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Internal rate of return (IRR)
I am doing an assignment about IRR. But I have an unclear concept on this topic. Are these paragraphs consist with each other? Many thanks for your help.
The internal rate of return
does not rate what a project is worth to a company; it only determines whether
a project is beneficial as an investment. In this way, the internal rate of
return acts as an investment tool rather than a guarantee of performance. A
project could have a lower expected return but a larger increase in the
shareholder's wealth. This option should be chosen over others, even if the
initial investment is higher.
When determining the
internal rate of return, the calculations assume that re-investments of
positive cash flows will occur. If an investment does not have positive cash
flows, the project's length of investment should be considered. A company using
internal rate of return should assume that a project will require a series of
cash investments with only one cash outflow at the end. This is most common
with venture-capital and private-equity investments that are risk factors to a
firm, but may prove to be substantial sources of revenue in the future.
Conclusion: It is probably true to say that where a calculation or
valuation is dependent upon a considerable number of variables and a large
number or varying pattern of time periods, the use of discounted cash flow
techniques is more appropriate than the traditional investment valuation approach.
It is also easy to incorporate in discounted cash flow calculations estimates
to reflect the effect of inflation upon future income flows and outgoings. Likewise,
whereas traditional methods cannot easily reflect the possibility of the future
sale of the income producing asset at an enhanced value, such a calculation is
easily incorporated in discounted cash flow calculations.
- ?Lv 71 十年前最愛解答
IRR is an evaluation tool to determine whether the expected return on investment compared to the Company's own cost of capital is worth investing. As we all know, all capital has cost. That is why the second paragraph says venture capitalists and private equity investors choose high IRR with high risk factors because they have a low cost of capital.
IRR depends on the assumption of discounted cashflow model and therefore, discount rate is a key factor in the measurement. In real life situation, it is very unlikely to be the case, as the interest rate is now being manipulated by the Governments to encourage investment and employment. There is also the possibility of trade wars between the East and the West and the instability of currencies further reduces the accuracy in cashflows.
For reference only.