The rate of return, or internal rate of return, is the rate of return generated by an investment. This is the discount rate at which the net present value of the investment is zero or at which the net investment proceeds are equal to the investment cost of the project.
Instructions
Step 1
In order to determine the rate of return on investment, it is necessary to solve the following equation:; - I - the amount of investment.
Step 2
The meaning of this indicator is that it shows the maximum allowable relative level of costs that can be spent on a given project. For example, if a project is fully funded by a bank loan, then the IRR value shows the upper bound of the interest rate on it. If the value of the interest rate is higher than the found value, the project will be considered unprofitable.
Step 3
Knowing the value of the rate of return, you can decide on the acceptability of the investment project. If the obtained IRR value is higher or equal to the cost of capital, then the project is accepted, if it is less than the cost of capital, the project is rejected. Thus, the rate of return is a "borderline" indicator ": if the value of the investment is higher than the internal rate of return, then as a result of the project it is impossible to ensure the return of money and their return, which means that the project must be rejected.
Step 4
The main advantage of this indicator is that, in addition to determining the level of return on investment, it allows you to compare projects of different sizes and durations. After all, the rate of return is calculated as a percentage, and the relative values are easier to interpret. In addition, this indicator makes it possible to determine the safety threshold for the project.
Step 5
However, keep in mind that the indicator in question has some disadvantages. First, this is an unrealistic assumption about the reinvestment rate, since it involves reinvesting the income received at the IRR rate, which is rarely feasible in real practice. Secondly, it is possible to obtain several IRR values in the case when there is an alternation of cash inflows and outflows. In addition, this indicator is very sensitive to the structure of the flow of payments and does not always allow evaluating mutually exclusive projects.
