Internal Rate of Return (IRR) is that rate of return at which the present worth of cash inflows amounts to today value of money outflows. Hence, it is that rate at which the NPV of the job will be o & the profitability index will be 1.
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Internal Rate of Return
Before undertaking a specific job, we need to analyze it from numerous angels. Among such techniques is Net Present Value that we had actually seen earlier. Another Essential method is by determining the Internal Rate of Return.
Let us understand what Internal Rate of Return is & how is it calculated & analyzed.
What is IRR?
For details on NPV & PI, please refer my posts:
NPV– Click On This Link
PI– success index
Now, let us take a look on how Internal Rate of Return is computed.
This is the formula for computing NPV:
where:
C t = net money inflow throughout the period t
C o= overall preliminary investment expenses
r = discount rate, and
t = number of period
As it will be needed to be computed through a computer application since of the complicated nature of the formula, it is generally determined with the assistance of trial & mistake technique.
By utilizing the trial & error method, you can use approximate rates & ascertain the NPV at that rate.
There are different benefits & downsides of IRR.
Let us have a look on them.
Advantages
Simple
As seen above, Internal Rate of Return is easy to compute. There is no such tough & fast formula & can be easily determined by a layman.
Gives Significance To The Time Value Of Cash
While other methods don’t think about impacts of inflation, deflation, etc., Internal Rate of Return approach provides due importance to the impact of time value of cash.
But is likewise accompanied by different downsides.
Let us take a look on the drawbacks:
Reinvestment Element Is Ruled Out:
There are different projects which need financial investment not just in the preliminary stage, however likewise over the life.
Size Of The Task Is Ruled Out:
If various jobs have various task size, the IRR technique will not suffice. This can be bothersome when two tasks require a very different quantity of capital out flow, but the smaller job returns a higher IRR. This would end up being an improper technique in such a case.
Hence, IRR is an excellent method to find the job with greater returns. The project having greater IRR is usually the much better job.
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