What is the internal rate of return?
The internal rate of return on an investment is the interest rate that will make the present value of all cash flows from that investment equal to zero. That is, for any positive net cash flow (a return on your initial investment), there must be a negative net cash flow that “cancels it out.” It is a financial metric used in finance to measure the profitability of investments or projects by finding the discount rate that will make all future cash flows equal. It was created by Irving Fisher in 1926, but he didn’t publish it until 1932. His idea was that changes in “prices” are not quite the same as changes in “prices plus change”. He came up with this within an era where interest rates were really interest minus change, but it’s still a good metric even today for comparing returns with different levels of risk.
IRR, or Internal Rate of Return, is a measure of how valuable an investment is at the end of its life. It’s calculated by taking the initial periodic payment (Pv), subtracting time value of money (T), and dividing by the capital invested (K).
The process is identical to “Simple Interest” calculation; except instead of having an annual interest rate, it has for IRR. Capital X = PV x (1 + IRR)^n, where n is the number of years in length.
The IRR is a useful tool for a company to use in deciding whether a project should be undertaken or not. If the IRR is greater than the cost of capital, it is worthwhile undertaking.
The key difference between ordinary return and IRR is that the Internal Rate of Return accounts for both the level of risk and time, making it a very useful tool for determining whether a specific project or venture is likely to be profitable.
Project Evaluation Using IRR Calculation
In finance, IRR is commonly used to evaluate investment decisions. In this regard, it gives a good indication as to whether the investment will result in profit or loss without having to wait until the end of the investment period as would be required by other methods such as Net Present Value (NPV) or Payback. IRR is also used to determine the amount of capital you require for a project.
How does Internal Rate of Return help with evaluating projects?
Projects with a high IRR are obviously preferred over others, because they will generate higher returns for the same level of risk. Moreover, calculating IRR is useful for understanding how changes in key inputs can affect project returns. For example, say you are an investor and you have the option of investing in two projects A and B. Project A is more risky than B but it also has higher returns than B. If both projects had an IRR of 20%, Project A would be preferable to Project B given that there’s no information on the risks of each project.
Understanding IRR Calculation
If we were to use IRR to compare two investment opportunities, we would need to know:
The cost of capital: This is a fixed percentage that includes all the costs associated with an investment such as: interest and fees for borrowing money, the opportunity cost of the capital used from other investments, etc. The risk involved with each project A and B: i.e. the risk that an investment will not bring any profits
How would we set each of these factors? Let’s consider Project A first. We know the cost of capital is 6%. We also know that for this particular type of project, it has a standard return rate of 20% so if we take the opportunity cost, it should be 6% x 20% = 120%. This is what you would expect to pay to invest in this type of business, knowing that you can get a 20% return. For Project B, because it has a higher risk level than Project A, its opportunity cost should be lower which means its cost of capital will also be lower at 5%. Therefore, you can calculate the IRR for both investments as follows:
IRR of Project A = (20% – 6%) / 6% = 14.67% IRR of Project B = (15% – 5%) / 5% = 20%
Because riskier projects should have a lower return, you can see from the above example that Project B is the preferred investment when compared to Project A.
In conclusion, calculating IRR has several advantages over other calculations such as NPV and Payback. Not only does it help with decision making, but it is also useful for understanding how risks affect return and the difference in return between projects is determined by the choice of discount rate.
