How Is Internal Rate of Return a Key Element In Making Financial Decisions

Contributed article in our business series. Enjoy! – Kimberly

Every business aims to achieve a considerable growth rate, and it can be scaled by making the right business decisions. Growth can be expected out of a change in plan i.e. diversification of business activities. This can be achieved by investing in new projects and new developmental opportunities.

What affects this crucial decision is the Internal Rate of Return (IRR) of the enterprise. It is the effective annually compounded rate of return at which all the cash flows associated with a particular investment comes to zero. Let’s have a quick view at how IRR helps you in making life-altering business decisions.

  • Helps in choosing the best project

An organization can have several project ideas to invest in, but it’s wise to select the best fitting investment option which yields better results. IRR helps in analyzing all the project values and provides you with an idea of expected yield from it. An ideal IRR exceeds the cost of capital of the company.

However, if this isn’t the scenario, you should drop the project and keep yourself on the safe side. Furthermore, you can use IRR to help you with business expansion projects or to renovate an existing process. Calculation of IRR is a challenging process as it requires iterative approximation to get to the solution. The easiest way to calculate it to use online tools like this Internal Rate of Return calculator.

  • Helps in the evaluation of buyback stock

Sometimes a company pays the market price of its share back to its shareholders and reabsorbs its own shares from the market. This proves to your investors that your own stock shares are a far better investment option for them. They yield higher internal rate of return than other capital investments to use the funds for.

  • IRR assists the process of capital budgeting

In the process of capital budgeting, you need to evaluate all the potential investments and expenditure which can be incurred. These expenses are generally made for long term assets and ventures. Before making any investment, you should determine the lifetime prospects of the cash flows occurring from the same. IRR is entirely dependent on the outcome and expected proceeds from the investment. This is how it helps in carrying out the process of capital budgeting effectively.

  • Analysis of risk involved

There’s a specific risk involved in all the business decisions as there’s no gain without risking a bit. IRR helps you in ascertaining the risk associated with the choices you make. Moreover, it enables you to analyze the projects into consideration. You can then chalk out the pros and cons of your options and wipe out ones with maximum risk. This is why IRR calculation turns out to be a crucial parameter while a company is planning to expand its ventures.

You must be mindful about the factors like IRR that can affect your the enterprise’s growth chart and show big numbers on the financial statement. Huge net profits are a significant source of motivation for the stakeholders to keep their faith in your organizational goals intact.

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