With uncertainty among investors thanks to market volatility, they are looking for bonds as safe investment options. Thus, Kotak Cherry discounted Kogta Financial India’s secured non-convertible debentures between 1 and 7 July at a 10% Internal Rate of Return (IRR). After the offer period, the rates dropped to 9.5%. These bonds are likely to offer higher returns than fixed deposits and lower risk than equities.
Like these bonds, an investment can reward its investors, provided that just the right investment decision is made. Among the many factors to analyze an investment avenue is its Internal Rate Of Return (IRR). IRR estimates the profitability of potential investments.
What Is The Internal Rate Of Return?
The internal rate of return (IRR) determines the profitability of potential investments. In a discounted cash flow analysis, IRR is a discount rate that makes all cash flows’ net present value (NPV) equal to zero.
In general, the higher the IRR, the more favorable an investment is. IRR is consistent across investment avenues and may thus be used to rank different prospective investments or projects based on their profitability.
When comparing investment choices with other similar traits, the investment with the highest IRR is likely to be regarded as the best.
Impact Of IRR On Investment Decisions
You can consider the IRR of your potential investments to make an informed decision. An IRR impacts investment decisions in the following ways:
- A common use of IRR is to analyze investment returns. In most situations, the advertised return assumes that any interest or dividend payments be reinvested back into the investment.
But what if you don’t reinvest dividends but take them as income when paid?
Are dividends not assumed to be reinvested and paid out?
What is the assumed return on the cash if dividends not reinvested are paid in cash?
IRR particularly impacts investment decisions about instruments, especially having complicated cash flows.
- IRR can impact your financial decisions, such as during insurance policy evaluation. Insurance policies with the same premiums and a high IRR are widely seen as being more desirable. This way, you’re more likely to choose a policy with a higher IRR.
- One scenario for IRR in capital planning is to evaluate what is more profitable — a new operational setup or an existing operation expansion. For example, a beverage company may use IRR to decide whether to introduce a new flavor or enhance an existing drink. While both could bring profits to the beverage company, the more profitable decision as prescribed by IRR will be chosen.
- If a company spends significant resources repurchasing its own shares, a higher IRR can convince the company that its own stocks are a superior investment to creating new products or acquiring other small startups.
Example of IRR
Consider the following scenario: you contribute Rs.3 lakh to the EPF each year apart from the maximum Rs.2.5 lakh. Assume that the interest rate will be 8%, and your marginal tax rate will be 30%.
So, each year, you will earn 8% of your accumulated amount and pay 30% of that amount in income tax.
(For the sake of convenience, consider the complete annual inflow and tax as one event. Note that this does NOT happen in reality!)
If Rs.3 lakh were deposited into the nontaxable EPF account each year for 20 years, it would have risen to Rs.1.48 crore. However, given the criteria, it will only accumulate to Rs.1.12 crore in the taxable account. The continuous taxation makes the true post-tax internal rate of return to be just 5.62%. So, it’s a deposit with a very long lock-in period and a return of 5.62% in a year.
A good deal? Quite possibly NO.
Why? Because there are ample investment opportunities in the market better than the above.
Rather than a taxable EPF account, why not invest in an equity fund?
Consider another example of an equity fund. In this situation, the same inflow would result in Rs.1.39 crore rather than Rs.1.12 crore. Moreover, it will only be taxed once, at a rate of 10%, when it is withdrawn. So, the true internal rate of return here would be 7.48%.
Comparing both IRRs, it is clear that an equity fund is better than an EPF.
What Is The Formula To Calculate IRR?
Note that IRR estimates use the same formula as NPV calculations. IRR does not represent the worth of an investment. The annual return is what brings the NPV to zero.
The formula of IRR is as follows:
In the formula, Ct denotes net cash inflow during the period t, C0 denotes total initial investment cost, IRR denotes the internal rate of return, and t denotes the number of time periods.
How To Calculate IRR?
Let’s understand how to calculate IRR with the help of an example.
Suppose that a company wants to proceed with either launching a new product or expanding a part of its business. Let the new product launch be Project A, and the business expansion be Project B.
Project A
Initial Investment = 2,50,000₹
Year one = 85,000₹
Year two = 95,000₹
Year three = 80,000₹
Year four = 70,000₹
Project B
Initial Investment = 1,00,000₹
Year one = 50,000₹
Year two = 35,000₹
Year three = 25,000₹
Year four = 20,000₹
To assess the profitability, the company must calculate the IRR for each project.
Keep the NPV to zero and solve for the IRRs using the formula. Furthermore, the initial investment is always negative because it represents an outflow.
Project A
0 = (−2,50,000) + 85,000 ÷ (1 + IRR)1 + 95,000 ÷ (1 + IRR)2 + 80,000 ÷ (1 + IRR)3 + 70,000 ÷ (1 + IRR)4
Thus, IRR for Project A is 12.6%.
Project B
0 = (−1,00,000) + 500 ÷ (1 + IRR)1 + 35,000 ÷ (1 + IRR)2 + 25,000 ÷ (1 + IRR)3 + 20,000 ÷ (1 + IRR)4
Thus, IRR for Project B is 13.72%.
Thus, proceeding with the business expansion would be a more profitable option for the company.
Financial Takeaways
IRR is a popular statistic for assessing a project’s annual return or the annual growth rate of an investment. But, it is not sufficient to be used alone. If used with other metrics, it may lead to a more accurate prediction. Furthermore, if an investor can get a slightly lower IRR from an investment that is significantly less risky or consumes less time, they may gladly proceed with the lower-IRR project.
FAQs
What does IRR measure?
IRR measures the expected growth rate of an investment.
Can IRR be negative?
Yes, when the total cash flow in investment is less than the initial investment, IRR is negative. In such cases, the investors receive negative returns on their investments.
Why is IRR important?
IRR is important because it evaluates the profitability of a potential project or investment.
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