Understanding Tax Terminology: Tax Rates
In the previous article, we discussed about how tax base calculations work. However, tax base calculations are just one part of the story. The other part of the calculation is the tax rate. Tax base and tax rate are multiplied to arrive at the tax amount owed by the organization. In this article, we will […]
An Introduction to Hedge Funds
The term “hedge funds” have become ubiquitous in the financial markets nowadays. This is a term which incites a strong emotional reaction from all market participants and observers. Some are of the opinion that these funds are evil and endanger the entire market with their reckless risk taking. Others are of the opinion that hedge […]
Longevity Bonds and Longevity Derivatives
In the previous article, we have already seen how pension funds have been adversely affected by an increasing amount of longevity risk. The increase in the average lifespan of people is definitely a positive development. However, it has an adverse impact on the financial situation of most pension funds. In order to mitigate longevity risks, […]
The TikTok Business Model
When we talk about social media, we often refer to companies like Facebook, Instagram, Twitter, and LinkedIn. However, in the past few years, another company has emerged as a huge player in the social media space. This company has created an application that is known for having high levels of user engagement. The application being […]
Financial Modelling For Leveraged Buyouts (LBOs)
Just like mergers and acquisitions, modeling for leveraged buyouts (LBOs) also requires special skill and knowledge. In this article, we will have a closer look at how leveraged buyouts work as well as how financial modeling techniques need to be adopted to meet the needs of investors indulging in LBO’s. What is a Leveraged Buyout? […]
The Internal Rate of Return (IRR) is another very important metric that can be used to determine whether or not a company must invest its resources in a project. If the company does decide to invest its resources in all the projects then the IRR can help us understand what should be the priority of these projects for the company.
Let’s understand Internal Rate of Return (IRR) with the help of an example. Let’s say that we have an investment that pays $10 on a $100 investment. So, we can clearly see that the rate of return is 10%. This means 10% of the money invested will be recouped every single time period. But this calculation was simple because there was only one return we received and we just had to calculate its size as compared to the original investment.
Now, consider the fact that for the same $100 investment, you are going to receive $20 for the first 2 years, $30 for the next 2 years and $50 in the 5th year. So what would be the rate of return for this investment? So here we are taking a complex schedule of cash outflows and inflows and we are basically coming up with a single rate that describes the rate of return. In the above example the rate of return is 13%.
This means that if we invested $100 and got a consistent rate of interest which was compounded at 13%, then that investment would be equivalent to the above investment. The above investment provides the same return as that of a bond with an annual coupon of 13%. This is the Internal Rate of Return (IRR) of the investment.
The calculation of Internal Rate of Return (IRR) with a formula is very complex and is never used in practice. We generally use financial calculators or MS Excel both of which have inbuilt IRR functions to find out the IRR.
The relationship between the IRR and the NPV is very important. In fact, it could be the defining characteristic of IRR. IRR is the rate at which NPV of the project is zero. This is clearly intuitive. Consider the fact that the rate of growth of your investment and the discount rate both will be the same in this case. Therefore they will nullify each other and the NPV will be zero at IRR.
The rule pertaining to the IRR is simple. A company must decide a hurdle IRR rate. Let’s say the hurdle rate is 10%. So, the company must then choose investments that pay over 10% and must reject investments that pay less than 10%. In the above example 13% is greater than 10% and hence the investment must be selected. In case the company wants to choose between 2 projects both of which have more than 10% return, then the one with the higher Internal Rate of Return (IRR) must be selected.
The IRR metric is also flawed. But its flaws are smaller as compared to the payback period method. It is for this reason that many companies do in fact use the IRR method to decide amongst investments. It is a little bit more intuitive to use. Its flaws have been discussed in the forthcoming article.
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