Financial Investment – Meaning, its Need and Different Types of Investments
It is human nature to plan for rainy days. An individual must plan and keep aside some amount of money for any unavoidable circumstance which might arise in days to come. Future is uncertain and one must invest wisely to avoid financial crisis in any point of time. Let us first understand what is investment […]
Present Value and Future Value of Money
Value of Money Depends Upon Time In the previous article we learned about the concept of nominal and real values of money. We realized that money today is more valuable than the same sum received at a future date because there is no risk involved in obtaining it and also the real value of money […]
What are Sustainability Bonds?
Finance and sustainable business practices have traditionally been considered to be separate fields. It was common for companies all over the world to participate in activism related to sustainable business practices. However, this activism was more a part of their social responsibility and would not have any impact on their bottom line. This has changed […]
Operating Cash Flow to Sales Ratio – Formula, Assumptions and Interpretation
Formula The formula for this ratio can be easily judged by its name: Operating Cash Flow to Sales Ratio = Operating Cash Flow / Sales Meaning Used Over a Period of Time: Conclusions must not be drawn based on a single number. A company may be able to convert its sales to cash for one […]
What are Soft Forks?
In the previous article, we have already read about cryptocurrency forks. We now know that a cryptocurrency system is basically software. Just like the software on our phones and laptops cannot stay static, the software responsible for cryptocurrencies cannot stay static either. It needs to be changed from time to time. The changes are done […]
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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