $80,000 with an initial rate of return of 12.5%, then let's consider what happens in the subsequent years.

The next year, we will receive $11,000, as the term deposit now has $110,000 earning interest at 10%.  Now, we have not made any additional outlays other than the original $80,000 to get this $11,000, so our rate of return this year is 13.75%.

And, each subsequent year, the rate of return grows by another 10% - which is the original internal rate of the return of the company.  By the seventh year, you are receiving over 20% rate of return, and better yet, it's still growing by another 10% each year.

Conversely, had we paid $120,000 for this company, the initial rate of return would have been 8.33%.  This would also grow by 10% each year, and it would take 6 years before we reached a rate of return of 12.5%.

Conclusion

The two most important things to consider when making an investment are:

• The quality of the underlying investment.
• The price that you pay