Ten Percent Rate of Return Model

Ten Percent Rate of Return Model

Ten Percent Rate of Return Model

Ten Percent Rate of Return Model

Despite the fact that some investors need to take account of taxesand others need to distinguish between some kinds of dollars andothers, the following discussion refers to investors who pay no taxesand who need make no such distinctions. This group certainly includesthe managers of private, noninsured pension funds whose assets exceed$150 billion and also probably includes many endowed institutions.The problem of generalizing the comments in the following paragraphsto include investors subject to taxes is not difficult. The obvious adjustments are to measure returns after taxes and to be sure that comparisons among portfolios be limited to those whose owners or beneficiariesare in similar tax brackets.

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Keeping in mind that the discussion relates to tax-exempt investors,the gentle reader can now proceed to a consideration of the problemof measuring returns. One prominent candidate for the role of suchmeasurement is the internal rate of return. This is the rate of returnwhich is calculated in finding the yield to maturity of a bond. It isthe rate of discounting of the cash flows associated with an investmentwhich makes their algebraic sum equal to zero. The following hypothetical example makes this clear.

The 10 percent rate of discount makes the algebraic sum of the cashflows equal to zero and is the internal rate of return. It measuresthe performance of the initial investment and assumes any additionsto the original investment earn the same rate of return.

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The internal rate of return is an interesting and useful number. It tells the rate at which the assets of a fund are growing becauseof returns on investments. All prudent fund managers and investorswill want to know the internal rate of return on their investments.

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