When you are evaluating an investment, a useful number number to know is the internal rate of return.
For some investments, like bank accounts, the internal rate of return is easy to figure because the bank tells you what it is. For example, a 5% simple interest bank account has an internal rate of return of 5%.
For other investments, you have to do some work to calculate the internal rate of return. This is especially true of investments like building a factory or getting an education. These kinds of investments generally don't pay money in nice even amounts like a bank account does. Nevertheless, you can calculate an internal rate of return for these investments, and use it to decide which investments pay best.
To evaluate investments and calculate an internal rate of return, we
need the concept of income stream.
Here is a 5% simple interest bank account, expressed as an income stream.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
Income | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 |
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
Income | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 |
Note: To keep things simple, we imagine that interest is paid annually. Most real life bank accounts pay interest monthly. Also, we imagine that we withdraw each year's interest payment from the bank. We don't leave it in the bank to compound (earn interest on the accumulated interest) during the following years.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
Income | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 |
This table shows the bank income stream and the machine income stream.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
Bank | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 |
Machine | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 |
Bank Account: -1000 + 50 + 50 + 50 + 50 + 50 +1050 = 300
Machine: -1000 +200 +200 +200 +200 +200 + 200 = 200
The income stream from the bank account adds up to $300. The income
stream from the machine adds up to $200. Does this make the bank account
better?
We use the "present value" concept. This concept is reviewed below, but it is introduced in its own Interactive Tutorial on Discounting Future Income. That tutorial includes a spreadsheet template for calculating net present values of income streams. Please try that tutorial now if the above question puzzled you.
The point is: The bank account income stream pays more money in
total, but most of that income is in the big lump of $1050 in year 6. The
machine pays less in total, but it pays more money per year in the years
that come sooner. Getting the money sooner is what may make the machine's
income stream have a higher present value than the bank's.
An income stream is a series of future values. The present value of an income stream is calculated by adding up the present values of all the items in the income stream.
To calculate a present value, we need to pick a discount rate. Since one of our alternative investments is a 5% per year bank account, let's pick 5% per year as the discount rate.
Year ª | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Total |
Machine income stream | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | |
1.05ª | 1.0000 | 1.0500 | 1.1025 | 1.1576 | 1.2155 | 1.2763 | 1.3401 | |
Present values, at a 5% discount rate | -$1000 | $190.48 | $181.41 | $172.77 | $164.54 | $156.71 | $149.24 | $15.14 |
The total of these present values is $15.14. This is the present value of the machine income stream at a 5% discount rate. (If you check the addition, you'll get $15.15, due to round-off error.) The tutorial on discounting future income has a nifty spreadsheet setup for calculating present values that you can copy and use in your own spreadsheet.
The fact that this $15.14 total is bigger than $0 is enough to tell us that the machine is a better-paying investment than a 5% interest bank account.
Not convinced yet? Let's apply the same calculation to the 5% interest bank account.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Total |
5% account income stream | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 | |
Present value, 5% discount rate | -$1000 | $47.62 | $45.35 | $43.19 | $41.14 | $39.18 | $783.53 | $0.00 |
At a 5% discount rate, the machine has a higher present value ($15.14) than the 5% bank account (with its present value of $0), so the machine is the better-paying investment.
So far, so good, but what if we have other alternative investments?
How do we compare them? How do we decide what discount rate to use?
We can define the machine's internal rate of return the same way. The internal rate of return for the machine is the discount rate that makes the present value of the machine's income stream total to zero.
Consider this table:
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Total |
Income stream | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | |
Present value, at a 5% discount rate | -$1000 | $190.48 | $181.41 | $172.77 | $164.54 | $156.71 | $149.24 | $15.14 |
Present value, at a 6% discount rate | -$1000 | $188.68 | $178.00 | $167.92 | $158.42 | $149.45 | $140.99 | -$16.54 |
The applet below allows you to change the discount rate to anything between 5% and 6%. Use the scrollbar on the left side. When the slide is all the way to the left, the discount rate is 5%. When the slide is all the way right, the discount rate is 6%. To move the slide, you can:
Please do not scroll down past this area until you have tried the applet.
The text resumes here: |
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Total |
Income stream | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | |
Present value, at a 5.47% discount rate | -$1000 | $189.63 | $179.79 | $170.74 | $161.63 | $153.24 | $145.30 | $0.06 |
The machine investment's 5.47% internal rate of return is higher than the bank account's 5% rate of return. This is sufficient to tell us that the machine is a better-paying investment.
Two cautionary notes:
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | IRR |
Machine | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | 5.47% |
5% bank account | -$1000 | $50 | $50 | $50 | $50 | $50 | $1050 | 5.00% |
The answer is: Even if the times when you'll need money don't match when the investment pays, you should still go by the internal rate of return. That's especially true if the investment pays you money before you need it.
That's because you can use the bank, even if you buy the machine. You can deposit the extra income from the machine into a 5% account. At the end of Year 6, you'll have a bigger lump of money than you would have had if you had put your $1000 in the bank.
Here's how it works, in laborious detail.
You buy the machine for $1000. At the end of Year 1, you get $200. You keep $50 for spending, just like you would do for the bank account (according to what we assumed), and put the extra $150 into the bank | End of year 1:
You get $200.00. You take $50.00. You add to bank account $150.00. Bank balance is $150.00. |
At the end of Year 2, the bank pays you 5% interest on your $150. That makes your bank balance $157.50. At the same time, you get another $200 from the machine. You keep $50 of that for spending, and put $150 in the bank. Your bank balance is $157.50 + $150 = $307.50. | End of year 2:
Bank adds 5% of $150.00, $7.50. You get $200.00. You take $50.00. You add to bank account $150.00. Bank balance is $307.50. |
At the end of Year 3, the bank pays you 5% interest on your $307.50. That makes your bank balance $322.88. The machine pays you another $200. You keep $50 and put $150 in the bank. Your bank balance is $322.88 + $150 = $472.88. | End of year 3:
Bank adds 5% of $307.50, $15.38. You get $200.00. You take $50.00. You add to bank account $150.00. Bank balance is $472.88. |
At the end of Year 4, the bank pays you 5% interest on your $472.88. That makes your bank balance $496.52. The machine pays you another $200. You keep $50 and put $150 in the bank. Your bank balance is $496.52 + $150 = $646.52. | End of year 4:
Bank adds 5% of $472.88, $23.64. You get $200.00. You take $50.00. You add to bank account $150.00. Bank balance is $646.52. |
At the end of Year 5, the bank pays you 5% interest on your $646.52. That makes your bank balance $678.84. The machine pays you another $200. You keep $50 and put $150 in the bank. Your bank balance is $678.84 + $150 = $828.84. | End of year 5:
Bank adds 5% of $646.52, $32.32. You get $200.00. You take $50.00. You add to bank account $150.00. Bank balance is $828.84. |
Finally, at the end of Year 6, the bank pays you 5% interest on your $828.84 That makes your bank balance $870.28. The machine pays you its last $200. Your withdraw the $870.28 from the bank, and you have $870.28 + $200 = $1070.28. By comparison, at the end of six years with the bank alone you get $1050. With the machine, you're ahead by $20.28. OK, it's not that much, but it does show that even if you don't need most of your money until Year 6, you wind up with more if you buy the machine. | End of year 6:
Bank adds 5% of $828.84, $41.44. Bank balance is $870.28. You get $200.00. The total you have is $1070.28. |
The internal rate of return is the interest rate that makes the present value of the investment's income stream -- its costs and payoffs -- add up to 0.A digression: We keep talking about the "internal" rate of return. Were you wondering if there is such a thing as an "external" rate of return? There is, and the above analysis is an example, because it takes into account the interest that you can earn from machine's payments in the bank, which is an investment separate from, and thus "external" to, the machine investment itself. (Thanks to H.E.M. for putting me onto this.)
Internal Rate of Return Summary (so far)
The internal rate of return is a measure of the worth of an investment.
If the risks are equal investments with higher internal rates of return
pay better.
1. Evaluating a bond sold at a discount.
2. Detecting an economic shortage.
3. The effect of regulation on innovation.
The Sam's Software Corporation (a fictitious entity) is selling 5-year
$1000 bonds that pay 10% interest per year. The bonds are selling at $900.
How do you evaluate the bonds as an investment?
The first step is to figure out what the income stream is. Which of
these is the income stream for a 5-year $1000 10% bond that's selling for
$900?
Please do not scroll down past this area until you have tried the applet.
The text resumes here: |
Income stream for $1000 5-year bond, paying 10% interest, bought at $900.
Year | 0 | 1 | 2 | 3 | 4 | 5 |
Income stream | -$900 | $100 | $100 | $100 | $100 | $1100 |
Since the nominal interest rate is 10%, let's evaluate the present value of this at 10%, and see what we get.
Year | 0 | 1 | 2 | 3 | 4 | 5 | Total |
Income | -$900 | $100 | $100 | $100 | $100 | $1100 | |
Income discounted at 10% | -$900 | $90.91 | $82.64 | $75.13 | $68.30 | $683.01 | $100.00 |
Just to be sure we're all together here, please answer this:
The $683.01 number in the above table comes from the formula $683.01
= F/(1 + i)ª. Fill in the entry boxes below with the correct numbers
for F, i, and a. (For each entry box, click in it to type in it, then press
Enter to see if you're right. You can also use the Tab key to move from
one box to the next.)
Let's find the internal rate of return for this bond. The applet below
allows you to change the discount rate to anything between 0% and 20% by
clicking and dragging the slide. To change the discount rate by 10%, click
in the space between the slider and the end. To change the discount rate
by 0.1%, click on the scrollbar's ends. As you change the discount rate,
the applet will recalculate the present value of the income stream.
See how close you can get the total present value to $0. The discount
rate at that the present value closest to $0 will be our approximation
of the internal rate of return. As before, make a mental note of this discount
rate, then go on.
Please do not scroll down past this area until you have tried the applet.
The text resumes here: |
Year | 0 | 1 | 2 | 3 | 4 | 5 | Total |
Income stream | -$900 | $100 | $100 | $100 | $100 | $1100 | |
Present value, 12.8% discount rate | -$900 | $88.65 | $78.59 | $69.67 | $61.77 | $602.35 | $1.04 |
Shortages can manifest themselves two ways. One is with long lines of buyers or empty store shelves. The other is with prices higher than cost plus normal profit. (More on "normal profit" later.)
Detecting the first type of shortage is easy -- you just observe the lines or empty shelves. Detecting the second type is harder.
How do you judge when prices are high? Use the internal rate of return! We'll illustrate this with our machine investment example.
Suppose that there are two investments available to large numbers of
investors. One is machines like this.
Our machine investment. But now, anybody can play.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | IRR |
Income | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | 5.47% |
As more and more firms buy machines, put them to work, and try to sell
the machine's products, what would you expect to happen to the typical
machine's income stream?
As the supply of the machine's products expands, and assuming that the demand curve stays the same, the prices of the machine's products should fall. This will cause the amount of income earned in years 2-6 to shrink. That will make the internal rate of return fall.
For example, suppose that annual income falls by just $1 to $199.
Here's the machine investment after competition starts to drive prices down:
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | IRR |
Income | -$1000 | $199 | $199 | $199 | $199 | $199 | $199 | 5.31% |
How far would you expect the income amounts to fall?
Please do not scroll down past this area until you have tried the applet.
The text resumes here: |
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | IRR |
Income | -$1000 | $197.02 | $197.02 | $197.02 | $197.02 | $197.02 | $197.02 | 5.00% |
How economic shortage fits with this:
If an investment has a high rate of return that persists over a long period of time, economists infer that competition must not be working as it should to lower income and equalize rates of return.
Normal profit is profit equivalent to what you could earn in the bank. No business would persist that didn't earn normal profit. Why put money into a business if you can do better in a no-effort bank account? But if the return to an investment stays higher than normal for a long time, that's an indication of an economic shortage, and some kind of monopoly restriction.
Some economists used to argue that the high rate of return to a physician's
education showed that there was an economic shortage of physicians. In
the late 1990s, managed care may reduce physicians' incomes to the point
that there is an economic surplus, with below-normal returns, particularly
to speciality training.
Let's go back to our original machine investment again. Imagine that
we have a patent to protect us against competitors and their price cuts.
Our machine investment, as before.
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | IRR |
Income | -$1000 | $200 | $200 | $200 | $200 | $200 | $200 | 5.47% |
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | IRR |
Income | -$1000 | $0 | $200 | $200 | $200 | $200 | $200 | $200 | ????? |
What happens to the internal rate of return?
Find the internal rate of return for this machine now. The applet lets
you change the discount rate to anything between 0% and 6% by using the
scrollbar. Click on and drag the slide, or click in the space between the
slider and the end to change the discount rate by 0.10%. Click on one of
the scrollbar's ends to change the discount rate by 0.01%. As you change
the discount rate, the applet will recalculate the present value of the
income stream. See how close you can get the total present value to $0,
then scroll down.
Please do not scroll down past this area until you have tried the applet.
The text resumes here: |
The discount rate that makes the total present value as close as you can get to $0 with this number of decimal places is 4.19%. The regulatory delay drops the internal rate of return to below what you can get from the bank. No one will invest in one of these machines now.
One way this machine's products could come to market would be if the prices for the machine's products go up. The prices would have to rise enough to make the internal rate of return as high as the bank's 5%. In this way, consumers wind up paying for the regulatory delay in higher prices. Notice that I didn't add any paperwork or testing cost to the calculations. The higher prices are purely because of the delay and the need to compete with other investments. Adding in the paperwork cost of complying with regulations would make the internal rate of return even lower.
Another way this machine's products could come to market would be if
the price of the machine goes down. Like the discounted bond, a discount
in the price of the machine would raise the internal rate of return. In
this circumstance, the machine's manufacturer would pay the delay cost
of the regulation.
There are two problems with this argument. One is that drug industry research spending has increased since 1962, even allowing for inflation. The rate of return is evidently still good enough to attract money into research.
The second problem is that regulation is there for a purpose: to keep unsafe and ineffective drugs off of the market. The industry's record is not spotless. "Research" is not necessarily good, unless it's research that might lead to safe and effective products.
Any testing system, whether adopted voluntarily by industry or imposed by government, discourages investment. The price you pay for safety and effectiveness assurance is a reduction in innovation. How much assurance do we get? Is the price too high?
These are issues that are better handled in class discussion than on
a computer. I hope that you now understand what the internal rate of return
is and how the concept figures in the controversy.
The present value of an investment is the amount of money you'd need now to be able to duplicate the investment's income stream. The present value is calculated using a discount rate which you set to equal your bank's interest rate or the rate of return of some other alternative investment.
The internal rate of return is the discount rate that makes the present
value of the investment's costs and payoffs add up to 0.
Investments with higher internal rates of return attract money away from investments with lower internal rates of return.
If a kind of investment has a persistently high internal rate of return, something is preventing the market from reaching a competitive equilibrium.
Regulation can reduce the rate of return to innovation, just by delaying
the payoffs. How to protect the public without stifling innovation is a
major problem of regulation, in pharmaceuticals, for example.
That's all for now. Thanks for participating!
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