Financial Analysis

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Common Financial Returns

From Wikipedia, the "open" encyclopedia

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Capitalization Rate (Cap Rate): the most commonly used, and one of the easiest to calculate, measures of the potential return on a proposed project. The "Cap Rate" compares the Net Operating Income (NOI) with the original cost to acquire the asset.

Cash on Cash Return: another popular and quick, measure of a proposed project, the cash on cash calculation compares the before tax first year cash flow against the amount of cash required to acquire the asset (generally the down payment). Caution should be used here. It should only be used as an indicator of further consideration of the potential project, or tossing it and moving on to other potential acquisitions.

Internal Rate of Return (IRR): a capital budgeting method used by firms to decide whether they should make long-term investments.

The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e. the yield on the investment.

A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk premium.

Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cash flows.

In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.

Marginal Internal Rate of Return (MIRR): Because the internal rate of return model assumes all cash flows (positive ones) are reinvested at the same rate of return throughout the life of the project, the marginal IRR model has evolved. Not only does it accommodate irregular positive cash inflows, but it also handles negative, or outflows of cash. Most financial analysts feel using the MIRR as the main yardstick to measure a project's success is more "real world".

NOTE: When doing financial analysis on prospective projects, be sure to compare similar projects and their returns. It is generally not accurate to compare dissimilar types of projects with one another. For example, comparing the returns of a retail mall in a declining neighborhood with a leased office building secured by a 35 year true triple net lease to a Federal government agency. Beware of "quick" and popular metrics, such as cash on cash.

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