Internal Rate of Return (IRR)
What is the Internal Rate of Return?
Internal Rate of Return is an annualized rate of return that takes into consideration the structure of cashflows on your investment. It differs from simple rates or flat profit rates in that it takes into account the time value of money, which is an important consideration in any investment decision. For example, a series of monthly payments of $100 for 10 months is valued differently than one lump sum payment of $1,000 in 10 months.
The power of IRR is that it allows you to compare different investments in a standard way. An investment that pays $200 every 2 months for 10 months has a lower IRR than an investment that pays $100 every month for 10 months, and therefore the latter investment is more attractive. You can use the cash you earn earlier to make other investments and earn returns on them. As an investor, you can use IRR to check the attractiveness of liwwa investments as compared to other fixed-income investments like government and corporate bonds, certificates of deposit, and stock dividends.
Note that IRR is not an inflation adjusted rate of return.
Does an IRR of 20% mean I will have 20% more cash in one year?
Not necessarily. If you invested $100 and, in one year, you received a lumpsum payment of $120, then yes, an IRR of 20% means you have 20% more cash at hand by the end of the year (See Scenario A in Table 1 below). If, however, you invested $100 and received 12 monthly payments of $9.18, your cash at hand increased by about 10.16% but your IRR is 20% (Scenario B in Table 1 below). These two cashflows are equally attractive from an investment standpoint. In the first case, you'll make 20% more cash by the end of the year, in the second case, you'll make 11.12% more cash by the end of the year, but you're making that cash earlier and you can re-invest it earlier as well!
|Date||Scenario A||Scenario B|
How does liwwa calculate the IRR for a funding campaign?
The first step is to look at the expected cashflow schedule. The first item on the cashflow schedule is the investment made by investors (the campaign pledges), which shows as a negative amount in the schedule (i.e. a cash outflow). The next few items on the schedule are the expected payment amounts and dates to be made by the borrower. Before a campaign is fully funded, we make the the assumption that it takes about 1 month for a campaign to be funded and for funds to be disbursed to the borrower. Once funds are disbursed to the borrower, the payment schedule differs from a campaign to another and depends on loan tenor, grace period, and the periodicity of payments (e.g. every month vs every 3 months).
Table 2 below shows an example of an unfunded campaign starting on January 1st, with a loan tenor of 12 months, periodicity of 2 months, and grace period of 1 month, and a flat profit rate of 10%.
|2015-01-01||-$100||This is a pledge made to the campaign. It shows as a negative amount, since it's a cash outflow.|
|2015-05-01||$18.33||This is the first scheduled payment. It shows as a positive amount or a cash inflow. Since the campaign is unfunded, the schedule is a projection and may change based on when funds are disbursed and/or timeliness of client payments.|
Once we've established the expected cashflow schedule, calculating the IRR is straightforward, and can be done by applying the Internal Rate of Return formula to the cashflow schedule above. Many spreadsheet applications, like Microsoft Excel, offer a function that allows you to calculate the IRR easily. You can copy the schedule above to a Microsoft Excel spreadsheet and apply the XIRR formula on the values and dates above. You should get a result of 13.66%. liwwa's internal implementation of IRR formula replicates the results produced by Excel's XIRR formula.
What happens to the cashflow schedule after a campaign is funded?
Once a campaign is funded, the schedule will be updated based on when funds are disbursed to borrower, which usually happens within one month of the start of a campaign. After the borrower starts making payments, the cashflow schedule will start including both the actual payments made and their dates and the scheduled payments to be made in the future. If a borrower is late on payments by a month or more, we adjust the expected cashflow schedule by shifting the future payments farther by one month or more. This keeps happening until a borrower is declared to be in default, after which the cashflow schedule will only include the past payments made and none of the future scheduled payments.
Why is liwwa transitioning to IRR instead of Annualized Profit?
IRR is a standard financial measure that better enables investors to compare the returns of their liwwa investments versus their other investments. We've received a lot of investor feedback that highlighted how challenging it was to understand how Annualized Profit is calculated and how to compare it to other investments; IRR goes a long way towards addressing those concerns.
We thank all of our passionate investors for their constructive feedback and would love to hear what you think about this feature. Please do not hesitate to contact us at firstname.lastname@example.org for any inquiries.
Further Reading: Excel XIRR