Understand the meaning and definition of internal rate of return
Internal rate of return (IRR) Overview
Internal rate of return (Internal Rate of Return)Scratch30IRR) is an important index in the evaluation of investment projects, which is used to measure the profitability of investment projects. It represents the discount rate that makes the net present value (NPV) of the project zero, that is, under this discount rate, the present value of the future cash inflow of the investment project is equal to the initial investment cost.
The internal rate of return can help investors to assess the risks and returns of the project, so as to make more informed investment decisions. When the IRR is higher than the expected rate of return or cost of capital of investors, the project is generally considered acceptable, while when the IRR is lower than the expected rate of return or cost of capital, the project is not optimistic.
The method of calculating the internal rate of return
There are usually two methods to calculate the internal rate of return: iterative method and dichotomy. The iterative method tries different discount rates until it finds the discount rate that makes the net present value (NPV) of the project zero; the dichotomy is a more efficient calculation method, which reduces the search range by half each time until it finds a value close to IRR.
Application scenario of Internal rate of return
Internal rate of return is widely used in investment project evaluation, enterprise value evaluation, bond pricing and other fields. For example, when evaluating a new factory project, the profitability of the project can be judged by calculating the IRR of the project; in M & A transactions, the value of the enterprise can be calculated by discounting the cash flow of the target enterprise; in the bond market, investors can evaluate the yield level of the bond by calculating the IRR of the bond.
Advantages and disadvantages of internal rate of return
Advantages:
oneScratch30. The internal rate of return fully takes into account the future cash flow of the project, which makes the investment decision more scientific. The internal rate of return can be directly compared with investors' expected rate of return or cost of capital to facilitate investment decision-making. The internal rate of return is applicable to all types of investment projects, such as equity investment, debt investment and so on.
Disadvantages:
1. The calculation process is complex and requires professional knowledge; 2. For projects with unstable cash flow, the internal rate of return may not accurately reflect the true profitability of the project; 3. The internal rate of return can not directly compare projects with different deadlines, so other indicators need to be introduced for auxiliary analysis.
Case analysis
Assuming that the investor plans to invest in a project, the initial investment cost is 1 million yuan, and the cash flow in the next five years is expected to be 200000 yuan, 300000 yuan, 400000 yuan, 500000 yuan and 600000 yuan, respectively. We can calculate the IRR of the project through the following steps:
Year cash flow (ten thousand yuan) 0-100 1 20 2 30 3 40 4 50 5 60Through the iterative method or dichotomy calculation, we can get that the IRR of this project is about 22.4%. If the investor's expected return is 15%, then the IRR of the project is higher than the expected rate of return, so you can consider accepting the project.