Projects or investments for which the IRR is higher than the opportunity cost of capital should be accepted.
The opportunity cost of capital, which acts as a hurdle rate, must exceed the IRR for the project to be approved by investors.
Please keep the following in mind:
When the opportunity cost of capital is equal to the IRR, then the NPV is 0.
When the opportunity cost of capital is less than the IRR, the NPV is greater than 0 (that is, if the discount rate is less than the IRR, the NPV will be positive).
Example : A bank may offer an investor a loan at 12% singapore business email list per annum. The investor plans to take out a loan and invest the funds in a project that has an internal rate of return of 16%. This means that 16% per annum is the maximum rate at which financing can be attracted for this project. If the project actually provides a profit of 16%, the investor will receive 4% net profit, and will also be guaranteed to be able to return the borrowed funds without financial losses for himself.
Let's consider a practical example of assessing internal profitability, which will be understandable not only to businessmen, but also to ordinary citizens.
Renting out your home may seem like a tempting way to make money. However, a lot depends on whether you own your own home. If you already own it, the initial costs will be minimal, making this business idea profitable from the start. But what if you plan to buy a home to rent it out and then sell it to pay off a loan?
The
Key Rule for Using the Internal Rate of Return Indicator
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Let's analyze the potential profit of this project. Let's assume that the property is worth 5 million rubles, and the monthly rent is 25,000 rubles. Ignore the tax expenses for the purchase and rent. Over three years, the total rental income will be 25,000 rubles multiplied by 3, which is 75,000 rubles.
Assuming the real estate market remains unchanged, the apartment will be sold at the original cost. As a result, after three years, the total income will reach 900,000 rubles plus 5 million rubles. The IRR of such a project will be approximately 6%.
Considering that the interest rate on bank loans is approximately 9%, it is more profitable to place free funds, say, inherited, in a deposit than to buy an apartment for rent.
However, if the value of the apartment increases significantly over the years, the project's VNI will improve.
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What is considered a good internal rate of return on investment?
The IRR is considered good if it is higher than the weighted average cost of capital used to finance the project, known as WACC.
If the IRR value of a project is higher than the WACC, then it can be considered successful and recommended for implementation.
If the IRR is lower than the WACC, the project should be considered ineffective.
WACC shows how much profit a company must earn to cover the cost of raising capital from shareholders and creditors.
What is considered a good internal rate of return on investment?
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Let's look at how to calculate WACC using an example.
Let us assume that the capital structure of the organization includes the following elements:
equity capital (ordinary shares) — 50 million rubles;
preferred shares - 10 million rubles (these shares provide the holder with the right to a stable income, priority receipt of dividend payments, and also the first return of investment funds in the event of liquidation of the company);
long-term loan - 20 million rubles;
short-term loan - 10 million rubles.
Cost of funding sources:
equity capital (common shares) - 15%;
preferred shares - 10%;
long-term loan - 12%;
short-term loan - 15%.
The capital structure and the share of each source of financing is as follows:
equity capital (common shares) is 0.5;
preferred shares have a share of 0.1;
long-term lending takes 0.2;
short-term loans amount to 0.1.
The interest rate an organization pays on borrowed funds, such as bank loans or bonds. This indicator reflects the company's costs in meeting its debt obligations.
The ratio of different sources of financing in the capital structure of the enterprise, including the share of equity capital, the share of borrowed capital and the share of alternative sources. This shows the percentage distribution of each of these sources in relation to the total investment.
Weighted average cost of capital
Now let's move on to calculating the weighted average cost of capital. The following formula will help us with this:
WACC = (share of equity * cost of equity) + (share of debt * cost of debt)
Let's count:
WACC = (0.5 × 15%) + (0.1 × 10%) + (0.2 × 12%) + (0.1 × 15%) = 8%
In the case under consideration, the average cost of capital of the enterprise is 8%.
A level below 8% is considered good. A value from 8% to 12% is considered satisfactory. If the value exceeds 12%, it is considered a bad indicator.