To determine the rate of profitability of investments, it is necessary to solve the following equation:?(СFm/(1+IRR^m) = I, where:- СFm – input cash flow in period m; IRR – internal rate of return (the rate of profitability of investment);- I – the value of the investment.
The meaning of this indicator is that it shows the maximum allowed relative level of expenditure that can be spent on this project. For example, if the project is fully financed by a Bank loan, the IRR value shows the upper limit interest rate on it. If the value of the interest rate will be higher values were found, the project will be considered unprofitable.
Knowing the magnitude of the norms of profitability, you can make a decision on the admissibility of the investment project. If IRR is higher than or equal to the cost of capital, the project is accepted, if less than cost of capital project rejected. Thus, the norm of profitability is "borderline" indicator": if the value of the investment is higher internal rate of return, the result of the project, it is impossible to provide a refund and their impact, and thus the project should be rejected.
The main advantage of this indicator lies in the fact that in addition to determining the level of profitability of investments it allows to compare projects of different scale and different durations. After all, the norm of profitability is calculated in percentage, and relative values are easier to interpret. In addition, this indicator provides an opportunity to determine the safety threshold for the project.
However, note that this indicator has some disadvantages. First, this is an unrealistic assumption about the rate of reinvestment, since it involves the reinvestment of earnings at the rate of IRR, which in practice is rarely feasible. Second, it is possible to obtain multiple values of IRR in the case where there is an interchange of cash inflows and outflows. In addition, this indicator is very sensitive to the structure of the stream of payments and does not always evaluate mutually exclusive projects.