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.

References

Cornett.

M, Adair.T, & Nofsinger. J, (2018). Finance: Applications and theory (4th

Edition). New York, NY: McGraw-Hill Education.

Gallo,

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.

Boston: Pearson.