Internal Rate Of Return
The Internal Rate of Return (IRR) is a system of measurement used to calculate the estimated profit from potential investments. It forecast the proposed financial expenditure required to invest in the functioning of any business. IRR is also defined as a discount rate making the net present value (NPV) of liquidity flowing in any particular project equivalent to zero. It can also be stated as the discount rate at which the net present value (NPV) of the proposed liquidity becomes equivalent to the initial investment. The value of NPV in the project can either be positive or negative. Due to this, the IRR for a project is also known as Annualised Effective Compounded Return Rate or Rate of Return.
Moreover, IRR is the estimated compound annual rate of return that is earned on a project or investment. The Internal Rate of Return (IRR) guarantees to generate a recovery against an investment until the completion of its tenure. Therefore, IRR is the rate at which the present value of a project’s net cash inflows becomes equal to the current value of its net cash outflows.
In simple words, the Internal Rate of Return (IRR) is also known as the Discounted Cash Flow Rate of Return (DCFROR). Therefore, while defining IRR, the term internal plays a crucial role in outlining its meaning. It is used to specify that the Internal Rate of Return remains unaffected by any external factors like the interest rate or inflation. We can agree with the fact that inflation is one of the biggest threat to an economy. Therefore, the study of IRR possesses a great significance contributing to the smooth functioning of a business, which further contributes to the sustainable development of an economy.
How Internal Rate Of Return Works
The Internal Rate of Return is a set of guidelines providing you with the most accurate suggestions to help you proceed with an investment. According to the IRR rule, "If the internal rate of return for investment is greater than the minimum required rate of return, then the investment should be pursued." Contrarily to this rule, if the IRR for investment is lower than the cost of capital, then the most efficient path is to reject it.
Therefore, to sustain in the rapidly growing economy, it becomes crucial for the students to understand the concept of IRR to produce useful results in their academics. Even after pursuing their academic career, students can use their knowledge of this subject to contribute to the sustainable development of the economy. So, if you are planning to adopt the practice of IRR, it is imperative for you to create a brokerage account. A brokerage account is necessary to purchase the investments for real that you are investigating. Thus, the complete working of Internal Rate of Return (IRR) revolves around the rule of IRR and the conditions satisfying it.
The Formula for IRR
The Internal Rate of Return (IRR) has the same formula as that of the Net Present Value (NPV). In mathematics, the formula for IRR can be given as follows
Internal Rate of Return (IRR) = Ct/(1+r)t - Co = 0
- Ct= net cash inflow during the period t
- Co= total initial investment costs
- r= the discount rate, and
- t= the number of time periods
How to Calculate IRR
To achieve more accurate results in the calculation of IRR, you need to follow the above formula sincerely. You need to set NPV equivalent to zero and find the value of the discount rate (r) or IRR. But to achieve real and accurate results, IRR must be calculated by the hit-and-trial method or using dedicated software to calculate IRR. This is because IRR cannot be calculated analytically. It can be concluded that it is favorable for a project to undertake with a higher Internal Rate of Return (IRR).
Moreover, IRR tends to be constant for the investments of varying types and can be used to rank multiple projects evenly. The project with the highest IRR can be considered best and has the maximum chances of being undertaken. In this analysis, the cost of investment is neglected as it is equal among various projects.
Example of Internal Rate of Return (IRR)
To achieve a better understanding of the Internal Rate of Return (IRR), you can refer to the example given below:
The management of an ABC Textile Company is planning to replace its rusty machine with a brand new one. The new machine will be capable of performing multiple tasks in a short time as compared to the old one. The capital to be invested in the installation of the machine will cost somewhere around $8,475. It will reduce the annual labor cost by $1,500 and increase machine life by approximately ten years. Thus, the minimum required rate of return, in this case, is 15%.
Required: Will it be beneficial for the ABC company to purchase a new machine? Use the Internal Rate of Return (IRR) method to determine your conclusion.
Solution: To conclude whether the proposal should be accepted or not. To determine this successfully, the internal rate of return achieved by machine would be found out first and then compared to the company’s minimum required rate of return.
The first step in finding out the Internal Rate of Return (IRR) is to compute a discount factor called Internal Rate of Return Factor. It is calculated by dividing the investment required for the project by net annual cash inflow to be generated by the project. The formula is given below:
Internal Rate of Return Factor = Net Initial Investment/Annual Cash Inflow
In this example, the required investment is $8,475, and the net annual cost saving is $1,500. Therefore, the cost saving is equivalent to revenue and would, further, be treated as a net cash inflow. This information is vital to calculate the Internal Rate of Return Factor and can be computed as follows:
Internal Rate of Return Factor = $8,475 /$1,500 = 5.650
Conclusion: According to the Internal Rate of Return (IRR) method, the proposal cannot be accepted as the internal rate of return promised by the plan (12%) is less than the minimum required rate of return (15%).
Limitations of the Internal Rate of Return (IRR)
Few most common limitations of IRR are described as follows:
- The most significant limitation of this process is its popularity to estimate the profitability of a project which can lead to its misuse if not used wisely. Depending on the initial investment costs, a project may have a low IRR but a high NPV.
- Another limitation of this method is the increasing complexity while using IRR to compare projects of different lengths. For example, it is possible for a project of short duration to have a high IRR contributing to the promotion of that investment. Also, it may have a low NPV.
- The growing misconception among people that, positive cash flows are generated in the middle of a project, and the money will be reinvested at the project’s rate of return.
Making Investments Based on IRR
To successfully invest in a project, you need to strictly follow the set of guidelines provided by the Internal Rate of Return (IRR). As per the guidelines, the probability to achieve fruitful results in your investment depends on the IRR for a project as compared to its capital cost. If the rule allows you to invest in a case where IRR is higher than its capital cost, the chances to achieve positive results are higher. But, if you neglect the guidelines provided by IRR and invest in a project without knowing it, the chances for your failure increases. Thus, it is imperative for a marketer to stick with the guidelines provided by IRR to achieve positive results and sustain in the market.
Textbooks On Internal Rate Of Return (IRR)
Investment Analysis for Real Estate Decisions, Volume 1
Published by Dearborn Real Estate in 2003
By Gaylon E. Greer, Phillip T. Kolbe (Authors)
Contemporary Financial Management
Published by Cengage Learning in 2011
By R. Charles Moyer, James McGuigan, Ramesh Rao, William Kretlow (Authors)
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