FNT1-TASK2-Deffinitions

FNT1-TASK2-Deffinitions - An Inside Look At Internal Rate...

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An Inside Look At Internal Rate Of Return by Linda Grayson The internal rate of return (IRR) is frequently used by corporations to compare and decide between capital projects, but it can also help you evaluate items in your own life, like lotteries and investments. The IRR is the interest rate (also known as the discount rate ) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis. Read on to learn more about how this method is used. (For more insight, read the Discounted Cash Flow Analysis tutorial.) IRR Uses As we mentioned above, one of the uses of IRR is by corporations that wish to compare capital projects. For example, a corporation will evaluate an investment in a new plant versus an extension of an existing plant based on the IRR of each project. In such a case, each new capital project must produce an IRR that is higher than the company's cost of capital . Once this hurdle is surpassed, the project with the highest IRR would be the wiser investment, all other things being equal (including risk). IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a company allocates a substantial amount to a stock buyback, the analysis must show that the company's own stock is a better investment (has a higher IRR) than any other use of the funds for other capital projects, or than any acquisition candidate at current market prices. (For more insight on this process, read A Breakdown Of Stock Buybacks .) Calculation Complexities The IRR formula can be very complex depending on the timing and variances in cash flow amounts. Without a computer or financial calculator, IRR can only be computed by trial and error. One of the disadvantages of using IRR is that all cash flows are assumed to be reinvested at the same discount rate, although in the real world these rates will fluctuate, particularly with longer term projects. IRR can be useful, however, when comparing projects of equal risk, rather than as a fixed return projection. Calculating IRR The simplest example of computing an IRR is by using the example of a mortgage with even payments. Assume an initial mortgage amount of $200,000 and monthly payments of $1,050 for 30 years. The IRR (or implied interest rate) on this loan annually is 4.8%. Because the a stream of payments is equal and spaced at even intervals, an alternative approach is to discount these payments at a 4.8% interest rate, which will produce a net present value of $200,000. Alternatively, if the payments are raised to, say $1,100, the IRR of that loan will rise to 5.2%. The formula for IRR, using this example, is as follows:
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This note was uploaded on 08/25/2011 for the course BUSINESS LET taught by Professor Mentor during the Spring '11 term at Western Governors.

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FNT1-TASK2-Deffinitions - An Inside Look At Internal Rate...

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