Making any decision regarding investments necessarily involves evaluating performance. This is understandable, since it is necessary to determine the criteria that will allow you to choose the most profitable projects. Most often, investors use a system of indicators to assess the economic efficiency of capital investments. Almost all of these indicators are subjective, as they depend on the decisions of the person who conducts the calculations. The objective indicator is only IRR - the internal rate of return, since it is determined solely by the indicators of the project itself, regardless of the investor's attitude. Let us dwell on it in more detail.
This indicator allows you to determine the level of profitability that is inherent in a particular project, that is, it is impossible to “squeeze” a large profitability. But the main practical significance is that the internal rate of return limits the maximum price of capital that is attracted to implement the project. For example, with an IRR of 10%, it’s definitely not worth taking a loan at a bank at 15%, since we won’t pay interest and we won’t make a profit.
It is possible to compare the internal rate of return not only with the price of capital, but also with the desired return or return on alternative projects. Of the two projects, the most profitable is the one whose IRR is greater. And if you want to get 10% of the profit from the project, you can take out a loan at 10%, and the internal profitability is determined at the level of 20%, then you can safely start implementation.
It is necessary to focus on how the internal rate of return is determined. The essence of the calculations is that it is necessary to find a discount rate at which the net cost of the project will be zero, that is, the amount of discounted profit will cover the discounted investment. In practice, various methods are used. The easiest way is to use specialized software to evaluate investments or draw up business plans. The MS Excel software product also contains a function that calculates IRR based on cash flow.
Somewhat more time-consuming methods that can be applied without using a computer are graphical solution searches and linear interpolation. The graphic method consists in the image in the coordinate plane of the dependence of NPV (net present value) on the discount rate. The point of intersection of the graph with the abscissa axis will characterize the value of IRR.
A linear interpolation calculation implies finding two NPV values - positive and negative - at different discount rates. Next, a determination is made of such a rate level at which the NPV reaches zero, based on the assumption of a linear nature of the dependence.
The above methods allow you to determine the IRR for those projects that are described by conventional cash flow. The peculiarity of this flow is that investments are made at the beginning of the project, and then there is a process of making a profit. Obviously, not all projects can be implemented in this way, some of them require investments even after a profit arises. As already noted, for such projects with non-classical cash flow, the IRR indicator is difficult to use. In connection with these, the MIRR indicator was developed - a modified internal rate of return. Its use allows you to take into account the peculiarities of unconventional flows and most objectively evaluate internal profitability.
The importance of the described indicator is difficult to overestimate, therefore, its calculation must be included in the assessment of the economic efficiency of investments. Depending on the features of the project, you must choose either IRR or MIRR.