The IRR, is the interest rate that originates a project , is in charge of calculating the profit of a financial investment . Which means that the percentage of profitability and loss can be evaluated with this complementary tool of the Net Present value.
We want to clarify that in many cases that decisions based on the Net Present Value are not systematic as is the Internal Rate of Return. Due to the irregularity of the flow of money, a mechanism is required to guarantee the Net Present Value to verify it with the Internal Rate of Return.
Mostly the internal rate of return works as a tool to finalize a decision regarding a business or project. This tool helps to determine if the commercial project will be beneficial, and that the shareholders can make their investment safe and reliable. The IRR in the market is the investment that gives a lower return, being similar to the flows and income of money at a percentage of return.
How to calculate the IRR?
To calculate the IRR it needs to correspond to the reduction or discount rate at the initial moment, the future current of collections with payments. This will lead to the NPV being similar to 0, with the correct formula it will capture this result, taking into account the elements that make it up.
- Formula NPV or Net Present Value.
- Ft: It means money flow in each period t.
- I0: It consists of the investment that is applied at the initial moment (t = 0).
- n: This is the number of time periods.
- k: This is the cost of capital used.
- Formula of the IRR or Internal Rate of Return.
- Qn: It is the cash flow of period n.
- n: It means the number of periods.
- I: Represents the initial investment value.
When to use IRR?
If you have started an investment for a company, you should take the IRR into account when accepting a loan or product from the bank. Before this you must calculate the interest risk that this can produce, if it offers you a risk of less than 5%, calculate about 8.7%. If the result you obtain is positive, you will decide whether to invest in the company, since you will have already determined the profitability.
If there is an entrepreneurial project or a business plan that will generate a 5-year profitability with benefits and effective production, you will need the IRR . So before accepting the business you will need to calculate the IRR, taking into account the minimum cut-off rate to be able to invest successfully.
The usefulness of using the Internal Rate of Return
We live in a changing system in a social, economic and political sense, therefore the fear of investing in the event of financial loss is understood. And that the marketing of purchase and sale could fall, and that also the economic situation is fluctuating, that is why it is useful to use IRR . This tool allows you to calculate in advance the profits that you could obtain by investing together with other investment formulas.
Having a criterion and strategic planning will allow us to understand the value and risk of an investment and thus reduce the uncertainty of the current market. In summary, IRR will help us to prevent and calculate in practice if it is possible to invest and generate enough without having to lose profits .
We have concluded this work, whose main purpose is to let you know what the IRR is and the characteristics of your investment.
