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What is Internal Rate of Return; Everything You Need to Know

9 Mins 04 Aug 2023 0 COMMENT

One of the primary tasks of a business owner is to ensure that the capital acquired is managed properly. To that end, the capital must be budgeted adequately, to meet the needs of the operation in the most efficient manner. To help with the same, business owner often rely on various tools and techniques. One such technique is the internal rate of return. If you own a business or are interested in investing in one, it is essential to know the internal rate of return, how it is calculated and what purpose it serves.

What is the Internal Rate of Return?

The internal rate of return is a discounting cash flow technique that provides an estimate of the rate of return achieved by a project. Essentially, it is the discounting rate wherein the total initial cash outlay along with the discounted cash inflows amount to zero. Thus, you could consider it to be the discounting rate at which the Net Present Value (NPV) is zero.

How is the Internal Rate of Return Calculated?

The internal rate of return is a metric that you can manually calculate. All you have to do is apply the formula used to determine NPV. You can use the formula given below to determine the internal rate of return.

IRR = (cash flows)/ (1+r)I - initial investment

Wherein cash flow refers to the cash flow for a specific time period, r refers to the discount rate and I refers to the time period in question.

To determine the internal rate of return, analysts usually have to rely on trial and error methods. They cannot count on analytical methods for the same. However, they can rely on alternatives provided by automation like different software. For instance, you can use Microsoft Excel and plug in the required financial functions to calculate the internal rate of return. The function uses cash flows at regular intervals to arrive at an internal rate of return.

When it comes to the interpretation of the results, the ideal internal rate of return is one where the cost of investment and the current value of cash flows matches. If a project is able to achieve such a score, it is a good indicator that the project is profitable. Simply put, this is the rate at which cash outflows and the exiting value of inflows are the same, adding to the appeal of the project. A company will go ahead with an investment if the IRR is higher than or equal to the hurdle rate or cost of capital.

How is the Internal Rate of Return Useful?

The internal rate of return is extremely helpful in narrowing down which project to go ahead with. For instance, if different projects incur the same amount of costs, it would be best to proceed with the one with the highest internal rate of return. Similarly, if you need to pick between various investment options wherein the cost of investment is the same, you can rely on the internal rate of return to help you choose the one which is most likely to be the most profitable.

However, practically speaking, since most projects tend to be long-running and have long-term effects, several techniques are put to use to budget capital. This fact highlights one of the limitations of using the internal rate of return as a metric to gauge profitability; it does not take duration into consideration. Plus, the internal rate of return also assumes that cash flows are reinvested at the same rate as the project, instead of the cost of capital. Thus, it may fall short of providing an accurate picture of profitability.

Despite its shortcomings, the internal rate of return is still useful and analysts now use a modified version to get a clearer idea of a project’s profitability. Now that you know more about the internal rate of return, you can make the most of it. Whether you are a business owner or investor, it can help you gauge the returns achievable on a project on an investment and help you make informed financial decisions. Use such metrics required, do your research thoroughly, and make financial decisions after considering all the aspects.

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