Internal Rate of Return IRR
2 May, 2023 by
M El Dabbas

The need to calculate the internal rate of return is now more than ever

In light of the current global fluctuations and the deteriorating economic conditions in most countries, inflation has become the most preoccupying concern for the nations of the world today, especially the poor and developing countries, as the actual values of some currencies are declining at an accelerated rate.

As a result, the expected profits from future returns may reflect actual losses. Considering this dimension in accounting programs - especially those that deal with investments with future returns - is inevitable for mature software companies that provide business solutions (ERP solutions).

OdooTec is one of the few companies in the Arab region that has paid attention to this matter and considered it important to quickly address it and circulate it with activities with future returns.

One of the most critical accounting principles that help business owners to predict the actual values of returns is what is known as the internal rate of return.

Internal rate of return (IRR) is an old principle proposed and developed in the middle of the last century. The discount rate (or interest rate) makes an investment's expected annual return equal to the net present value.

The purpose of calculating the internal rate of return

The purpose of calculating the internal rate of return (IRR) is to anticipate the profitability of the project, whether selling real estate or lands, or any investment with future returns, taking into account the expected inflation rates, as it can be used to compare the profitability of the proposed projects to decide to enter any of them. IRR equation helps select the best of these projects when there is more than one project offered for investment.

If calculating this rate and predicting the value of actual future returns is indispensable for successful business owners, now, with the acceleration of inflation, it is more important than ever.

NPV and its relationship to IRR

To know in more detail the internal rate of return from the mathematical point of view and the method of its calculation, it is necessary first to understand the net present value (NPV), which expresses the difference between the value of the future and current cash flows of a project or investment. In other words, the net present value equation enables us to know the actual value of future returns at present.

To mathematically calculate the net present value (NPV), the following elements must be known:

  • The investment value is the project cost value as it is entered in a negative value in the equation.
  • The number of periods during which payments will be received. Such as twelve future payments (12) to be received within twelve years.
  • The value of each return. The return value may be fixed or variable.
  • The discount rate or the interest rate, where an interest rate must be determined to anticipate inflation, which is the prevailing interest rate in the market, such as if the interest rate is, for example, 12%

The following mathematical formula is used to calculate the NPV value:

NPV = C0 + C1 / (1 + r)^1 + C2 / (1 + r)^2 + C3 / (1 + r)^2 + …. + Cn / (1 + r)^n

Where C0 is the value of the investment (cost), which is listed in a negative value, (r) refers to the interest rate, (n) is the number of periods during which payments will be received, (C1, C2, C3,...Cn) are the values of these payments.

Through this equation, the value of the internal rate of return is calculated, which is the value of the interest rate (r) that makes the NPV equal to zero.

Example of calculating NPV and IRR

Assuming that 1,000,000 (one million) riyals will be invested in building a property, for example, with fixed future returns in the next four years equal to 400,000 each year, with the interest rate being 15%. Then the values of the net present value can be summarized as follows:

  • Market interest rate: 15%
  • The value of the amount invested in the project:  1000000
  • Return on investment in the first year:  400000
  • Return on investment in the second year: 400000
  • Return on investment in the third year: 400000
  • Return on investment in the fourth year: 400000

By substituting in the previous equation, the net present value is as follows:

NPV = -1000000 + 400000/ (1 + 15%) + 400000/ (1 + 15%)^2 + 400000/ (1 + 15%)^3 +  400000/ (1 + 15%)^4 = 141991

Calculating IRR in this example

To calculate IRR (Internal Rate of Return), we have to define the interest rate ratio (r) that makes the NPV equal to zero instead of 141991 in the previous example.

In this case, the value of the IRR will be 21.86% instead of 15%, and therefore calculating the value of the payments based on an interest rate of (21.86%) will help us to recognize the actual value of the cost and profitability of each future payment, and then make the right decision in moving forward with investing in This project or not.

OdooTec supports calculating IRR for real estate investment payments

OdooTec has now decided to support the calculation of the internal rate of return in one of the most important activities with future returns, which is real estate investment, where the expected future returns from installments of sold or rented real estate are considered the origin of this particular activity.

Without going into the details of the internal return equation (IRR) as a user, the system will help you expect the actual value of the profits of your future annual investment returns. The payment takes into account the expected inflation rates. Then you can review these profits from the beginning and thus adjust the prices until they reach fair values for your profits from the anticipated installments so that they are not affected by the expected inflation rates. 

Calculating the internal rate of return (IRR) through the system

The same example as above is used to calculate the IRR value and determine the cost and the profitability of each planned annuity payment. The system initially calculates the internal rate of return (IRR) through the entered information as follows:

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.

M El Dabbas 2 May, 2023
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