There are three primary methods of evaluating the financial return of a capital investment. You can look at a static or pro forma return on investment (ROI), an internal rate of return (IRR) or the net present value (NPV) of an investment. Actually, you can use all three methods to have a more complete financial picture. There are other less useful but widely used methods to evaluate the return on an investment such as calculating the payback period.
The Internal Rate of Return (IRR) calculation takes into account the time value of money. As mentioned above, time value of money is a financial principle that a dollar today is worth more than a dollar tomorrow due to expected or realized inflation. In other words the longer you have to wait for an investment to return a dollar the less it is worth to you today. The IRR calculation takes a series of investment inflows and capital outflows and returns the average annual rate of return over the investment period to yield a zero net present value (NPV).
For example, an investment that has a ten-year time horizon might return a 10% IRR which is the average annual return of the investment. Some years the return will be higher and some years it will be lower. IRR is useful for comparing strategic investments that have the same time horizon but different planned cash flow streams. It also provides clarity because it discounts future cash flow.
Choose carefully from among your investment options during your financial planning process. You have a finite amount of disposable cash for growth opportunities. Your strategic investment plan should include a calculation of return on investment (ROI), net present value (NPV), and internal rate of return (IRR) for each business opportunity.
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