One of the most important financial measures used in analyzing investment in any organization is the internal rate of return (IRR), which is an integrated measure with the return on investment (ROI) measure because they contribute to evaluating the investment process in the company and developing plans to develop it and make it more successful, which contributes to making decisions that are most appropriate to the company’s current situation. . Although the numbers that express the two terms are similar when measured within one year, they differ when measured over long periods. The internal rate of return relates to how the company benefits from its investments, while the return on investment is concerned with measuring the profit that resulted from its investments. Below, we explain more details about the two metrics and show you how they integrate together to achieve the overall benefit of the company.
Definition of internal rate of return
The internal rate of return (IRR) is sometimes known among organizations as the internal rate of return, and it is the relative accounting measure that is relied upon to measure the profitability of an investment and the feasibility of starting it. It can also be used to compare investments that a company can make to choose the best one in terms of return. It depends on converting the net present value of the investment (NPV) to zero in order to be able to make the value of the incoming cash flow from investments exactly equal to the value of the outgoing cash flow, with the aim of determining the average that the investor expects to receive in exchange for what he provides to the company.
What is the meaning of net present value (NPV)?
The term net present value refers to the difference between the value of the current financial liquidity received by the company and the financial liquidity left or paid as expenses and costs during a specific period of time. It indicates the value of securities and how their value may vary in the future, and based on that, the financial budget that suits the company is prepared.
There is an equation that describes the process of converting the net present value to zero, and it is expressed in the following image:
And in this equation:
- B denotes the cash flow received during the year or financial period, which is denoted by the symbol t.
- C denotes cash issued during year t.
- r denotes the discount rate.
- Indicates the initial investment.
- The letter n means the end of the financial period during which the net present is required to be calculated, and it ranges from 1 to n.
The importance of the internal rate of return
The internal rate of return is relied upon to make decisions in the organization, taking into account other considerations. It enables you to know the value of the profit that you can achieve from many investments and choose the best among them. The higher the rate of return over the cost incurred for production, the more successful and profitable the project will be. Calculating the internal return is important for all institutions that invest in new projects for several reasons, including:
Determine the success of the investment.
Calculating the internal rate of return for potential or available projects to invest in helps determine the best among them for investment and achieving a good annual return. You obtain information about these projects, the time periods during which they are expected to achieve profit, and their cost, and then extract the value of the expected profits. By comparing the results of more than one project, you can choose the one with the highest return and profit.
Project feasibility study
This rate is a reliable accounting method for determining the project’s feasibility and suitability in terms of cost. If the result of the calculation is a high rate, then the project is eligible to start. However, if the rate is low, it is better to look for an alternative. The condition for the feasibility of a single project is that the internal rate of return be greater than or equal to the cost of capital, while if the ratio is measured for more than one project, the project that showed the largest difference between the internal rate of return and the cost of capital must be chosen.
An accurate measure of profitability
Internal rate of return is an accurate and reliable measure of profit because it is based on taking time into account, and the volume of cash flow is also a key consideration. Therefore, it is the best measure that can be relied upon to make decisions.
risk assessment
Sensitivity analysis of various variables can be carried out based on the internal rate of return, so it is easier for the company’s management to control the cash flow and prepare the project in a way that protects it from loss in the face of these variables and thus helps in avoiding and moving away from potential risks.
How is the internal rate of return used in companies?
The internal rate of return is used as an accounting tool that states the following:
Decision making
This means that it works to provide information about the expected percentage of profit during a certain period of time for one or more projects, and a decision is then made about the optimal project to start based on the percentage of internal return it achieved.
Evaluate the project in terms of risks.
The internal rate of return can be used, in addition to other measures, to identify and evaluate the challenges and risks that may face a particular project in which the company intends to place its investments. Based on the potential risks, it is decided what will be done regarding the project, whether canceling it or amending some of its provisions so that it achieves the expected profits from it.
define the priorities.
The internal rate of return is based on evaluating investment opportunities, knowing which projects bring the most financial benefits and profits to the company, and thus determining which projects have priority to start and exploit their profitable returns, then starting the following projects.
Resource allocation
When the internal return rate is calculated and the project to be started is reached, the company prepares the resources and infrastructure that the project needs to suit it so that it can be benefited on the broadest scale.
Study acquisition and merger opportunities.
If you intend to acquire a company or carry out a merger between your company and another company, calculating the internal rate of return helps you determine whether the time is appropriate for this process or not by conducting a financial feasibility study for the deal.
How to calculate the internal rate of return
The internal rate of return is calculated in several ways, including:
- Use the IRR equation in spreadsheets such as Excel or others.
- It is the iterative process of projecting cash inflows and outflows that turns the net present value to zero.
- By using a calculator that specializes in calculating financial transactions.
- Using Qoyod accounting software.
When calculating the IRR, you need to know the value of the investment’s incoming and outgoing cash flow, in addition to determining the discount rate. The rate is calculated at different institutions using the following steps:
- Get the required values, which are:
- Initial amount of investment.
- Expected financial liquidity.
- Discount rate.
- Incoming and outgoing financial flow.
- Start by calculating the values required for the net present value equation, which are:
(NPV = (CF1 / (1 + IRR)^1) + (CF2 / (1 + IRR)^2) + CFn / (1 + IRR)^n.
that:
- NPV stands for Net Present Value.
- The symbol CF denotes the cash flow obtained by the organization during fiscal period t.
- The symbol n indicates the number of periods for which the net value is to be measured.
- The symbol IRR denotes the internal rate of return.
- The cash flows for each period are denoted by CF1 to CFn.4.
- Extract the IRR value such that NPV = zero using one of the methods mentioned above.
- After the value equals zero, the discount rate is calculated with the following equation:
Discount factor = initial investment ÷ annual net cash flows.
- After obtaining the discount rate, the discount price is extracted, an example of which is as follows:
If you have the following data:
- Initial investment value = 200
- Net annual flows equal 50.
- Economic life of the project = 5
So the discount factor is 200 ÷ 50 = 4.
Based on the aforementioned information, the value we obtained as a discount factor falls between 4.1 at a discount rate of 7% and 3.9 when the discount rate is 8%, and then 8% is taken as the internal rate of return for the project.
Example of an internal rate of return
In this paragraph, we present to you an example that shows you how to calculate the internal rate of return based on the steps mentioned above, and this example is as follows:
| A commercial company wants to invest 20,000 riyals in a new commercial project. The company is expected to receive 15,000 riyals every year for the next 7 years. How can the internal rate of return for this project be known? To solve, the equation is applied as follows: 0 = -20,000 + 15,000 / (1 + IRR)^1 + 15,000 / (1 + IRR)^2 + 15,000 / (1 + IRR)^3 + 15,000 / (1 + IRR)^4 + 15,000 / (1 + internal rate of return)^5 By solving this equation, you can know the internal rate of return. |
Definition of return on investment (ROI).
Return on investment is known as a measure that is useful in analyzing the performance of investments from a financial perspective, specifically measuring the percentage of difference between what was spent investing in the project as a whole and what profits were achieved in the end. This is with the aim of determining whether investing in this project is profitable or not.
The difference between the internal rate of return and the return on investment
Although the internal rate of return and return on investment are important for measuring the financial performance of companies, they differ from each other in several aspects, which we explain below:
| Comparison | Internal rate of return | Return on investment |
| the definition | It is a measure relied upon to decide whether to start an investment or not. | A reliable measure to measure the percentage of profit returned from an investment is. |
| Its connotations | A higher rate of expenses indicates the feasibility of the project, while a lower rate indicates that it will not achieve any profit. | A high percentage indicates large profits achieved by the project. |
| What is measured | Liquidity or cash flow. | Profits. |
| Temporal considerations | It is concerned with the value of money over time, and its value can be measured over 30 years. | It does not care about the value of money but rather measures the investment performance over one year only. |
| Its result | It measures the minimum return on capital and converts the value of the inflow so that it equals the investment outlay. | It measures the ratio that expresses the increase or decrease in investment during a certain time. |
| Accuracy ratio | Provides an accurate analysis of investment performance. | Its evaluation is not accurate and cannot be relied upon alone, especially given the long period over which the investment is required to be measured. |
| How to calculate it | Initial project capital ÷ annual net cash flows | (Investment cost minus the final value of the investment) ÷ Investment cost. |
| the goal | Determine the discount rate taken to bring the net present value to zero. | Determine whether the project is feasible or not. |
Example of using an internal rate of return with a return on investment
The two metrics are often used together to learn more details about the performance of the project whose feasibility is to be measured. Although the internal rate of return helps to know the percentage that the project can achieve over the years of work on it, the return on investment enables us to know how profitable the project will be compared to the expenses that were made for it. Therefore, they must be used together to achieve a broader and more comprehensive vision, an example of which is as follows:
| Your company faces two distinct investment opportunities. The first project requires a capital of 200,000 riyals to give a return of 300,000 riyals over 6 years. The second project requires a capital of 300,000 riyals with a return of 400,000 riyals over 6 years.
ROI for the first project = (300,000 – 200,000) ÷ 200,000 = 0.5 x 100 = 50%. ROI for the second project = (400,000 minus 300,000) ÷ 300,000 = 0.3 x 100 = 30%. If the internal return rate for the first project is 20% while the second project has a rate of 10%, then the first project will be more successful than the second project. |
Advantages of an internal rate of return
There are many advantages that can be obtained when calculating the internal rate of return for projects, including:
- Knowing the feasibility of the project or making a decision to work on an alternative project.
- It explains any risks that the project may encounter while working on it and how to avoid them.
- The problem of choosing the appropriate discount price can be avoided by calculating it.
- Through it, you can choose from a number of investment projects, even if they have similar characteristics.
Disadvantages of the internal rate of return
There are drawbacks to the internal rate of return measure despite all its characteristics, and these drawbacks are as follows:
- It does not measure the possibility of changing returns over time, and this makes it unsuccessful as a measure of long-term projects.
- If you want to compare two projects separated by a period of time, this will not be your appropriate measure because of its inability to measure the change in returns.
- It is considered an inaccurate measure of the cost of the required investment as well as its expected profits because it adopts the idea of investing all the money in new projects.
Conclusion
The Qoyod accounting system helps you obtain an accurate calculation of the internal rate of return, linking it to the percentage of return on investment, so that you can identify your company’s strengths and weaknesses with regard to financial and investment performance. In order to be able to do this smoothly, you must try the Qoyod accounting system for free without the need to add your credit card information, enjoy unlimited accounting services, and keep your data in complete security. So subscribe now and tell us the result of your experience in the comments.
Join our inspiring community! Subscribe to our LinkedIn page and Twitter to be the first to know about the latest articles and updates. An opportunity for learning and development in the world of accounting and finance. Don’t miss out, join us today!
