Why can't IRR (internal rate of return) be used to assess the holding of operational projects?

October 29, 217, Lee Gongzi's article

(This article is suitable for readers who have investment experience in real estate projects. Readers who have no financial concept at all should skip it. )

IRR (internal rate of return) is usually used to assess the investment return of real estate development projects.

apart from the complicated financial explanation, the practical significance of IRR to the development project can basically be understood as the annualized rate of return of the project.

the calculation method of IRR is to enter the formula IRR in Excel, then select the amount of "initial investment" and calculate the gross profit for a certain period of time.

but in fact, IRR has many preconditions, which is only applicable to property rights sales projects, but not to operating projects.

Personally, there are three main problems that make IRR not applicable to operating projects:

There are three concepts of funds for investment projects, 1. The total investment of the project (including the total investment amount of the project, such as shareholders' share capital, bank loans, other capital allocation amounts and financial costs); 2. Self-owned capital (only the money actually paid by one's own enterprise, excluding the investment of other shareholders, bank loans and other capital allocation); 3. Shareholders' investment (all investors' money does not include bank loans and other capital allocation).

for example, for a project with a total investment of 6 million yuan, its capital structure may be: 1 million yuan of inferior funds (including 2 million yuan of self-owned capital of the enterprise and 8 million yuan of investment from other shareholders), 45 million yuan of priority funds (including 35 million yuan of bank loans and 1 million yuan of fund allocation) and 5 million yuan of financial costs.

if you want to calculate the return on investment or investment feasibility of the project, it depends on whether it is aimed at the overall investment of the project, its own funds or shareholders' investment.

the return on the overall investment may be very low, but it may be very good from the perspective of its own funds (because the leverage of funds used is relatively high).

therefore, to judge the feasibility of the project, we must first make clear which investment fund is used as the base to calculate IRR, otherwise there will be misjudgment.

in addition, in the actual project development, capital leverage (introducing bank funds or other sources of funds) will definitely be used, and it will never be 1% invested by itself. In other words, completely using the total investment of the project as the calculation base of IRR is simply not in line with the actual situation. Therefore, the IRR value of the total project investment calculated in this way has no practical significance.

it is unlikely that the sales-oriented project will make a big investment again after it is completed, and basically there is not much late investment

. Unlike business projects, the biggest feature is that there will be a big investment in renovation after 8 to 1 years of operation. Every 8 to 1 years, it is called a renovation cycle. As long as it is a market-oriented holding project, it will generally be sold in the second renovation cycle (sold to a large capital party or entered the capital market, that is, asset securitization), and it will not be held for more than two renovation cycles.

However, when calculating, the general financial personnel do not understand this important feature. When calculating the return of the project, they will mechanically calculate the return of 4 years (usually according to the actual serviceable life of the land to calculate the time, the linear growth of income and cost to calculate the profit), so that the calculation has been seriously inconsistent with the actual situation, and the calculation results obtained in this way have been greatly deviated, which is actually of little reference value. Of course, it cannot be used as the basis for investment decisions.

as I said before, after holding the project for several years, there will be a big re-investment such as house maintenance or renovation. After the second renovation cycle begins, the project is likely to be capitalized, which is equivalent to a one-time realization and sale, and a huge income will come in. In the early stage of project operation, there may be some rental or membership fee income, or deposit income included in the account. In the course of operation, some deposits may be returned to customers one after another. All these will lead to large fluctuations in the yield curve.

As for why this kind of project with large income fluctuation is no longer applicable to IRR evaluation, it is determined by the underlying calculation logic of IRR. For details, please refer to the more professional discussion in Zhihu.

if IRR is not suitable for holding business projects, how to evaluate the feasibility of holding projects?

for different types of business projects, the industry attributes are different, and the evaluation indicators are not the same. At present, the industry has not completely reached the * * * knowledge and unity, but the most fundamental evaluation indicators of business projects should all be related to cash flow (not entirely the concept of profit).

at present, hotel projects are generally measured by GOP ("GOP" is the abbreviation of "Gross Operating Profit", that is, operating gross profit, which is reflected in the income statement as the balance of income minus costs, labor costs, direct expenses of operating departments and indirect expenses of back-office departments).

The old-age management project is trying to adopt the method of "EBITDA÷ in the stable operation period ÷ the proportion of total investment in the early stage" for evaluation. The rationality of this indicator will be continuously tested in practice.

(EBITDA is short for Earnings before Interest, Taxes, Depreciation and Amortization, that is, the profit before interest, tax, depreciation and amortization. EBITDA is widely used by private capital companies to calculate their operating performance. )

different types of projects should be evaluated by different indicators, just like different rulers measure things with different scales. Using the wrong indicators can only show that the company has not understood the nature of its business, and there must be many detours in the future, or even a dead end.

In addition, it should be mentioned that the evaluation index cannot be simplified into a single quantitative index, such as measuring the economic level of a city with GDP and measuring the achievement of life with money. This single-dimensional simplified thinking is a low-level mental model, which is an endless thinking trap. To evaluate the success of a project, there must be at least three large accounts to calculate: economic account, political account and technical account. Most people are just used to calculating economic accounts, and the level is not enough.