Is use of XIRR appropriate when dividends are not reinvested?

[Borty]

I am currently calculating internal rate of return (IRR) values for assorted
investments using Excel's XIRR function. For some investments distributions
have been reinvested, whereas for others distributions have been paid out as
income. Now I have repeatedly read that the IRR formula assumes that
distributions are reinvested, although one source suggests that the
assumption is merely that the opportunity for reinvestment exists. Several
personal financial investment programs that I have looked at (MS Money and
Quicken Personal Plus) clearly use the IRR formula to calculate annualised %
returns whether distributions are reinvested or not. My question is whether
it is appropriate to use the XIRR formula to calculate returns on investments
when distributions have been taken as income and not reinvested. I'd greatly
appreciate help on this.

 

[Fred Smith]

Certainly you can use XIRR. If dividends have been paid out in cash (rather
than reinvested), then they are a cash flow which has been received. You
account for them the same as if you withdrew cash from the portfolio.
Include the paid dividends in the table of cash flows, and XIRR will
properly calculate the return.

IRR does not assume that dividends have been reinvested. It can handle
either way. What you've likely read is that when rates are published (such
as for mutual funds), the published rate assumes dividends have been
reinvested.

Regards,
Fred

 

[Borty]

Thanks for the prompt reply Fred. It is true that published rates from
mutual funds do publish that their rates assume that dividends have been
reinvested, but there are definitely many references to the fact that the IRR
computation does assume that distributions are reinvested. You will see this
if you do a google/ yahoo search using the keywords "IRR reinvestment
assumption". As I understand it that's why the modified IRR (also available
in Excel) was developed. However, I wonder if the problem is only relevant
to situations involving business decisions with regard to capital projects,
which seems to form the basis of many discussion in regard to IRR. Any
comments?