The key rule for using the internal rate of return indicator
Posted: Sun Jan 12, 2025 7:04 am
The internal rate of return (IRR) investment decision rule establishes the following principles:
Projects or investments for which the IRR is higher than the opportunity cost of capital should be accepted.
The opportunity cost of capital, which acts as a hurdle rate, must exceed the IRR for the project to be approved by investors.
Please keep the following in mind:
When the opportunity cost of capital is equal to the IRR, then the NPV is 0.
When the opportunity cost of capital is less than the IRR, the NPV is greater than 0 (that is, if the discount rate is less than the IRR, the NPV will be positive).
Example : A bank may offer an a complete list of unit phone data investor a loan at 12% per annum. The investor plans to take out a loan and invest the funds in a project that has an internal rate of return of 16%. This means that 16% per annum is the maximum rate at which financing can be attracted for this project. If the project actually provides a profit of 16%, the investor will receive 4% net profit, and will also be guaranteed to be able to return the borrowed funds without financial losses for himself.
Let's consider a practical example of assessing internal profitability, which will be understandable not only to businessmen, but also to ordinary citizens.
Renting out your home may seem like a tempting way to make money. However, a lot depends on whether you own your own home. If you already own it, the initial costs will be minimal, making this business idea profitable from the start. But what if you plan to buy a home to rent it out and then sell it to pay off a loan?
The key rule for using the internal rate of return indicator
Source: shutterstock.com
Let's analyze the potential profit of this project. Let's assume that the property is worth 5 million rubles, and the monthly rent is 25,000 rubles. Ignore the tax expenses for the purchase and rent. Over three years, the total rental income will be 25,000 rubles multiplied by 3, which is 75,000 rubles.
Assuming the real estate market remains unchanged, the apartment will be sold at the original cost. As a result, after three years, the total income will reach 900,000 rubles plus 5 million rubles. The IRR of such a project will be approximately 6%.
Considering that the interest rate on bank loans is approximately 9%, it is more profitable to place free funds, say, inherited, in a deposit than to buy an apartment for rent.
However, if the value of the apartment increases significantly over the years, the project's VNI will improve.
Projects or investments for which the IRR is higher than the opportunity cost of capital should be accepted.
The opportunity cost of capital, which acts as a hurdle rate, must exceed the IRR for the project to be approved by investors.
Please keep the following in mind:
When the opportunity cost of capital is equal to the IRR, then the NPV is 0.
When the opportunity cost of capital is less than the IRR, the NPV is greater than 0 (that is, if the discount rate is less than the IRR, the NPV will be positive).
Example : A bank may offer an a complete list of unit phone data investor a loan at 12% per annum. The investor plans to take out a loan and invest the funds in a project that has an internal rate of return of 16%. This means that 16% per annum is the maximum rate at which financing can be attracted for this project. If the project actually provides a profit of 16%, the investor will receive 4% net profit, and will also be guaranteed to be able to return the borrowed funds without financial losses for himself.
Let's consider a practical example of assessing internal profitability, which will be understandable not only to businessmen, but also to ordinary citizens.
Renting out your home may seem like a tempting way to make money. However, a lot depends on whether you own your own home. If you already own it, the initial costs will be minimal, making this business idea profitable from the start. But what if you plan to buy a home to rent it out and then sell it to pay off a loan?
The key rule for using the internal rate of return indicator
Source: shutterstock.com
Let's analyze the potential profit of this project. Let's assume that the property is worth 5 million rubles, and the monthly rent is 25,000 rubles. Ignore the tax expenses for the purchase and rent. Over three years, the total rental income will be 25,000 rubles multiplied by 3, which is 75,000 rubles.
Assuming the real estate market remains unchanged, the apartment will be sold at the original cost. As a result, after three years, the total income will reach 900,000 rubles plus 5 million rubles. The IRR of such a project will be approximately 6%.
Considering that the interest rate on bank loans is approximately 9%, it is more profitable to place free funds, say, inherited, in a deposit than to buy an apartment for rent.
However, if the value of the apartment increases significantly over the years, the project's VNI will improve.