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13.4 INTERNAL RATE OF RETURN The internal rate of return (http://content.thuzelearning.com/books/Baker.6866.18.1/sections/ch13_sect1_8#ch13_key1) (IRR) is another return on investment method. It uses a discounted cash flow technique. The internal rate of return is the rate of interest that discounts future net inflows (from the proposed investment) down to the amount invested. The return for a particular investment can therefore be known. The IRR recognizes the elements contained in the previous two methods discussed, but it goes further. It also recognizes the time pattern in which the earnings occur. This means more precision in the computation because IRR calculates from period to period, whereas the other two methods rely on an average investment.

The IRR computation is not very complicated. The computation requires two assumptions and three steps to compute. Assumption 1: Find the initial cost of the investment. Assumption 2: Find the estimated annual net cash inflow the investment will generate. Assumption 3: Find the useful life of the asset (generally expressed in number of years, known as periods for this computation). Step 1: Divide the initial cost of the investment (Assumption 1) by the estimated annual net cash inflow it will generate (Assumption 2). The answer is a ratio. Step 2: Now use the look-up table. Find the number of periods (Assumption 3). Step 3: Look across the line for the number of periods and find the column that approximates the ratio computed in Step 1. That column contains the interest rate representing the rate of return.

How is IRR used? It can take the rate of return obtained and restate it. The restated figure represents the maximum rate of interest that can be paid for capital over the entire span of the investment without incurring a loss. (You can think of that restated figure as a kind of break-even point for investment purposes.) The fact that a rate of return can be computed is the benefit of using an IRR method.

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