Internal Rate of Return and the Investment Behavior of a firm
Dr Sandeep Kulshresthafinancewisdom@easy.comThere are Professors across the world who teaches Financial Management in a veryscientific way. It is good to explain financial terms scientifically to those who have either an idea or knowledge of these terms. One of the mind-boggling financial tools is theInternal Rate of Return which is commonly used to analyze the efficacy of aninvestment proposal. Internal Rate of return is also known asdiscounted cash flowrateof return.In more specific terms, the IRR of an investment is theinterest rateat which thenet
present valueof costs (negative cash flows) of the investment equals thenet present
valueof the benefits (positive cash flows) of the investment.
I will define Internal Rate of return as “a calculation of such discount rate whichbrings equality to the net present value of the initial investment with the net present value of future returns”.
Before understanding this further, let us understand few concepts, as below;
Net Present Value (NPV):
Suppose you have $100 in hand today and if invested in aproject, you may get it back as a return in three years. Do you think it is a good return?Can you buy same things in $100, three years from now, as you buy now? The answer is “no” as the value of the $100 will not be same in future as it is today. If you get say$110 after three years, you may feel good because your money gets appreciated. Butstill, would you not be interested to know what is the present value of that $110, so thatyou may understand whether it’s worth investing. Suppose the net present value of $110 which you will get after three years still comes to be $100, will you still invest? Theanswer again is “no”. So, you will definitely be interested if it comes to be more than$100. Hence, Net Present Value is the present value of the future benefits which iscalculated easily from the net present value tables available.
The inflow and outflow of cash in any business venture or investments.You invest $100, which is a cash outflow and you get $110 after three years, which is acash inflow
The rate used to discount future cash flows to the present value is akey variable of this process. A firm'sweighted average cost of capital(after tax) is oftenused as a discount rate but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors. Another approach to choosing the