Why do we need the internal rate of return nowadays more than ever
Inflation has emerged as the most pressing concern for the nations of the world today, especially the poor and developing countries, due to the current global fluctuations and the deteriorating economic conditions in most nations, as the actual values of some currencies are declining at an accelerated rate.
As a result, actual losses may be reflected in the predicted profits from future returns. This dimension may be essential for those software companies that provide ERP solutions for investments with future returns.
OdooTec hastened to address this problem by applying the internal rate of return (IRR), which makes the expected return on investment over a specific period equal the net present value.
The benefit of calculating the internal rate of return
The internal rate of return can be used to compare the profitability of various proposed projects before choosing one. It can be used to predict the profitability of any project, including the sale of real estate or land, as well as any investment with future returns. When more than one project is available for investment, the IRR equation aids in choosing the best one.
If determining this rate and forecasting the value of actual future returns is essential for successful business owners, it is now more crucial than ever due to the acceleration of inflation.
NPV and its relationship to IRR
Understanding net present value (NPV), which represents the difference between the value of the future and current cash flows of a project or investment, is essential before learning more about the internal rate of return mathematically and how it is calculated. Using the net present value calculation, we may determine the current worth of future returns.
To calculate NPV value, the following elements must be known:
The project cost, which indicates the investment value as it is entered in a negative value in the equation
The number of periods within which payments will be received. Such as eight payments (8) to be received within eight years or eight months
The return value. This value may be variable or fixed
The discount rate (interest rate). This interest rate must be determined to anticipate inflation, representing the prevailing interest rate in the market. For example, the interest rate may be 10%
The following mathematical formula calculates the NPV value:
NPV = C0 + C1 / (1 + r)^1 + C2 / (1 + r)^2 + C3 / (1 + r)^2 + …. + Cn / (1 + r)^n
Where (r) denotes the interest rate, (n) represents the number of periods during which payments will be received, and (C1, C2, C3,..., Cn) denotes the values to be received as payments, C0 is the investment value (cost), which is listed in a negative value.
Via this equation, the internal rate of return is IRR calculated, which is the value of the interest rate (r), which makes the NPV equal to zero.
Example of IRR and NPV calculation
Assuming, for example, that 1,000,000 (one million) riyals will be invested in the construction of a property, with set future returns of 400,000 per year over the following four years and an interest rate of 15%. The values of the net present value can then be summarized into the following:
15% market interest rate
The project's investment was worth 1,000,000.00.
First-year return on investment: 400,000
Second-year return on investment: 400,000
Third-year return on investment: 400,000
Fourth-year return on investment: 400,000
The net present value can be calculated by substituting in the previous equation as follows:
NPV = (-1000000) + 400000/(1 + 15%) +400000/(1 + 15%)^2 +400000/(1 + 15%)^3 +400000/(1 + 15%)^4
Calculating IRR in this example
We must specify the interest rate ratio (r) that reduces the NPV from 141991 in the preceding example to zero in order to calculate the internal rate of return (IRR).
Calculating the value of the payments based on an interest rate of (21.86%) will enable us to understand the actual cost and profitability of each future payment, allowing us to decide whether to move forward with investing in this project or not. In this case, the IRR will be 21.86% instead of 15%.
OdooTec supports IRR for the payments of real estate investment
OdooTec now supports the internal rate of return (IRR) in the Real Estate business, which is considered an essential field that requires the IRR concept. We can also provide this methodology for any other field that depends on future installments, such as selling and leasing cars, as is the case with one of our customers.
Without going into the internal return equation (IRR) mathematically, as a user, the system will assist you in estimating the actual value of the gains from your upcoming annual investment returns. According to the IRR calculation, considering the expected inflation rate, the enterprise will anticipate the actual and profit values for each forthcoming installment. This way, The prices can then be adjusted until they are at acceptable levels for your profits from the anticipated payments so that they are unaffected by the expected inflation rates.
Utilizing the system to determine the internal rate of return (IRR)
The IRR value and the cost and profitability of each anticipated payment are calculated using the same scenario as earlier via the system. The following is how the system initially determines the internal rate of return (IRR) using the data entered:
The following figure shows the effect of the internal rate of return, IRR, on the expected profits from future installments as the system calculates the profitability of each payment once the contract payments are created.
In this example, the unit cost one million riyals and was sold for 1.6 million riyals in four installments of 400,000 annually. The system calculated the value of the internal rate of return, and accordingly, the cost and profitability of each of the future payments were calculated.
Note that each installment cost is calculated based on the calculated IRR, and then this cost is subtracted from the total project cost remaining with each installment. Hence, the remainder of the total cost with the last installment is zero.