When the investment is done it is by and large done for returns. No one invests when there are no returns involved on the base value. It could have been easy to know the rate of return one avails on investment but there are multiple factors affecting the return and calculation for same. When we talk about Internal Rate of Return it is more complicated to understand the same. Here is all you need to know about Internal Rate of Return by FinanceShed.
What Is Internal Rate Of Return?
Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from a project or investment equal zero. These cash flows can be positive as well as negative. One can take decisions regarding business enterprise on the basis of Internal Rate of Return and also the return one can get from new project can be evaluated.
If the IRR so calculated exceeds the company’s required rate of return, the company can proceed with the project. If IRR is less than the company’s desired rate of return, they should not adopt the project.Every investor wants the investment plans which gives best investment plans with high returns.
Formula For Calculating Internal Rate Of Return
IRR = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
In order to calculate IRR, the net present value should be kept at zero. IRR cannot be calculated at the fixed percentage, one has to go with trial and error method or have to use any software based calculation. The general rule of IRR is Higher the project’s IRR, better it is and vice versa. IRR can also be used to rank multiple projects and the projects which has higher IRR can be selected assuming cost of projects to be equal.
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Why to Calculate Internal Rate of Return?
By comparing the estimated internal rate of return on an investment to that of an annuity payment to that of a portfolio of index funds, you can have various assumptions of the risks involved in the project. Expected return is not the only thing to look at one must also consider the risk involved in the prospective projects and thus one should always go for risk assessment process. It is universal rule that you cannot get higher returns without taking higher risks.
Once you determine the internal rate of return of your project you have to compare the same to the cost of capital. You IRR has to be greater than or equal to the cost of capital and this is obvious as the returns should be greater than the costs incurred. If the IRR does not reach to the cost of capital the project should be rejected.
The major advantage of using IRR is it clearly defines how much return you can expect out of the concerned project. Based on this rate one can take decision regarding the projects to be accepted and rejected. The disadvantage of this method is that this method fails to give perfect rate of return when the prospective project has multiple cash flows and has both positive and negative cash flows in the period under consideration.