0
$\begingroup$

The definition of the internal rate of return is the interest rate that causes the net present value to equal zero. However, interest rates can be given in two forms: nominal and effective. So, is the internal rate of return a nominal or effective interest rate? Or both?

$\endgroup$
4
  • 1
    $\begingroup$ it should be an effective rate. csun.edu/~ghe59995/docs/… $\endgroup$ Aug 31 at 14:02
  • $\begingroup$ Would it also be a nominal rate since m=1 in the effective rate equation i = (1 + r/m)m - 1 $\endgroup$ Aug 31 at 14:14
  • $\begingroup$ I would argue that (maybe only guess?) - in most cases - it is not a nominal rate as most instruments feature sub-annual periodic payments (monthly, quarterly). $\endgroup$ Sep 1 at 6:17
  • $\begingroup$ That just means it isn't a nominal annual rate. But you can have a nominal rate for periods other than annual. $\endgroup$ Sep 4 at 10:29
1
$\begingroup$

It's a bit of a moot question, to be honest.

If your saving account pays you 5% annual, with monthly compounding, then the effective interest rate is = (1 + 0.05/12)^12 -1 = 5.116%

In other words, if you have an investment which compounds every month or quarter, and you want to know the effective rate over another period (typically over a year), you use the calculation above. This is because there is a difference between the frequency of the compounding (in the example, monthly) and the frequency of the effective rate you want to calculate (typically annually).

When you are calculating an IRR, all of these become moot points. There is no more any distinction between the frequency of the compounding and that of the effective rate you are after; in fact, you can calculate IRRs for sets of cashflows which pay at irregular intervals.

$\endgroup$
4
  • $\begingroup$ So because IRR requires equally spaced periodic cash flows, you are saying that the effective and nominal rate will always be the same? $\endgroup$ Sep 4 at 10:31
  • $\begingroup$ Excel's IRR() function requires periodic cashflows - the abstract concept of IRR does not! Indeed, one can use Excel's XIRR function when cashflows are at irregular intervals. I am saying that, in my mind, the question doesn't make much sense at all, for the reasons I outlined above. $\endgroup$ Sep 4 at 14:37
  • $\begingroup$ If in the abstract IRR doesn't require regular periodic cash flows, then what period of time would such an IRR be applied to? Can you give an example of this? XIRR returns an effective annual rate that sets the NPV equal to zero, so it isn't quite the same is it? $\endgroup$ Sep 7 at 22:12
  • $\begingroup$ Theoretically, you could calculate an IRR with the frequency you want. Nothing stops you from calculating monthly quarterly etc IRRs. Eg, if you apply Excel's IRR function to monthly cashflows, you will get a monthly IRR. In practice, everyone does it on an annual basis. Again, the distinction between nominal and effective is IMHO a moot point. $\endgroup$ Sep 9 at 21:00

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.