Internal rate of return - a key indicator of investment efficiency.

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2020-07-03 02:09:06

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Any decision relating to investments necessarily involves assessment of effectiveness. This is understandable, since it is necessary to determine the criteria that will allow you to choose the most profitable projects. Most often, investors use the system of indicators to assess the economic efficiency of capital investments. Almost all of these indicators are subjective, since they depend on the decisions of the person who conducts the calculations. An objective indicator is the only IRR-the internal rate of return, since it is determined solely by indicators of the project regardless of the attitude of the investor.  we shall discuss it in more detail.

This index allows to determine the level of profitability that is inherent in a specific project, that is “squeeze” a larger margin is impossible. But the main practical value is that the internal rate of return limits the maximum price of capital, which is involved for the project. For example, with IRR at 10% to take a Bank loan at 15% is definitely not worth it, because we do not pay interest and do not receive a profit.

To Compare the internal rate of return is not the only cost of capital but the desired yield or a yield of alternative projects. Of the two projects, the most profitable is the IRR which more. But if you want to get with a project 10% of the profits, you can take a loan at 10%, and the inner yield is defined at 20%, then you can safely proceed to implementation.

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Need to focus on how is determined by the internal rate of return. The essence of the calculations lies in the fact that you want to find a discount rate where the NPV of the project will be equal to zero, i.e. the sum of discounted profits will cover discounted investment. In practice, use a variety of methods. Easiest to use specialized software for evaluating investments or making business plans. Software MS Excel also includes a function that calculates the IRR based on cash flow.

A Somewhat more time-consuming methods that can be applied without the use of computer graphics are finding solutions and Lineinaya interpolation. The graphical method is to picture in the coordinate plane based on NPV (net present value) of the discount rate. The point of intersection of the graph with the abscissa axis and will reflect the value of the IRR.

Calculation using linear interpolation involves finding the two values of NPV – positive and negative – if different rates of discount. Next is the determination of the rate at which the NPV reaches zero, based on the assumption of a linear dependence.

The above methods allow us to determine the IRR for both projects, which are conventional cash flow. The peculiarity of this flow is that investments are made at the beginning of the project, and then the process of profit. Obviously, not all projects can be implemented in a similar way, some of them require investments and after there is profit. As already noted, for such projects with non-classical cash flow indicator IRR bit difficult to use. In connection with these has been developed indicator MIRR – modified internal rate of return. Its use allows to consider features conventially streams and more objectively assess the internal rate of return.

The Importance of the described indicator is difficult to overestimate, so his calculation must be necessarily included in the assessment of economic efficiency of investments. Depending on the nature of the project you must select either the IRR or MIRR.


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Alin Trodden - author of the article, editor
"Hi, I'm Alin Trodden. I write texts, read books, and look for impressions. And I'm not bad at telling you about it. I am always happy to participate in interesting projects."

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