Anti-Money Laundering Activities at Commercial Banks
In the previous article, we have already seen how commercial banks inadvertently help anti-social elements in laundering money. We have also seen why commercial banks are preferred by anti-social elements when it comes to laundering money. We know that commercial banks have already put in place a lot of processes to stop this money laundering […]
Calculating Free Cash Flow to Firm: Method 3: EBIT
In the previous articles, we learned about how to calculate the cash flow from operations if the cash flow statement or the income statement were given in the question paper. In many cases, these financial statements may not be given in full in the question paper. Instead, some excerpts from these statements may be provided […]
How Credit Rating Works ?
It may seem like the banking business is about money. However, the banking business is really all about information. Until banks have the required information about a prospective borrower, they cannot ascertain the risk and make the loan. This is where credit rating comes to the rescue. It this article, we will have a closer […]
The Voting Process
After the solicitation, packages are sent out, and the creditors are given all the information that they need, it is time to vote. Voting is an important part of the reorganization process. This is the part where the will of the creditors becomes known to the debtor organization and to the public in general. However, […]
Asset Reconstruction Companies
The Indian banking system is reeling under a glut of Non Performing Assets (NPA’s). The unpaid debts of Indian corporations and households have risen to alarming levels. High level bureaucratic meetings are being held to get rid of this menace. Nonperforming assets could appear on the balance sheet of banks. This could cause a ripple […]
The Internal Rate of Return (IRR) is another very important metric that can be used to determine whether or not a company must invest its resources in a project. If the company does decide to invest its resources in all the projects then the IRR can help us understand what should be the priority of these projects for the company.
Let’s understand Internal Rate of Return (IRR) with the help of an example. Let’s say that we have an investment that pays $10 on a $100 investment. So, we can clearly see that the rate of return is 10%. This means 10% of the money invested will be recouped every single time period. But this calculation was simple because there was only one return we received and we just had to calculate its size as compared to the original investment.
Now, consider the fact that for the same $100 investment, you are going to receive $20 for the first 2 years, $30 for the next 2 years and $50 in the 5th year. So what would be the rate of return for this investment? So here we are taking a complex schedule of cash outflows and inflows and we are basically coming up with a single rate that describes the rate of return. In the above example the rate of return is 13%.
This means that if we invested $100 and got a consistent rate of interest which was compounded at 13%, then that investment would be equivalent to the above investment. The above investment provides the same return as that of a bond with an annual coupon of 13%. This is the Internal Rate of Return (IRR) of the investment.
The calculation of Internal Rate of Return (IRR) with a formula is very complex and is never used in practice. We generally use financial calculators or MS Excel both of which have inbuilt IRR functions to find out the IRR.
The relationship between the IRR and the NPV is very important. In fact, it could be the defining characteristic of IRR. IRR is the rate at which NPV of the project is zero. This is clearly intuitive. Consider the fact that the rate of growth of your investment and the discount rate both will be the same in this case. Therefore they will nullify each other and the NPV will be zero at IRR.
The rule pertaining to the IRR is simple. A company must decide a hurdle IRR rate. Let’s say the hurdle rate is 10%. So, the company must then choose investments that pay over 10% and must reject investments that pay less than 10%. In the above example 13% is greater than 10% and hence the investment must be selected. In case the company wants to choose between 2 projects both of which have more than 10% return, then the one with the higher Internal Rate of Return (IRR) must be selected.
The IRR metric is also flawed. But its flaws are smaller as compared to the payback period method. It is for this reason that many companies do in fact use the IRR method to decide amongst investments. It is a little bit more intuitive to use. Its flaws have been discussed in the forthcoming article.
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