Hazen G. (2003), defines internal rate of return as an accounting technique used to compare and measure investments profitability of two or more projects in capital budgeting. It’s also known as effective interest rate when applied in the computations of savings and loans. It’s not affected by the factors such as inflation.
Basically, internal rate of return of investment involve interest values on present costs and the benefits obtained through in cash flows and out cash flows. The present cost values are considered negative cash flows while the present profits or benefits are the positive cash flows i.e. Negative cash flows = Positive cash flows. Cash flows statements are designed to show the relative change in a company’s cash amount during a given period of time. They are similar to income statements in that they both measure flow of money in a given period of time. The only point to consider is that cash flow statements deal only with cash transactions.
This technique is commonly used in the evaluation of the viability and performance of investments in the market place. It’s also used in the evaluation of the expected performance in terms of profitability, therefore a strategic technique for any prospective investment. When the internal rate of return of an investment is higher, the investment is viable enough hence desirable to undertake without any risk of making losses. This becomes a factor to consider especially in the purchase decision of an on-going investment. Investors will choose investments with relatively higher internal rate of return because they do not want to risk their huge capital investment on such projects or businesses.
Therefore, for a firm to manage several investments comfortably there is need for higher interest rate of return than the capital invested. Firms within the same level or industry can easily be compared since there is no difference in the variables considered such as the cash flows. Such differences are normally brought up by external factors which may affect the amount of operating capital and the net benefits from firms operating from different environments and with differing levels of production.
Application of Internal rate of return
Hartman and Schafrick (2004) argue that the internal rate of return is used as a function to measure efficiency of any given establishment’s investment. A project can only be accepted by an investor if its internal rate of return is higher than the cost of the capital invested. This adds value and quality to the establishment hence deemed economically profitable and such investors will have no risk to take the charge in the adoption and running of such an investment. Therefore, internal rate of return is only affected by internal variables which are also the key components such as the capital, cash flows (in and out), number or period of time and the actual rates of interest incurred for that particular period of time.
Advantages of Internal rate of return
- Internal rate of return confirms the money theory of perfect use of time and value of money. Any investor expects higher returns for a particular amount of money invested after a given period of time.
- The investor is capable of assessing the profitability of the investment without necessarily calculating the initial capital employed.
- It clearly shows the essentiality of cash flows method in the process of determining a budget for a given amount of capital. The relationship is drawn between the present operating value which is normally the initial capital and the current cash flow value, the difference between the two variables is then used to estimate the viability and profitability of the investment.
- It’s not biased in any way hence a uniform ranking method in the comparison of two or more projects.
- It ensures that stakeholders or investors get maximum profits therefore the fear to take risks is eliminated.
Disadvantages of Internal Rate of Return
- It is technical and requires mathematical skills to understand it. If the net investment is identified correctly and the period of time stated one can be able to interpret the internal rate of return for any project.
- It’s based on assumptions which are unrealistic. One assumes that if he invests money on internal rate of return and profits are made, then he can reinvest on the same internal rate of return which seems to be successful.
- It’s not good for comparing two different projects. It only compares projects in the same field of production. This is because of the varying characteristics of the variables from one project to another. Such variables are heterogeneous.
From the above example one can accept investment B because it has higher cash inflow though with lower internal rate of return (27%).
According to Pogue (2004), one proves investment is giving higher profits in a period of one year for example i.e. Net Profit Value, by using the following calculations;
- Investment A = 10500- 5% (20000+20000) = $8500
- Investment B = 2000- 5% (15000+1500) = $ 500
Therefore, from the above Investment A is profitable than Investment B. It is event enough that project A is doing extremely well as compared to project B. The $ 8500 is the profit or benefit resulting from the project above. The investor may decide to reinvest the benefits and using the same rate of interest to calculate expected future profits of the business. At any given moment therefore an investor will go for project A since his fear and risk uncertainties are reduced. Future prospects of the business can as well be determined and strategic plans implemented with accordance to the set future objectives for the establishment.
In conclusion, Bruce (2003) says internal rate of return is decision making equipment used by investors to determine the expected benefits of investments from their projects. In the case where the resultant investment benefits are lower than the assumed internal rate of return, it signifies overestimation and the assumption are based on the existence of more viable projects to facilitate for more cash flows. Only the start-up capital is analyzed which is normally used throughout the investment.
The internal rate of return technique can as well be used to select appropriate interest rate among several rates. This can help solve critical problems concerned with numerous internal rates of return and measures of the rate of efficiency for applying a particular method.
Stakeholders can compare two or more investments with ease and predict the way forward for their businesses through percentage projections and values of cash flows observed, analyzed and decisions made on the basis of profitability levels. This ensures the project maintains a competitive advantage in the market.
Bruce J. Feibel. (2003) Investment Performance Measurement. New York: Wiley.
Hartman, J. C. and Schafrick, I. C. (2004). The relevant internal rate of return: The Engineering Economist 49(2), 139-158.
Hazen, G. B. (2003). A new perspective on multiple internal rates of return: The Engineering Economist 48(2), pp. 31-51.
Pogue, M. (2004). Investment Appraisal: A New Approach. Managerial Auditing Journal.Vol. 19 No. 4, pp. 565-570.