The internal rate of return (IRR)
The IRR is used by investors to estimate the profitability of potential investments. It is the discount rate that equates the net present value of all cash flows from a certain investment to zero (Patrick & French, 2016). Both IRR and NPV rely on the same formula. The IRR is calculated using two ways: programmed software and trial-and-error method. This paper focuses on how IRR is calculated using the trial-and-error method. Below are the steps involved:
- Use an arbitrarily selected discount rate to compute the NPV of the project.
- If the NPV computed is negative, try a lower rate, but if it is positive, then try a higher rate.
- Continue applying the process above until the project’s NPV is equal to zero.
- Determine the exact rate using linear interpolation.
How IRR supports capital business decisions versus the NPV model
Generally, the IRR is the rate of growth expected to be generated by an investment. Although a project might end up generating a different IRR from the actual rate of return, a better chance of strong growth would still be provided by an investment with substantially a higher IRR (Ben-Horin & Kroll, 2017). Both IRR and NPV are used in comparing the profitability of expanding new operations with that of establishing new ones. For instance, an energy company may use the two methods to decide whether to expand and renovate the existing power plant or open a new one. These two techniques are also useful in stock buyback programs. On the other hand, the two methods differ because IRR does not consider changing factors such as different discount rates, while NPV does.
Simple rate of return and capital budgeting
This is the incremental amount of net income an investor expects from a potential investment opportunity divided by the investment in it. This technique is used for capital budgeting analysis to determine incremental changes as a result of investing in a fixed asset and whether to invest in the asset (Bornholt, 2017). Apple Inc is a good example of a company that uses a simple rate of return when making a purchase or investment decisions. The organization uses this technique to determine the returns it expects from investment. It also considers the effect of inflation and the time value of money when applying this technique.
References
Ben-Horin, M., & Kroll, Y. (2017). A simple, intuitive NPV-IRR consistent ranking. The Quarterly Review of Economics and Finance, 66, 108-114.
Bornholt, G. (2017). What is an investment project’s implied rate of return?. Abacus, 53(4), 513-526.
Patrick, M., & French, N. (2016). The internal rate of return (IRR): projections, benchmarks, and pitfalls. Journal of Property Investment & Finance.