Liability Driven Investing
In the previous articles, we have already studied the difference between defined benefit plans and defined contribution plans. We now know that defined-benefit plans promise to pay the retiree a fixed nominal amount whereas defined contribution plans promise to pay the retirees the worth of their investment portfolios. There is a big difference between the […]
Root Causes of Inadequate Cash Flow in the Retail Sector
In the previous articles, we have already seen how important cash flow is for the retail sector. We have also explained how the lack of adequate cash flow can be a cause of concern and even causes many retail businesses to shut down. However, the fact that retail businesses have cash flow issues is an […]
Exorbitant Privilege: US Dollar
The financial community of the world is at a consensus that the current economic system provides the United States government with exorbitant privileges. This means that the system does not treat all countries equally. Rather it provides an unfair advantage to the United States because the dollar is the reserve currency of the world. The […]
IPO: An Exit Route for Start-Ups
The typical successful start-up obtains funding from various private investors at the earlier stages of the business. Now, these investors do not want to stay with the company forever. They just provide capital to help the company become a full-fledged business. Once the operations of the company are in order, the private investors generally want […]
How a Whatsapp Message Nearly Took Down a Company
Almost everybody knows that Whatsapp messages are often used to spread false information. A lot of times this information is related to politics. During election campaigns, politicians run concerted smear campaigns against their opponents using messaging services like Whatsapp. It is a known fact that in many terrorist attacks, Whatsapp has been used by the […]
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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