Think about the cash flows associated with putting in the bank for five years, assuming you draw out the interest each year and then close the account. Now think about a set of hypothetical cash flows associated with putting the same money in a business, operating for five years, and then selling out. Write an explanation of why the IRR on the business project is like the bank’s interest rate. How are the investments different?
The Internal Rate of Return (IRR) is a measurement used in estimating the profit in a certain project or investment. It is the rate at which the discount realizes the net of the present value (NPV) of investment. The internal rate of return is the same as net present value, and therefore the formula to calculate the two is the same. Some business contexts refer to the internal rate of return as an effective interest rate. The IRR is used to make decisions on whether to proceed with the project or not; this is determined by comparing the expected returns versus the capital used in the investment (Pogue, 2004). If the internal rate of return is less than the cost of investments, then the better option is to terminate the project. Positive IRR is profitable while negative ones lead to a loss. The NPV and IRR are calculated using the following formula:
Ct= Cash flow during time t
C0= Cost of Initial investment
r= discount rate
t= period of investments
The IRR is calculated by setting NPV value to zero then r; the discount rate is determined.
Investments at the bank account and in the project are considerably the same if the interest rates are equal. However, at lower interest rates at the bank, investments in projects will be profitable.
Taking an initial investment of $2000 as the present value, the investor will receive quarterly payments of $100 every year and $2833 in the fifth year. Considering the interest rate to be 11.2% per year;
PV=-$2000 and 12/100
1st year; present value=$100/1.12= $89.29
2nd year; present value=$100/1.12^2= $79.72
3rd year; present value= $100/1.12^3= $71.18
4th year; present value= $100/1.12^4= $63.55
5th year; present value= $2833/ 1.12^5 = $1607.52
Adding up the totals will be: -2000+ 89.29+79.72+71.18+63.55+1607.52= $-88.74
Negative values indicate that an investment of $2000 in a project will be a loss (Magni, 2010). The interest rates, if increased to 13% will be good to invest in the bank or in a project.
Magni, C. (2010). “Average Internal Rate of Return and Investment decisions: a new perspective”. The Engineering Economist, 55(2), 150-181
Pogue, M. (2004). Investment Appraisal: A new approach. Managerial auditing Journal. Vol. 19 No. 4, p. 565-570
by EssayRoyal, Dec. 7, 2019, 7:20 p.m.