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  • Limitations of the internal rate of return

  • Limitations of the internal rate of return

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    Generally, the investment or project with the highest IZF is preferred. IZF is attractive because of its ease of comparison, but it also has limitations: To calculate the IZF, there must be an initial cash outflow (the purchase of the investment) followed by one or more cash inflows. If the investment generates negative cash flows in the meantime, it cannot be used.

    It does not measure the size of the investment or the return. Consequently, the IZF favours investments with high returns, even if the euro amount of the return is relatively low.

    For example, an investment of EUR1 that yields EUR3 has a higher IZF than an investment of EUR1 million that yields EUR2 million. However, the latter brings in EUR1 million (instead of only EUR2). The IZF method is best suited for analysing venture capital and private equity investments. These usually have multiple cash investments and a single cash outflow at the end via an IPO or sale.

    What is the difference between IZF and WACC?

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    The weighted average cost of capital (WACC) is the price a company in Exness Singapore and Asia pays to borrow money from bondholders, other lenders and shareholders. In terms of the IZF formula, the WACC represents the "required rate of return" that the IZF of a project or investment must exceed in order to create value for the company. The rate of return can also be referred to as the hurdle rate, opportunity cost or cost of capital.

    IZF vs. WACC example

    For example, if a company's WACC is 10%, the proposed projects must have an IZF of 10% or more to add value. An IZF below 10% indicates that the company's cost of capital is greater than the expected return from the proposed project or investment.

    In other words: If you were to buy a lemonade stand with your credit card at an annual interest rate of 10% (like the WACC), you would need to earn more than 10% each year (like the IZF) to make a profit. Otherwise, you would lose money every year and not add value to your assets.

    The difference between NPV and IZF

    The net present value (NPV) of a project or investment measures its potential value to society (in euros). The IZF, on the other hand, forecasts the return that a project or investment can generate. Both NPV and IZF can give analysts a clearer picture of which projects (or investments) can create the most value for a company.

    Example: IZF vs. NPV

    Let's look at the example from earlier again:

    The profit from the EUR 300,000 machine would be EUR 460,000 (EUR 150,000 EUR 150,000 EUR 150,000 EUR 10,000 = EUR 460,000). Based on a discount rate of 5% and an NPV calculator, the net present value is EUR116,714.23.

    The NPV gives the value in euros and provides more information to make a more informed decision.

    IZF: Important findings

    A company can usually expect a higher return from a project or investment if the IZF is higher. Therefore, IZF can be an important indicator of the success of a proposed investment.

    A capital budgeting decision must also take into account the value added by the project. In capital budgeting decisions, decision-makers usually consider both the IZF and the NPV.

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