In this lecture, we are going to discuss internal rate of return, also known as Iara.
Like NPB, Iora is also used to evaluate and represent how good an investment opportunity is.
However, there are some differences between the two.
So let's first understand what Iran is and then we will compare it with an bivy.
Iraq is simply the rate at which present value of your future cash flow is equal to the initial investment
you are doing.
So basically, if I invest a thousand dollars today and get 600 dollars at the end of each year for
the next two years.
I will first find the present value of these cash flows, which is given by six hundred, divided by
one plus are raised to Power-One and six hundred divided by one, plus are raised to the power to.
This is for the first year and this is for the second year.
I equate this with the initial investment that I am doing.
When I solve this equation for the answer that I will get is the internal rate of return.
And in this example, the Ayata is coming out to be 13 percent.
The other way of looking at it is that you can imagine that you have just bought a thousand dollars
in a bank account.
Which is giving you 13 percent compound interest.
Then you can withdraw six hundred dollars at the end of last year.
So at the end of the first year, the interest earned would be 13 percent of thousand dollars, which
is 130 dollars.
So the total at the end of last year is one thousand one hundred thirty.
You withdraw 600 dollars at the end of last year.
So the net balance in your account at the end of last year is 530 dollars.
Now, one five thirty dollars, you get 13 percent interest, which makes it a total of six hundred
dollars.
So at the end of India, you can withdraw this six hundred dollars.
I've shown you this example to make the point that Ayata is equivalent to compound interest rate at
which you can achieve the same cash flow.
So if you have an initial investment of a thousand dollars and this compound interest rate, you can
achieve the same future cash flow as shown in the example.
Now, how can we use Iraq to say whether an investment opportunity is good or not?
Once you find Ayata, you can compare it with the best possible risk free rate or the rate at which
you have raised the capital.
If Ayata is greater than this rate, it means that this opportunity is better than the best risk free
option available.
So we can say that it is a good opportunity.
Similarly, if you have two or more investment options, you can compare their IRR to decide which is
giving better return on investment.
That higher return on investment that is higher, Ottoway does not mean higher profits.
In absolute terms, higher profit is given by the project, which is higher and Billy.
And it is not necessary that the project with hired IRR will also have hired and bevvy.
Let me show you a simple example for this.
Suppose you have two investment options in option A. You're investing a thousand dollars.
And in the next year, you'll get back fifteen hundred dollars.
Now, the risk free rate of interest is 10 percent.
Using these three values, you can calculate the present value for this option, which comes out with
360 three point six dollars.
So the net present value of option A is three sixty three point six dollars, and if you calculate internal
rate of return on this investment, it is coming out to be 50 percent.
So it is basically fifteen hundred minus thousand by a thousand, which is 50 percent.
Similarly, when you do the same calculations on option B, where you are investing two thousand dollars
and getting a return of twenty seven hundred fifty dollars in the next year, the IRA comes out with
thirty seven point five percent, whereas the present value is five hundred dollars.
Notice that the IRR of Option A. is more than IRR of Option B.
But the pewee of option is less than option B higher ayata suggest that the return of investment is
higher.
So on the thousand dollars that you invested in option A., you are getting 500 dollars extra.
Whereas on the two thousand dollars you are investing in option B. you're getting only 750 dollars back,
so the return on investment is higher in option A..
However, the net gain that you get an option, it is only 363 dollars as compared to option B.
So out of these two options, depending on what your ultimate agenda is, if you want to maximize gains,
option B is the right option for you.
And if you want to maximize our way, then option A is the best option for you.
Now, let us go to a software tool and learn the implementation of Ayata.