When a company is trying to decide whether or not to
launch a new product, they need to determine whether the product will be worth
investing the time and money into its development. In other words, the company
needs to know what the return on investment will be. One way to determine the
return on investment is the internal rate of return. The internal rate of
return is the percentage rate that each invested dollar earns for each period
for which it is invested. (Cornett, Adair, & Nofsinger) Knowing the
internal rate of return allows the investor to compare the company’s yield on
different investments because it measures the project’s estimated return. The
internal rate of return estimates what the interest rate should be based on its
estimated future cash flow. One problem with the internal rate of return is
that when using it as the only method, the estimated rate of return on the
initial investment may not actually represent what the actual compound rate of
return truly is. (Titman & Martin, 2016)
When using the internal rate of return to determine if
a company should move forward with a project, the internal rate of return for
the project must exceed the cost of capital. If the project does not meet this
standard it should be reconsidered or adjusted to meet the standard. When
determining the internal rate of return for a project, a company could use the
net present value. The net present value is the present value of the cash flows
at the required rate of return of on a project compared to the initial investment.
(Gallo & Wessel 2017) Net present value is found by first finding the
present value of the yearly projected returns. Then, you would divide the
projected cash flow by 1+discount rate. It is easier to find the net present
value using excel than by hand. It can be more easily explained as the difference
between the inflow and outflow of cash. (Gallo & Wessel 2017)
Net present value is relevant to the
internal rate of return because the company may need to estimate the net
present value using different interest rates in order to determine whether or
not they should proceed with a project. (Gallo & Wessel 2017) The internal rate of return compares projects
that vary in size by comparing the investment size. This can allow companies to
compare the net present value of two different sized projects when the internal
rate of return is similar. (Titman & Martin, 2016) After the two projects
are compared, the company would determine if the internal rate of return
exceeds the cost of capital. If it does then the company would approve the
project. However, if the internal rate of return does not exceed the cost of capital,
the company should be extremely cautious about approving the project.
M, Adair.T, & Nofsinger. J, (2018). Finance: Applications and theory (4th
Edition). New York, NY: McGraw-Hill Education.
A., & Wessel, M. (2017, December 06). A Refresher on Net Present Value.
Retrieved January 30, 2018, from https://hbr.org/2014/11/a-refresher-on-net-present-value
Titman, S., & Martin, J. D.
(2016). Valuation: the art and science of corporate investment decisions.