Financial Troubles in the Fracking Industry
The fracking industry has had a huge impact on the financial situation of the world in the past decade or so. The process of hydraulic fracturing also known as fracking has allowed countries like the United States to produce oil from shale reserves. The result has been that the United States has become the third […]
How are Broadcasting Rights Revenue Split Amongst Franchises?
In the previous article, we have already seen the importance of broadcasting revenue. We also know what the shortcomings of broadcasting revenue are. However, in this article, we will have a closer look at a bigger problem which is how the revenue generated by the sale of broadcasting rights should be split between various stakeholders. […]
Advantages and Disadvantages of Variable Lease
In the previous article, we have already seen what a variable lease is and how it is different from traditional leases which are used by retail companies across the world. We are now also aware of the manner in which variable leases are structured. We know that the popularity of variable leases has been rapidly […]
Impact of Rising Interest Rates on Retail Sector
The retail industry has been financially struggling for a significant amount of time now. This struggle has been exacerbated by multiple factors. However, post 2022, a new and important macroeconomic variable has changed which has further accelerated the financial troubles which are being faced by the retail industry. For the past decade or so, the […]
Qualitative Issues While Conducting Equity Valuation
Equity valuation focuses on estimating what the likelihood of the company being a successful enterprise in the future is. Now, it is difficult to construct any model which can predict the success of any enterprise. For example, consider the fact that new age companies like Google and Facebook share almost none of the characteristics that […]
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.
Your email address will not be published. Required fields are marked *
