Return on Investment – Internal Rate of Return

Return on Investment – Internal Rate of Return By R. S. Miolla

Agenda • 1) What is return on investment (ROI)? • 2) Internal Rate of Return • 3) Net Present Value Method (NPV) compared to Internal Rate of Return (IRR).

1) ROI or Capital Budgeting • Answers: Is this a good financial investment? • Simple ROI computed as (Returns – Investment)/Investment • Assume 10k investment, 3k return for 4 years • (12,000-10000)/10,000 = 20% • A long-term investment • Example: buying equipment, opening a plant • Simple ROI may use cash or profit as return.

2) Internal Rate of Return (IRR) • Gives the % rate of return on the investment. Computed based on the cash inflows and time value of money. • Can be called the yield on the investment. • Contrast to Simple Return on Investment = {(return-investment)/investment}/# years. • Note simple ROI can be annualized.

2) IRR - Calculation • Can be done in Excel • Financial calculator • Online calculator • Phone Apps • Financial tables

2) IRR - Example • Investment of $50,000 • Return or cash inflow of $20,000 a year for 3 years. • IRR = 9.7%

Strengths of IRR vs. NPV • 1) Projects of different initial investments are easily compared. • 2) A firm can set a hurdle rate for IRR (maybe its cost of capital plus 5%) and all projects are easily compared to the hurdle rate.

Summary • 1) Return on investment. • 2) Internal rate of return. • 3) NPV and IRR compared.

Return on Investment – Internal Rate of Return