Every business unit is supposed to make investment decisions rationally in order to make efficient investment choices.
Making rational investment decisions can help a business unit experience higher profitability from an investment. While irrational decisions can result in heavy losses.
But, how can a business unit make rational decisions?
A business unit can make rational decisions by using financial metrics and computation ratios like Net present value, Internal Rate of Return (IRR), Payback period, etc.
The Internal Rate of Return (IRR) is one of the most important financial metrics that facilitate rational decision-making for investors.
Let us understand the detailed answer to the question ‘What is IRR?’.
Companies use Internal Revenue Rate (Internal Rate of Return (IRR)) to evaluate profit centres and decide between major capital projects.
But this financial metric can also help you to evaluate certain financial events in your life, such as loans and investments.
Internal Rate of Return (IRR) is also known as discount rate. It is the interest rate that is used to find the current total value (NPV) of zero of a bunch of cash flows (good and bad) .
Discounted cash flow method is used for finding out the Internal Rate of Return (IRR) during financial analysis.
Internal Rate of Return (IRR) as mentioned above is used by business units to make corporate finance decisions.
For example, a company will choose an option to either buy a new machine for production or use the current machine by comparing the Internal Rate of Return (IRR) of each option.
The first huddle an investment decision faces is that the Internal Rate of Return (IRR) of investment should be more than the cost of capital for the company to be profitable.
When the first hurdle is passed, the next step is to compare the Internal Rate of Return (IRR)s of all the options. The project with the highest Internal Rate of Return (IRR) is then selected.
The Internal Rate of Return calculation takes the cash inflows and the timing of such inflows into consideration in the formula.
Internal Rate of Return (IRR) can only be calculated using the trial-and-error method unless computer software is used.
Equation or IRR formula;
0 = CF0 + {CF1 / (1 + IRR)} + {CF2 / (1 + IRR)} ^2 = NPV = aggregate of cash flows from each period discounted at Internal Rate of Return (IRR).
Where:
CF0 = Initial investment or outlay
CF1, CF2…, CFn = Cash Flows
n = Each period
N = Holding period.
NPV = Net Present Value
IRR = Internal Rate of Return
Let us understand the concept in crystal clear terms with the help of an IRR example:
Suppose, A loan was taken for Rs. 400000 with repayment of Rs.2100 Each month. The period of the loan is 30 years.
Then, the Internal Rate of Return (IRR) (or initial rate of return) on this loan annually is 4.8%.
Because the payments are made equally and at equal intervals of your time, another approach is to discount these payments at a 4.8% discount rate, which can produce a net present value of Rs. 400,000.
Putting the suggestions within the Internal Rate of Return (IRR) computation Formula:
The Internal Rate of Return (IRR) is generally indicated the profitability of any prospective project or investment, it is based on future estimates and might differ from actual profitability.
Still, decisions can be made on the basis of the Internal Rate of Return (IRR).
Internal Rate of Return (IRR) can be used to draw some conclusions which are as follows;
Better profitability is indicated by a higher Internal Rate of Return (IRR); therefore, businesses use Internal Rate of Return (IRR) to compare the profitability of two or more projects or investment options. The project or investment option with a higher Internal Rate of Return (IRR) is selected to earn maximum profit.
Businesses generally use Internal Rate of Return (IRR) for profitability analysis of the Net Present Value. Internal Rate of Return (IRR) provides a better understanding of net present value.
For example, a lower net present value but a higher Internal Rate of Return (IRR) indicates that the project might see substantial growth, but it will not add much value to a cost-bearing entity.
It is mostly a short-term project or investment.
On the other hand, a higher net present value but a lower Internal Rate of Return (IRR) indicates that the return might come slowly, but it would reward the entity with significant value.
It is mostly a long-term project.
Whether the Internal Rate of Return (IRR) is good or bad will depend on the cost of capital and the cost of investment opportunities.
For example, a real estate investor may pursue a project with an Internal Rate of Return (IRR) of 25% if the same investment in real estate offers a return, say, 20% or less.
However, this comparison assumes that the risk and effort involved in making these complex investments are almost the same.
If an investor can get a slightly lower Internal Rate of Return (IRR) for a less risky or time-consuming project, then they may gladly accept that low Internal Rate of Return (IRR) project.
In general, however, a higher Internal Rate of Return (IRR) is better than a low one, if everything else is equal.
There are several advantages of using the Internal Rate of Return as a measure to assess the financial factors. Some of these advantages are as follows:
Internal Rate of Return (IRR) is a subjective metric. The cost of capital is the rate at which the business agrees to fund the project.
Computation of Internal Rate of Return (IRR) does not require the cost of capital, which removes the risk of computing the wrong rate.
Once the Internal Rate of Return (IRR) is calculated, the projects can be compared on the basis of Internal Rate of Return (IRR), and one of them can be selected.
The Internal Rate of Return (IRR) is calculated by calculating the interest rate where the present value of future cash flows is equal to the investment required.
The advantage is that the cash flow period for all future years is also considered and, therefore, each cash flow is given equal weight through the amount of cash flow time.
Internal Rate of Return (IRR) is a simple way to compare two or more investments or projects.
Internal Rate of Return (IRR) provides a quick comparison measure for capital decision making.
A business unit has to compare the rates of Internal Rate of Return (IRR) to make a capital budgeting decision based on Internal Rate of Return (IRR).
The business has to choose an investment or project with the highest Internal Rate of Return (IRR).
The Internal Rate of Return (IRR) is a useful financial metric, still, it has some limitations. The drawbacks of using Internal rate of return are as follows:
The Internal Rate of Return (IRR) is overly optimistic. The Internal Rate of Return (IRR) does not take into account the inherent nature of the reinvestments.
Typically, reinvestment is done at the cost of capital and not at a rate of return. It leads to the overestimation of future cash flows.
The disadvantage of using the Internal Rate of Return (IRR) method is that it does not take into consideration the project size compared to the projects.
Cash flow is simply compared to the amount of money that is used to generate that cash flow.
This can be difficult if two projects require a very different amount of money spent, but a smaller project returns a higher Internal Rate of Return (IRR).
For example, a project costing Rs. 1000000 with an expected cash flow of Rs. 250000 over the next five years has an Internal Rate of Return (IRR) of 7.94 percent, while Rs. 100000 projects with an expected cash flow of Rs. 30000 over the next five years has an Internal Rate of Return (IRR) of 15.2 percent.
Using the Internal Rate of Return (IRR) method alone makes a small project even more attractive, and ignores the fact that a larger project can generate much higher and perhaps more profitable revenue.
Although the Internal Rate of Return (IRR) allows us to calculate upcoming cash flows, it assumes that such cash flows can be reinvested at the same rate as the Internal Rate of Return (IRR).
That assumption does not happen as the Internal Rate of Return (IRR) is sometimes a very high number and the chances of such a return are often rare or very limited.
The Internal Rate of Return (IRR) approach is only concerned with the estimated cash flow generated by the injection and ignores future costs that may affect profits.
Considering an investment in trucks, for example, the cost of fuel and future repairs may affect profits as fuel prices fluctuate and the requirements for repairs change.
A dependent project may be necessary to purchase vacant land where a truck network is parked, and that cost will not result in an Internal Rate of Return (IRR) calculation of revenue generated by ship operations.
A single project might have multiple Internal Rate of Return (IRR)s. This case may generally occur when any investment or project has both positive and negative cash flows over its life.
Businesses may look for a return on investment (ROI) when making large budget decisions.
ROI tells the investor about the return any investment or project may earn in the entire life span; it is not an annual return rate. while the Internal Rate of Return (IRR) informs the business what annual growth rate it can achieve.
These two numbers will usually be the same within one year but will not be the same for long.
ROI is a percentage increase or decrease in investment or project from the initiation to the end of the investment or project.
It is calculated by taking the difference between the current or expected future value and the initial value, dividing it by the cash outlay, and multiplying by 100.
ROI calculations can be calculated in almost any activity by applying the above formula.
However, ROI cannot be relied upon in long-term investments or projects.
The Compound Annual Growth Rate measures the annual return on investment throughout the investment or project.
The Internal Rate of Return (IRR) is also the annual return rate. However, the Compound Annual Growth Rate usually uses only the starting and ending values to provide an average annual return.
The Internal Rate of Return (IRR) is unique as it involves recurring cash flows — indicating that inflows and outflows are frequent when it comes to investing.
The Modified Internal Rate of Return (IRR) takes into consideration that the reinvestment can be done at different rates, while Internal Rate of Return (IRR) considers that the cash flows are reinvested at the same rate.
Further, it does not matter if the project is expected to generate positive or even negative cash flows, MInternal Rate of Return (IRR) shows a single value for it, while Internal Rate of Return (IRR) might have multiple values in such a case.
Since Modified Internal Rate of Return (IRR) solves the issues in the Internal Rate of Return (IRR), it is a better and more realistic approach than Internal Rate of Return (IRR). MInternal Rate of Return (IRR) is generally lower than the Internal Rate of Return (IRR).
Any investment decision should be made after taking into consideration the profitability of various investment options and comparing them, a decision should be made for the best benefit of the business.
It is natural to do a cost-profit analysis. We understood the concept of the Internal Rate of Return (IRR) and how to interpret and use it in making investment decisions.
You can use the concept of Internal Rate of Return (IRR) in making daily life financial decisions too.
Internal Rate of Return (IRR) can be used in making decisions for Investments involving cost and cash inflows.
Net Present Value (NPV) is the difference between the present value of cash inflows and the current cash outflow.
NPV is used in the capital budget and investment planning to analyse the benefits of a projected investment or project.
NPV is the result of calculations used to determine the current value of the upcoming cash inflows.
A higher Internal Rate of Return (IRR) indicates better profitability.
Therefore, businesses use Internal Rate of Return (IRR) to compare the profitability of two or more projects or investment options.
The project or investment option with a higher Internal Rate of Return (IRR) is selected to earn maximum profit.
The time value of (TVM) is the idea that the total amount of money is more expensive now than the same amount that will be in the future because of its current revenue potential.
This is the ultimate goal of finance. The amount in cash is worth more than the same amount to be paid in the future, and the amount of time is also called the current discounted value.
For Example, if the Cost of Capital of a business unit is 10%. The present value of Rs. 100 Receivable after one year will be;
Rs. 100 * (1/1.10) = Rs. 90.9091.
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