Internal Rate of Return
The net present value method measured our return as a dollar amount, but what if we want to measure it as a percentage rate? Then we use the internal rate of return, which is the actual return that we get on the investment as a percentage rate.
The net present value method and the internal rate of return method are two ways of making the same calculation. The net present value is shown in a dollar amount and the internal rate of return as a percentage.
Study Tip: The internal rate of return is the actual return an investment returns. If the internal rate of return is higher than the hurdle rate, then you accept the investment.
For the internal rate of return, we need to know what percentage return we are getting. If we take the numbers from earlier, we invested $100,000, which created a return of $25,000 for 10 years. That return would be a 21.4% return (i.e., the internal rate of return). The CPA problems won’t require you to calculate the 21.4% return.
Here’s where we see a big difference between the hurdle rate and the actual rate of return. The hurdle rate was 10%. We wanted to make a 10% return on our investment, and the actual rate of return, the internal rate of return was 21.4%.
If we were expecting to make 10%, but we actually made 21.4%, then would we accept this investment decision? Absolutely, because we’re making more than twice the amount that we thought we would be making.
If the internal rate of return is higher than the hurdle rate, then you accept it, and if the internal rate of return is lower than the hurdle rate, then you reject it.
Summary Chart of Decision-Making Methods
| Measured By | Pros | Cons | Formula |
|---|---|---|---|
| Time | Easy to Calc | Doesn't Use TVM | Investment/Undiscounted Cash Flows |
| Time | Uses TVm | Harder to Calc | Investment/Discounted Cash Flows |
| Net Income | Gives Annual Return | Doesn't Use TVM | Investment/Accounting Income |
| $ | Uses TVM | Harder to Calc | PV of Cash Inflows-Investment |
| % | Uses TVM | Harder to Calc | % that Causes NPV to be $0 |
To understand the example better, we have added borders to the table.