Your profit stopwatch

PORTFOLIO POINT: Analysing internal rates of return is helpful when assessing the relative merits of investment opportunities.
When it comes to evaluating the potential of a project or investment – fund managers, bankers and chief executives everywhere turn to a metric known as the internal rate of return. It’s a simple but powerful method for analysing and comparing opportunities.

IRR is not a concept widely taught outside business schools, and yet individual investors who understand the internal rate of return or IRR – and more importantly how to use it – are able to identify superior trading opportunities. Let’s take look how it works and use it to identify a few trading opportunities.

At the heart of the IRR is the time value of money concept. $100 invested for one year at 10% is $110, therefore $100 now or $110 in one year has the same value.

At the same time, this means that your 'cost of funds’ is 10%. If you put yourself on the other side of this transaction and borrow $100 at 10%, then you need to repay $110 at the end of the year and therefore that money needs to work harder in order to put you in the black.

Because the payment dates of takeover trades can range from two weeks and six months, using what we call a 'discounted cash flow’ calculation like the IRR allows trades with different durations to be more easily compared.

To take some real-life takeover examples in the market at the moment, consider a number of situations where securities are facing event driven re-ratings from the likes of Austereo (AEO), ING Industrial Fund (IIF) and Fairfax (FXJPB).

Let’s take the bid for Austereo from Southern Cross Media (SXL). Assuming acceptances for AEO exceed 90% –which seems likely based on feedback from stakeholders so far – then its shareholders should receive the following payments (note that these figures were taken from close of trade Wednesday).

Valuation of cash bid for Austereo
	15 Feb	15 Feb	6 Apr	4 May
Buy AEO	-$2.11
Brokerage	-$0.01
Payments
Ordinary Dividend		$0.05
50% Acceptance Capital Payment			$2.00
90% Acceptance Capital Payment				$0.10
Total cash flows	-$2.12		$2.00	$0.10
IRR	12.70%

Note that the IRR here is calculated using the XIRR function in Excel. What this feature allows you to do is convert a series of irregular future payments into a single annualised return on one’s initial investment (for more about this feature click here).

Assuming the AEO bid proceeds on the dates it has indicated in announcements lodged with the Exchange, then on a purchase of AEO at a price of $2.11 the return over the 2.5 months allotted is equivalent to an annual return of 12.7% - which is a very solid gain given that for most of us the cost of capital or the price at which people can borrow money is around 7.5%-8.0% per annum.

By way of contrast, let’s look at the cash bid for ING Industrial Group from Goodman Group, again using Wednesday’s closing prices.

Valuation of cash bid for ING Industrial
	15 Feb	30 Mar
Buy IIF	-$0.535
Brokerage	-$0.001
Payments
75% Scheme Approval Payment
90% Acceptance Capital Payment		$0.54
Total cash flows	-$0.536	$0.54
IRR	2.9%

As you can see from the above table, if you buy IIF for 53.5c per unit and accept the cash offer payable by late March 2011, the IRR on the trade is just 2.9% annualised, which is clearly not an adequate return when you consider the cost of capital.

However, this all changes markedly if there is even a small fluctuation in the share price. If you can buy ING Industrial for just 53c a share or half a cent less then the IRR on the trade increases to 11.4% which is very much in the same league as the Austereo opportunity.

The internal rate of return doesn’t just apply to takeovers and can be quite easily applied to hybrids and convertible notes. In fact, by using IRR we can identify an opportunity that is potentially much more lucrative than both of the above situations.

In late 2010, Fairfax management stated that its intention to redeem the convertible note FXJPB at their face value of $100 each by April 2011. Given that FXJPB was trading at around the $100.50 mark, this doesn't appear to be such a good deal however FXJPB holders will also receive one final quarterly coupon or interest payment before the notes are redeemed, as follows:

Valuation of FXJPB
	15 Feb	30 Apr
Buy FXJPB	-$100.50
Brokerage	-$0.22
Distributions
April 2011		$3.31
Redeem at face value		$100.00
Total cash flows	-$100.72	$103.31
IRR	13.30%

For investors looking to use the internal rate of return to eke out good gains from event driven situations, three important conditions must be met:

1. Investors must understand the timetabling of deals, and consider the possibility that they may be disrupted.
2. Buying at exactly the right price is crucial, which means giving very specific instructions to your broker.
3. The mathematics of IRR investing need to be practiced again and again and understood so that you avoid unnecessary mistakes.

The internal rate of return is just a metric, but a metric that can prove invaluable when you are looking at short-term investments of varying length but well understood cash flows. Investors should be careful though. While Excel’s XIRR function is extremely useful, like all computers it is only as good as the information that's fed into it.