Alec J. Pacella
Growing up in the 1970s meant that we had some really cool toys. Among the coolest were electric racing sets. Known as “slot cars,” these sets provided hours of fun, especially when all the neighborhood kids brought over their individual sets to create super tracks.
AFX was considered the king of slot cars, but one day I noticed a new upstart on the shelf: Tyco. And their set was really cool. The grooved channel that ran down the center of each lane was gone. And the hand controller could not only adjust the speed of the cars but also allow them to change lanes. I had to have it so after hoarding up my weekly allowance, and dipping into my birthday money, I finally saved up enough to buy one. And it was great racing, requiring all sorts of new strategies. But it also created a problem. I had a fair bit invested in the AFX products but neither the miles of slotted track nor the stable of cool slot cars were compatible with the Tyco products.
A few months ago, I took us back to school in this column and this month we are starting third period. To discover how slot cars relate to the concept of capital accumulation, read on.
IRR (internal rate of return) is similar to that wiz-bang Tyco racing set of my youth; a terrific concept that can be very useful. But it has some limitations. And to better understand these limitations, we need to first under- stand what IRR is actually measuring. The textbook definition of IRR is the rate of return that each dollar earns in an investment while it’s invested. But this definition underscores a major point of clarification; IRR only con- siders money that is internal or inside of the investment. Once money comes out of the investment, IRR makes no assumptions about what we do with that money. IRR doesn’t care; the only thing IRR cares about money that comes out of an investment is that it is no longer in the investment. But, as an investor, I care because I can do something with that money.
Here’s a simple example to illustrate this point. Suppose I’m considering two different investments. Each are equally attractive and have the same perceived degree of risk. Investment A costs $100,000 to purchase and I expect it to produce $10,000 each of the five years that I plan
to own it. At the end of the fifth year, I anticipate selling it for $100,000. I don’t need a financial calculator to deter- mine that investment A has an IRR of 10%. Investment B will also cost me
$100,000 upfront. But it will produce no cash flows for the five years I will own it and at the end, I expect to sell it for $161,051. I will need a financial cal- culator for this one; PV is ($100,000), FV is $161,051, n is 5, and if I solve for I/YR or in this instance, IRR, I am greeted with 10%.
Great – but even though both invest- ments have an IRR of 10%, which is better for me? And if you are think- ing it doesn’t matter, consider that I was thinking the same thing when I pulled the trigger on that wiz-bang Tyco racing set. Here is why. IRR makes no consideration of what I can do with the
$10,000 that comes out of investment A each year. As I said earlier, the only thing that IRR cares about money that comes out of a deal is that it is no longer in the deal. And let’s assume that I follow along and don’t care either. Each year that the $10,000 comes out of the deal, I simply put it into a mason jar and bury it in the back yard. At the end of five years, I get the $10,000 in cash flow from year five and the $100,000 in sale
proceeds. Then I walk out to the back yard, dig up those four mason jars, still containing $10,000 each, and I dump everything into one big pile. That pile will have $150,000 in it, right? In terms of an annual rate, how much did my original $100,000 investment grow over those five years? PV is ($100,00), FV is
$150,000, n is 5 and when I solve for I/YR, I will see 8.45%. In this instance, the rate is referred to as the Capital Growth Rate, or CGR. More on that in a sec.
The only thing that [internal rate of return] cares about money that comes out of an investment is that it is no longer in the investment. But, as an investor, I care because I can do something with that money.
But first, a question. Why has this happened – why does investment A have an IRR of 10% but a CGR of only 8.45%? For the same reason that, by itself, the Tyco racetrack looked so good, right up until I considered the bigger picture. The money that was in the deal did well, earning 10% over the life of the investment. But the money that came out of the deal didn’t do so well – the mason jar equates to an IRR of exactly zero. As a result, our total pile of cash, which is what most investors really care about, is smaller when compared to investment B. With B, nothing came out; all $100,000 that was originally invested remained in the deal the entire time and earned 10% annually over those five years. The result is a bigger pile of cash. Again, IRR only considers money in the deal. Capital accumulation also considers money that came out of the deal and can be reinvested at a chosen reinvestment rate. And if that reinvestment rate is lower than the native IRR, the pile of cash for that alternative has to be smaller.
Looping back to CGR, in a capital accumulation application, the generic I/YR component is termed the Capital Growth Rate. It measures the annualized rate at which the total original invested capital as well as the reinvested cash flows collectively grows over the holding period. I hesitate to use the term “composite yield,” as the strict academics among us would likely frown. But that’s what it is telling us – how much our total capital is \growing over a given time period. And if you think we are done with this topic, think again!
Now that we have a grip on the concept of capital accumulation, next month we will move on to fourth period and discuss a similar concept called Modified Internal Rate of Return. And don’t worry, there will be more to come on the AFX vs. Tyco story as well!
For Properties Magazine, December 2022