Will your company make or lose money on a project or investment? Here’s how to find out!
When your business finally begins making money, you should invest to make even more money. Businesses have to make the most out of their profits, and savings, by realizing solid investments that will grow year after year. If you don’t invest, you’ll miss out on important opportunities to enhance your financial worth. Organizations use various types of financial data and analysis tools when it comes to making investment decisions. If you have a fresh product idea or are thinking about buying shares in different companies, don’t rush into planning. You need to be sure that the undertaking is meaningful. When you want to use corporate funds, know for sure if you’ll make or lose money on the project.
The question now is: How are you supposed to establish the feasibility of a proposal? It’s simple, actually. Calculate the internal rate of return and you’ll get your answer. The internal rate of return, IRR for short, is an important decision metric that can be applied to predict the amount of cash you’ll receive in the future. It helps your company compare one project/investment to another and, most importantly, figure out if it’s viable. The moment that IRR is settled on, it’s measured against the organization’s minimum rate of return. The higher the internal rate of return is, the greater growth potential is. If the IRR happens to be lower, the proposal needs to be rejected immediately.
Using IRR in financial decision-making
You’re at a loss because you don’t know what project is worth pursuing. This is where the internal rate of return comes into play. It offers a simple means to compare the feasibility of various projects under consideration. Professionals such as financial managers are completely unaware of the deficiencies relating to IRR and aren’t fully prepared to interpret its significance or adequate usage.
If you take the time to examine several investments, you’ll immediately discover that they are based on attractive internal rates of return. The metric has been deployed to justify investment decisions. It’s not hard to understand the allure of IRR, as it provides a pretty straightforward comparison of the annual return of a specific investment. You’re not looking at a distortional calculation. On the contrary, you can select the right projects. Most importantly, you don’t risk creating unrealistic expectations for yourself or shareholders, for that matter.
Nevertheless, the internal rate of return shouldn’t be the only metric used in the financial decision-making process. It’s expressed as a percentage, which means that IRR doesn’t take into consideration the overall extent of the arrangement. To put it simply, it should be used in conjunction with other metrics to confirm the results derived from capital budgeting.
IRR shouldn’t be confused with ROI
When examining the return on an investment, you can use two metrics: internal rate of return and return on investment. The return on the investment refers to the increase or decrease in ratio concerning a business deal over a certain time frame. Attention needs to be paid to the fact that IRR and ROI are complimentary metrics, the only thing that sets the two apart being the time value of money. IRR, on the other hand, is useful for capital budgeting estimates when undertaking expansions. The IRR decreases comparatively to the ROI, which remains constant.
It isn’t easy to realize estimates for project-based programs or processes because they involve factors that change. The accuracy depends on what is taken as cost and return. ROI might now always provide a good answer. The formula for calculating IRR is the same formula for calculating NPV. So, is there any difference? Yes. The NPV is replaced by 0 and the discount rate is replaced by IRR. The formula for calculating IRR isn’t complicated.
If you’re considering private equity investments, it’s not a good idea to calculate the ROI, as you can find out the expected return on the stocks involved. IRR takes into consideration investment growth, yet ROI accounts for the timing in managing cash flow. What you need to remember is that both metrics have their strengths and weaknesses.
IRR vs. Compound annual growth rate
As a rule, the IRR is more flexible as compared to the compound annual growth rate (CAGR) in the sense that it considers multiple cash flows and periods. In other words, it doesn’t take into account all the variables that occur as far as investments are concerned. The compound annual growth rate is focused on the initial investment amount, as well as the final value for determining the growth rate. Indeed, the calculation is simpler as compared to the internal rate of return (it can be calculated by hand), but that doesn’t make up for its limitations.
Imagine the following scenario: You wish to invest in an idea, which necessitates the acquisition of particular instruments to manufacture high-precision parts for an important customer. The project is likely to extend over a long period and, when it comes to an end, the company will make their own parts. The amount required to get the project off the ground is $500,000. Estimated cash flows for the years to come are $150,000, $170,000, $190,000, and $200,000. Expansion is determined according to the legal contract that the client has agreed to signing. You can save approximately $80,000 when it comes down to the equipment. You need to know for sure if you’ll experience future success.
The IRR can come in handy for more complicated problems. For instance, if you’re dealing with variable cash inflows and outflows, it’s highly recommended to use the IRR formula. You can calculate the internal rate of return with Excel. If you believe that using the Excel IRR functions is too complicated, use an online calculator. You simply enter the predicted cash flows and the dates of their occurrence. Once the input parameters are completed, the calculator will automatically determine the IRR of your project/investment.
To sum up, you don’t have it easy. You need to have a guarantee that you’ll make profit from your investments, which is why you should make decisions based on calculations. Now, you know what the right tool is for good quality decision-making.