The two factors used to evaluate securities and investments in finance are risk and return. The rate of return is expressed as a percentage of the original investment. Since absolute returns can be confusing, the focus is on percentage returns.
For example, Project A takes a Rs 500,000 investment and provides a profit of Rs 50,000, but Project B requires a Rs 100,000 investment and yields a profit of Rs 25,000. The latter is preferable since it provides greater value for money. The first project has a 10% return on investment, whereas the second has a 25% return on investment.
Internal Rate of Return
The internal rate of return, or IRR, is a measurement used to assess the profitability of investments and projects. It is the discount rate that brings the present value of future cash flows from an investment to the same level as the initial investment. If the IRR exceeds the cost of money or capital, the investment is profitable; otherwise, it is not.
If there are X consecutive cash flows following the initial investment, the IRR is a solution to a polynomial of degree X. As a result, there will be X roots. The equation is difficult to solve, but Excel offers an IRR function that makes things easier. Simply put the cash flows in a column, with the first cash flow representing the original investment being negative and the remaining cash flows representing the project’s cash inflows.
Stream of cash flow
In the first example, the cash flow stream will shift from negative to positive with a single sign change. Because a project or a security requires an initial investment, the first cash flow will always be negative.
Following cash flows can be either good or negative. Mixed cash flows, on the other hand, have numerous sign shifts. As a result, the examination of such cash flows may provide multiple real positive IRRs. Managers have a difficulty when evaluating projects with multiple real positive IRRs.
Yield to Maturity
The Yield to Maturity (YTM) of a bond is the internal rate of return. Bonds typically include just cash flows, therefore the problem of multiple real positive YTMs is hardly seen. In the case of bonds, Excel’s IRR function can be used.
The rate function, on the other hand, may be used to calculate the IRR on a bond’s coupon date. The yield function should be used if we are between coupon dates. It’s important to note that the YTM is calculated using the bond’s bad price rather than its clean price. As a result, before using the yield function, compute the accumulated interest and add it to the stated price, which will be a clean price.
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