Auto Loans and Personal Finance
Personal finance gurus seem to have differing opinions on many subjects. Some of them believe that mutual funds are good investments whereas others think the exact opposite. They seem to agree on very few things and auto loans are one of them. Almost every personal finance guru in America believes that auto loans are bad […]
External Credit Enhancement in Infrastructure Financing
Infrastructure projects continue for a long period of time. Sometimes these projects continue for decades. Hence, they need long term finance. On the other hand, there are entities such as insurance companies and pension funds which are looking to invest their money for long periods of time. Ideally, insurance companies and pension funds should be […]
Role of the Finance Function in the Financial Management for Corporates
The Finance Function in Corporates We often read about how corporates are doing financially with reference to their profits, asset values, debt, equity, and other measures. These measures are indicative of how well the corporate is doing financially. The next time you read about these measures, do think about the people who enable these performance […]
Steps to Create a Financial Model
Financial modeling is not a perfect science. In fact, it would be fair to say that financial modeling is part art and part science. This is because the specific steps required to create a financial model cannot be chalked out. However, there is a broad framework which needs to be followed in order to create […]
Why Timing the Market is a Bad Idea ?
Stock market investments can be akin to gambling depending on the procedure used for making these investments. If the investments are rooted in fundamental research, then they are the result of skilled judgment and therefore cannot be called gambling. On the other hand, many investors invest in the stock market as if it was a […]
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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