Internal Rate Of Return Essay Example

most instances, pursue a project that would yield the most financial benefit to the company.It can be said that a project or proposal the company would like to is the one most likely to yield the most profits in the long run, or the longer period of time over the lifespan of the business. How do we arrive at the Internal Rate of Return? In mathematical terms, the internal rate of return is the projected discount rate that makes the Net Present Value Calculation to zero.

Net Present Value is defined as the difference between the present value of cash inflows and the present value of cash outflows. Net Present Value (NPV) is used in capital budgetting to analyze the profitability of an investment or project. Practically speaking, the NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. The equation for calculating the NPV is as follows: defintion of terms Initial investment: the investment at the beginning of the project. Cash flows: measure of the actual cash generated by a company or the amount of cash earned after paying taxes and all other expenses.

IRR: Internal Rate of Returnn: The Last year of the lifetime of the project. Calculating the IRR is done through a trial-and-error process that looks for the discount rate that yields an NPV equal to zero. The calcualtion can be arrived at with the use of of the IRR function in a spreadsheet program or with the use of a programmable calculator. In practical terms, the IRR examines the negative and positive cash flows and generates an interest

rate. This rate represents the value another investment would need to generate in order to be equivalent to tha cash cash flows of investment being considered.

For example, assuming a 5% interest rate, $100 interested today would be worth $105 in one year, using the formule of $ 100 multiplied by 1. 05. In reverse, $100 reciaved one year from now would only be worth $ 95. 24 today if the formula would $ 100 divided by 1. 05, asuuming a 5% interest rate.

Another example that can be used is with the use of NPV calculations, could be defined as follows: Initial: =I(0)( I being the benefits, and the ) meaning zero yield from the investment being the first year of investment), =- $ 100,000( the initial investment) Year 1=I(1)= + $ 175,000 Year 2=I(2)= + $ 175,000.Year 3=I(3)= + $ 175,000 For this set of cash flows, the IRR calculations that yield an NPV of zero is 166%. The IRR is needed because it gives the potential investor a projected, or simulated, return that can be directly compared to the company's hurdle rate. The hurdle rate of a company is the risk adjusted return a project needs to generate in order to be considered. Hurdle rates across all corporate initiatives may range from as low as 15% for safe investments, meaning these investments are well and readily acceptable to most investors, to as high as 100%, for the riskiest projects.

These projects may be inadvisable for investors to consider for their inherently high risks that come with these types of financial undertakings. For this resaon, the IRR is sometimes named as the break-even rate of return.

It is the rate at which the value of cash outflow equals the value of cash outflow.

Works Cited.

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