INTRODUCTION
In the world of finance, one of the fundamental concepts studied and used is the internal rate of return (IRR). It is used by investors and businesses alike to gain insights into the profitability of a potential investment. In other words, it is the rate at which future cash flows (or profits) will make up for the amount initially invested. Investors will generally look to maximize their return when investing, thus the internal rate of return is of utmost importance to them.
WHAT IS THE INTERNAL RATE OF RETURN?
At its simplest, the internal rate of return is the rate at which all present and future cash flows received from a specific investment will equal (or exceed) the present value of the investment. A common example of this is the rate of return that is achieved if a project is funded with debt, as debt has the highest priority to all cash flows received from the project.
The IRR helps to compare potential investments and is one of the most important investment considerations for investors. For example, if a business is looking at investing in a new project or project system, and must make a decision between two projects with different cash flows, the IRR will help them to decide which one is the most profitable.
HOW TO CALCULATE THE INTERNAL RATE OF RETURN
The internal rate of return is calculated by setting the present value of the cash flows (inflows and outflows), plus any future cash flow, equal to the initial investment. The calculation of the IRR needs to be done for each potential investment to compare potential returns.
The formula for calculating the internal rate of return is as follows:
IRR = initial investment + present value of cash flows / present value of initial investment
To calculate the internal rate of return, the investor must first obtain the net present value (NPV) of the investment, which can be calculated using the formula:
NPV = present value of cash flows - present value of initial investment
Once the net present value has been calculated, the investor can then use the formula above to calculate the internal rate of return.
EXAMPLE
Suppose a company is considering investing in a new project that has an initial investment of $100,000 and a projected income of $20,000 per year for five years. The expected rate of return is 5%.
To calculate the internal rate of return, the company must first calculate the net present value of the investment. Using the formula above, the NPV is calculated as $32,160.
Using this information and the formula for the internal rate of return, the internal rate of return is calculated as 10%.
CONCLUSION
The internal rate of return is an important measure that investors use to evaluate potential investments. It helps them to decide which investment will provide the most return, and thus help them to decide which project is the most profitable. The IRR can be calculated by calculating the net present value of the investment and then using the formula for the internal rate of return. By understanding the internal rate of return, investors can make more informed decisions and maximize their returns.
