Return on Investments

Measures of Return on Investments

By
Mary Avant
Lesley Wilfong
Mathematics of Finance
Dr. Janusz Kawczak
07/16/2005

Return on Investments

Abstract
Measuring returns on investments plays a vital role in investment decision making.
There are several methods that can be used in measuring the return on investments. The
two most commonly used are the Net Present Value and the Internal Rate of Return.
Both of these methods show the returns on investments but in different ways. In certain
situations, one method is more beneficial than the other. For example, when the internal
rate of return does not work, investors can use net present value to find their solutions.
As an investor, it is crucial to know how to calculate each of these methods and when to
use them.

Return on Investments

Introduction
Net present value and internal rate of return both produce results that provide
investors with an insight as to which investments will produce the best returns. While the
formulas for each are similar, these methods offer different information that is useful to
investors. Although the net present value is always possible to find, there are
circumstances in which the internal rate of return cannot always provide a reasonable
answer.

Finding Net Present Value

Net Present Value (NPV) is the difference between the present value of all
returns and the investment costs [1]. After finding the NPV, the amount found can
show an investor if he or she will gain any money from the investment [7]. Once the net
present value is found, investors will be able to evaluate their investment and see if the
investment is a good choice.
When finding the NPV, all transactions must be discounted back to the present
time. This is shown in Equation 1.
T

NPV v t Bt

Equation 1

t 0

T=maturity date of the investment

t=time
v= 1/(1+ i)

*Discount Factor*

B= transaction at time t

Return on Investments

Evaluating Net Present Value

Net present value helps investors to see if an investment is a wise choice or not.
After finding the net present value, then an investor can compare that amount to zero.
This will show an investor if their investment will benefit them. If the net present value
is greater than zero then the investment would be a wise investment, because the investor
would be profiting from it.

Example 1
Bill invests 3000 dollars in stock. A year later he receives a return of 5550
dollars. In one year he reinvests 2000 dollars and he receives a return of 3500 dollars one
year later. Find the NPV at 15% and 20%.

NPV@15%= -3000 + 5550(1+.15)-1 2000(1+.15)-2 + 3500(1+.15)-3

NPV@15%= -3000 + 4826.09 1512.29 + 2301.31
NPV@15%= $2615.11
NPV@20%= -3000 + 5550(1+.2)-1 2000(1+.2)-2 + 3500(1+.2)-3
NPV@20%= -3000 + 4625 1388.89 + 2025.46
NPV@20%= $2261.57

Return on Investments

In Example 1, both investments would give an investor a profit. This is because

each net present value is greater than zero. Therefore, investing would be a wise decision
in this case for both interest rates (15% and 20%).

Problems with Net Present Value

Even though the net present value will always give you an answer, it may not
always be so easy to calculate. When discounting back the cash flows to bring them to
present value, at what rate to discount may not always be known [4]. Also, the rates are
always subject to change and often times it is hard to know how the rates are going to
change over the term of the investment [4]. If both of these factors cannot be known for
certain, the NPV may not always be a true measurement of what the return on the
investment will be.

Internal Rate of Return

The Internal Rate of Return (IRR) is defined as the interest rate that makes net
present value of all cash flow equal zero [3]. The internal rate of return is used to
compare different projects and provide an idea of whether an investment will gain or lose
money. The internal rate of return is mostly used by private investment directors. This is
because of the fact that in private funds, the owners possess more regulation over the cash
inflow and outflow of the fund; therefore, it is vital that they are able to calculate if they
are going to make money or lose money [8]. Although the internal rate of return can be
hard to calculate, and sometimes not able to be calculated at all; when found, it is a very
valuable tool for investors.

Return on Investments

Strengths and Weaknesses of the Internal Rate of Return

There are several strengths, as well as weaknesses, of the internal rate of return.
Internal rate of return is used widely by business people to help with investment decisionmaking [6]. It is proven to be very useful when making evaluations of different projects
by comparing the internal rates of returns of separate investments. When assessing an
investment in order to discover whether it is going to gain or to lose money, investors
have to find the internal rate of return and compare it to the price of the investment. If
the internal rate of return is below the amount of money that the investor put into the
investment, then the project will turn out to be unfavorable, and the investor will lose
money on it. On the other hand, if the internal rate of return is calculated to be above that
amount, the project will be favorable and will gain money [2]. The internal rate of return
is also helpful because it can be calculated even when the deposits and withdrawals are
made at asymmetrical periods [5]. The internal rate of return can stand as a solid figure
of comparison and is extremely useful when it works properly.
However, there are also certain weaknesses that the internal rate of return
possesses. The internal rate of return is a percentage that can be very difficult to
calculate. Also, there are times when the internal rate of return can produce multiple
rates. When this occurs, the investor must figure out which of the internal rates of return
is best suitable to use. Despite constant criticism, the internal rate of return is vital for an
investment and should be used when able.

Return on Investments

How to Calculate the Internal Rate of Return

Calculating the internal rate of return can prove to be a difficult and lengthy
process. The equation of IRR is actually the solution of NPV=0. There are many
programs used today, ranging from Microsoft Excel to the TI-83 SOLVER, that assist in
finding the internal rate of return. The internal rate of return can have several outcomes.
It can be positive, negative, or even have multiple roots. The following are examples of
each type of outcome you can receive when calculating the internal rate of return:

Example 2
John invested money in two separate private funds. In the first year, he invested
1000 dollars in each fund. In one year, he received returns of 200 dollars in one fund and
400 dollars in the other. The next year, John reinvested 100 dollars in fund one and 500
dollars in fund two. One year later, he received returns of 1100 dollars on the first fund
and 1900 dollars on the second. Which of Johns funds has the better internal rate of
return?
Fund 1

NPV=0= -$1000 + $200( 1 + i )-1 100( 1 + i )-2 + 1100( 1 + i )-3

To simplify the problem, substitute x for (1 + i ).
NPV=0= -$1000 + $200x-1 100x-2 + 1100x-3
Next, solve for the variable x. For this example, Microsoft Excel is being used to
calculate the internal rate of return.
i= 0.06901131, or 6.901131%

Return on Investments

Fund Two

NPV=0= -$1000 + $400( 1 + i )-1 - $500( 1 + i )-2 + $1900( 1 + i )-3

NPV=0= -$1000 + $400x-1 - $500x-2 + $1900x-3
i= .2371825, or 23.71825%
Because a higher internal rate of return is desired, Johns better fund would be Fund
Two.
This type of example has outcomes with a single positive internal rate of return, thus it is
the easiest of IRRs to calculate. This kind of example shows how to compare separate
projects, which is one of the internal rate of returns positive qualities.

Example 3
Cindy has decided to invest in a private fund. She begins by investing 1000 dollars, and
in one year, she receives a return of 2000 dollars. The next year, Cindy reinvests 2500
dollars, and one year later, she gets a return of 500 dollars. Evaluate the internal rate of
return.

NPV=0= -$1000 + $2000( 1 + i )-1 - $2500( 1 + i )-2 + $500( 1 + i )-3

NPV=0= -$1000 + $2000x-1 - $2500x-2 + $500x-3
i = -.75919615, or -75.919615%
For this example, Microsoft Excel Solver was used to calculate the IRR.

Return on Investments

When the IRR is calculated, the result was negative; therefore it means that the investor is
losing money on the project. When this occurs, investors usually reconsider whether they
will reinvest. The net present value would be the best method to use in this particular
circumstance.

Example 4
James has stock in Krispy Kreme Doughnuts. In the first year, James invested
1429 dollars and received 5000 dollars in return a year later. The next year, he reinvested
5817 dollars in his stock. One year later, he received a return of 2250 dollars. What is
James IRR, and if there are multiple IRRs, which is the best to use?

NPV=0= -$1429 + $5000(1 + i )-1 - $5817( 1 + i )-2 + $2250( 1 + i )-3

NPV=0= -$1429 + $5000x-1 - $5817x-2 + $2250x-3
For this example, Microsoft Excel Solver was used.
i= .0605393, or 6.05393%
i= .176615, or 17.6615%
i= .261796, or 26.1796%
Since this example produced three possible IRRs, you must choose which internal rate of
return is best. However, in a situation where the internal rate of return is calculated to
have multiple roots, it is impossible to choose which the best IRR is and which the
worst is. Each internal rate of return that is presented is mathematically correct. In

Return on Investments

Example 4, 6.05393%, 17.6615%, and 26.1796% all make the NPV equal zero. It is
purely a matter of circumstances and opinions. This is why calculating an internal rate of
return can prove to be so complicated. For example, James has to choose out of the three
possible IRRs which he thinks will benefit him the most. If James evaluates his stock as
a rather strong one, or if he is a person who is not afraid to take risks, he would most
likely choose the largest of the IRRs. In this case, that would be the 26.1796%. On the
other hand, if James does not think his stock is sturdy, he would probably choose the
smallest IRR, which is 6.05393%. Each investor must make decisions such as these.
They must be able to evaluate their investments and assess various scenarios with each
separate project and IRR. As vague and inexact as this may seem, it is all just a matter of
opinion and a decision that investors are obliged to make. In cases like Example 4, it is
useful to use the NPV as well to assist with decision-making.

Conclusion
To conclude, internal rate of return and net present value are both valuable to
investors when making investment decisions. Through our research, we have found
situations where the internal rate of return cannot be calculated. When this occurs, it is
more beneficial to use the net present value to compare investment options. However, if
the internal rate of return does work, often times it can give investors a clearer picture of
which investment to choose. Measuring the returns on investments is often a complicated
process, but is necessary in order to be successful in the financial world.

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10

References
[1] Guthrie, Gary L., Lemon, Larry D. (2004). Mathematics of Interest Rates and
Finance. Upper Saddle River: Pearson Education, Inc.
[2] Internal Rate of Return. 1995-2005. http://toolkit.cch.com/text/P06_6550.asp
[3] Internal Rate of Return IRR. 1999-2005.
http://www.investopedia.com/terms/i/irr.asp
[4] Kantrowitz, Mark (2005). Net Present Value. http://www.finaid.org/loans/npv.phtml
[5] Lott, Christopher (2005). Subject: Analysis - Internal Rate of Return (IRR).
http://invest-faq.com/articles/analy-int-rate-return.html
[6] Martin, Ray. 1997. Internal Rate of Return Revisited: Economic Analysis.
http://www.riskworld.com/nreports/1997/rmartin/html/nr7aa001.htm
[7] Net Present Value- NPV. (1995-2005) www.investopedia.com/terms/n/npv.asp
[8] Thatcher, William. 2005. The Difference Between IRR and TWR.
http://www.commonfund.org/Commonfund/Archive/News/IRR_TWR_4_14_200
3.htm