To evaluate an investment or the business situation of a business, economists need to understand the concept of IRR - Internal Rate of Return. Let's find out What is IRR? and the most accurate IRR calculation formula through the following article.
What is Internal Rate Of Return (IRR)?
IRR stands for the phrase Internal Rate of Return, which means the internal rate of return or the rate of return of a business used to budget and evaluate the performance of business investments. In addition, IRR is also used for financial analysis, estimating the profitability of investments.
For example, applying an investment with an IRR of 12% means that the investment will generate an annual rate of return of 12% over the life of the investment.
The Most Accurate IRR Formula
The formula for calculating IRR depends on NPV (NPV - Net Present Value is net present value):
IRR = r1 + NPVr1 * (r2 – r1) / (NPVr1 – NPVr2)
- r1 small discount rate at which NPV>0
- r2 is the larger discount rate where NPV < 0
- NPVr1 is the net present value when the discount rate is r1
- NPVr2 is the net present value when the discount rate is r2.
Or we can also calculate by the formula as:
- t is the time to calculate the cash flow
- n is the total project time
- r is the discount rate
- Ct is the net cash flow at time t
- C0 is the initial cost to implement the project
Meaning of IRR
IRR has an important meaning to calculate the profit that can be achieved when investing in a project, it is a measure for businesses to evaluate the effectiveness of the project and should focus on one project or split the investment capital. many projects.
- IRR is greater than or equal to capital then the project can be profitable.
- If IRR is less than capital, the project may lose.
- Enterprises that develop many projects will be carried out in order of IRR from high to low.
The Role Of IRR For Businesses
For the development of businesses, IRR is an important indicator to help evaluate the feasibility of a project. Projects with larger IRR are more feasible. If the projects with the feasibility rate are not high, the project with the highest rate should be selected for implementation.
How Is the IRR Used?
Management may use this rate of return to compare other investments. And decide which capital projects should be funded and which should be abandoned. For example, IRR can help managers choose between upgrading equipment or enhancing product development.
Businesses often set a minimum required rate of return on investments. If a proposed project cannot generate an IRR above the minimum rate of return, the proposal is dead in its infancy.
Similarly, the IRR of a project must exceed the cost of capital or the interest rate of a loan taken out to finance the investment. An IRR lower than the cost of capital would probably kill the project.
Investors can use the IRR to calculate the expected return on buying stocks. It can also be used to calculate a bond's yield to maturity. And it is also possible to balance risks and benefits when buying real estate.
Venture capitalists and private equity investors use the IRR to evaluate investments in companies. The IRR is suitable for situations involving a one-time cash investment. This is followed by one or more cash returns over time.
Advantages and Disadvantages of the IRR . Index
The concept of IRR - internal rate of return also has its own advantages and disadvantages in business investment.
The advantages of IRR are:
- How to calculate IRR as a percentage, uncomplicated, independent of capital. From there, investors can compare, compare and evaluate to choose which project to invest in with more profit and efficiency.
- IRR helps investment project owners to come up with effective strategies and business plans to get the best profit.
- IRR indicates the profitability of the project does not depend on capital, helping investors evaluate investment opportunities.
- The IRR indicates the highest rate of interest a project can accept.
Besides the advantages, the IRR index also has disadvantages which are:
- Calculating IRR takes time because there are many cases where IRR will be calculated based on hypothetical data.
- There may be errors in the calculation leading to missed investment opportunities that generate large efficiency and large profits.
- The IRR is not always optimal for a project, especially when the project has unstable funding, multiple sources, or an uneven discount rate.
- The formula for calculating IRR is completely based on NPV, so when the NPV is unstable, the data is also inaccurate, leading to an error in calculating IRR.
Relationship Between IRR and NPV
IRR and NPV both represent the achievable performance of a project. IRR is a percentage, and NPV is an amount. Depending on the specific case, investors or businesses will use IRR or NPV data:
- Where it is necessary to describe the exact amount, the NPV should be taken into account.
- In case it is necessary to evaluate many projects at the same time, regardless of technique or time, it will be evaluated through the IRR index.
What Limitations Does the IRR Have?
The limitation of IRR when evaluating a project is the time factor.
- The project has a short time frame, calculating the high IRR is easy to misjudge the potential of this project. However, the fact that the NPV of this project may be low is not necessarily the efficiency and profitability of the project.
- Projects for a long time, if the calculation of IRR is low, it means that the profit can be slow and small. However, the investor can benefit from the value generated during that period.
Through the above article, surely you all have knowledge about the index What is IRR?? IRR is the internal rate of return, used to evaluate the profitability and efficiency of an investment project. From the IRR calculation formula in the article, investors can monitor and evaluate the selection of suitable projects by themselves.
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