Green Belt in Lean Six Sigma

Undergraduate student in Production Engineering at the Federal University of Mato Grosso do Sul. She is volunteer as marketing director at the Young Brazilian Association of Production Engineering, has certification as White Belt Lean Six Sigma, copywriting and web content production. 

In this article, we will show you how to calculate the Internal Rate of Return (IRR), so you can make more profitable and safe investments.

How to compute for Internal Rate of Return? Learn now!

Have you ever heard of the Internal Rate of Return (IRR)? This is an important indicator used in the economic viability analysis of a project and serves to ensure more profitable and <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/money-investment">safe investments</a>.After all, no one wants to make an investment without being sure that they will make a profit from it, right? Each and every investment project must be <a target="_blank" rel="dofollow" href="https://www.voitto.com.br/blog/artigo/roi">carefully analyzed</a> and, to help in this task, we have the Internal Rate of Return.You will learn about IRR from the following topics:<ul><li>What is the Internal Rate of Return?</li><li>How to compute the Internal Rate of Return?</li><li>Practical example of how to compute IRR,</li><li>Limitations of the Internal Rate of Return,</li><li>Importance of the Internal Rate of Return,</li><li>Become an excellent investor!</li></ul><h2>What is the Internal Rate of Return?</h2>The Internal Rate of Return (IRR) can be defined as the discount rate that makes the Net Present Value (NPV) of a project equal to zero. The rate corresponds to the present value of anticipated cash inflows with the initial cash outflows.In other words, the Internal Rate of Return is a metric used to evaluate the return percentage of a project to the company. When finding this rate, it will usually be compared to the Minimum Attractive Rate of Return (MARR) to decide whether or not the project should be accepted.If the IRR is greater than the MARR, the investment must be accepted, otherwise it will be rejected. In general, companies will give preference to projects that have the greatest difference between the required rate and the internal rate of return.To better understand the Internal Rate of Return, you should think of it as a project expected growth rate. As such, projects with a much higher IRR than others will have a much better chance of growing.<h3>How can IRR ensure assertive investments?</h3>One of the main applications is in the <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/financial-advisor">investments analysis</a> such as establishing new operations or expanding existing ones.For example, a power company is deciding whether to open a new plant or renovate and expand an existing one. While both options are good for the company, it is likely to choose the option that has the highest internal rate of return.While IRR is an attractive metric for many, it should always be used in conjunction with NPV (Net Present Value) to get a clearer picture of the value represented by a potential project a company might undertake.<h2>How to compute the Internal Rate of Return?</h2>Computing the Internal Rate of Return is quite simple. The formula used is based on the same formula used to calculate NPV. To find the IRR, equate the NPV (negative cash flows) to zero, as follows: <Image quality="95" width="478" height="132" src="https://images.prismic.io/voitto-blog/bef9b0fd-2e8b-4285-8315-6591b0e75ea0_Internal+Rate+of+Return.jpg" alt="Internal Rate of Return Formula" title="Internal Rate of Return Formula" /><ul><li>NPV = Net Present Value</li><li>Ct = Net cash inflow during the period t</li><li>C0 = Total Initial Investment Costs</li><li>IRR = Internal Rate of Return</li><li>t = The number of time periods</li></ul>As you may have noticed from the formula, IRR cannot be easily calculated analytically. Therefore, to calculate the internal rate of return we can use a financial calculator, software such as <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/excel-for-beginners">Excel</a> or find out by trial and error.And to help you on this journey, we have prepared a free guide on how to take your first steps in Excel, check it out!<h3>Take your first steps in Excel!</h3>Several times we get lost in so many Excel functions, and we don&#39;t know where to start and what to learn. To help you, we created the <a target="_blank" rel="nofollow" href="https://conteudo.voitto.com.br/ebook-primeiros-passos-no-excel">First Steps eBook in Excel</a> to guide your practice with the tool, as well as how and where to learn about its most complex resources. Learn how to solve everyday problems quickly and efficiently in Excel.By downloading our eBook, you will learn the first steps to create your spreadsheets and use their basic and essential functions.Let&#39;s get started?<a target="_blank" rel="nofollow" href="https://conteudo.pocketbook4you.com/ebook-fist-steps-in-excel"> <Image quality="95" src="https://images.prismic.io/voitto-blog/5ad839f3-56eb-4c5b-a198-380f5e858ce8_Bot%C3%A3o+Banner+Cursos+-+TLSS+%2817%29.png" width="1025" height="205" alt="[EBOOK] Fisrt Steps in Excel" title="[EBOOK] Fisrt Steps in Excel"/></a><h2>Practical example of how to compute IRR</h2>A project has an investment of US$ 325,000.00, which occurred on year zero. Considering an analysis period of 5 years, an annual cash flow of R$ 90,000.00, and a minimum required rate of 9% per year, <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/decision-making">decide whether the project should be accepted or not</a>. <Image quality="95" width="284" height="304" src="https://images.prismic.io/voitto-blog/89998549-5dab-4641-919c-d03b914a5955_Internal+Rate+of+Return+image+02.jpg" alt="Practical example of how to compute IRR" title="Practical example of how to compute IRR" /> To do the calculation, just set up a table like the one above and use the (IRR) function in Microsoft Excel, selecting all cash flows (including the initial investment) in the function parameters.By doing so, we get an internal rate of return equal to 11.93%. In other words, if we analyze the viability of this project only by the IRR, this investment will be approved, as the IRR is greater than the minimum rate required by investors.<h2>Limitations of the Internal Rate of Return</h2>Although Internal Rate of Return is the single most important performance benchmark for private-equity investments and ideal for analyzing capital budgeting projects, it has its limitations.It is not always good to use this indicator alone, as mentioned earlier. In this way, it is necessary to take into account the interest rate, future cash flows and even the modified internal rate of return (MIRR) compute, as we will understand bellow:<h3>Internal Rate of Return vs Net Present Value</h3>Depending on the initial investment costs, a project may have a low IRR but a high NPV, which means that while the company&#39;s rate of return on this project is slow, the project may also be adding a large amount of overall value to the project. organization.A similar problem arises when using IRR to compare projects of different lengths. For example, a short-lived project might have a high IRR, making it look like an excellent investment, but it might also have a low NPV.On the other hand, a longer project may have a low IRR, earning returns slowly and steadily, but as mentioned before, it can add a large amount of value to the company over time.<h3>Wrong IRR analysis</h3>Another problem with IRR is not strictly inherent in the metric itself, but rather a common misuse of IRR. It is often stated that IRR assumes that when positive cash flows are generated during the course of a project (and not at the end), the money will be reinvested at the project&#39;s rate of return. This can rarely be the case.Instead, when positive cash flows are reinvested, it will be at a rate that most closely resembles the cost of capital. Incorrectly calculating using IRR in this way can lead to the belief that a project is <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/profitability-index">more profitable</a> than it actually is.This, along with the fact that long projects with fluctuating cash flows can have several distinct IRR values, has led to the use of another metric called the modified internal rate of return (MIRR).MIRR adjusts the IRR to correct these problems, incorporating the cost of capital as the rate at which cash flows are reinvested and existing as a single value. Due to the correction that MIRR makes to IRR, a project&#39;s modified rate of return will generally be significantly less than the IRR for the same project.<h2>Advantages of using IRR</h2>Evidently, calculating the IRR is of paramount importance for any investment. It is essential that anyone who decides to invest is aware of this indicator.It is also important to know how to interpret the results obtained from the IRR calculation, so as not to fall into the possible traps that a superficial analysis can generate. A good investor will never use just one financial indicator in his analysis, but a set of them, such as NPV and Payback, for example.Often, investors will choose projects with a lower internal rate of return, which in the long run will bring considerable benefits from the point of view of adding value to the company.In addition, it is important to have a good understanding of your own risk tolerance or the company&#39;s investment needs, risk aversion, and other options available. How to develop these skills? Get the <a target="_blank" rel="noopener" href="https://www.thinkleansixsigma.com/article/six-sigma-belt">Lean Six Sigma</a> certification!<h2>Become a specialist in Lean Six Sigma! </h2>It&#39;s time for you to start your training in one of the most valued methodologies on the market!With our <a target="_blank" rel="nofollow" href="https://thinkleansixsigma.thinkific.com/courses/lean-six-sigma-black-belt-upgrade">Green Belt training in Lean Six Sigma</a>, you will develop fundamental skills and knowledge for your professional growth!Our teaching methodology has content such as videos, exercises, complementary readings and personal assistance, so you can take the next step towards Green Belt professional recognition in Lean Six Sigma.Don&#39;t waste time and reach the next level in your professional career!<a target="_blank" rel="nofollow" href="https://thinkleansixsigma.thinkific.com/courses/lean-six-sigma-black-belt-upgrade"> <Image quality="95" src="https://images.prismic.io/voitto-blog/97fe760e-630f-45d0-9d4a-8f9cf76c75ef_Green+Belt+-+Bot%C3%A3o+Banner.png" width="1026" height="206" alt="Green Belt in Lean Six Sigma" title="Green Belt in Lean Six Sigma"/></a>

How to make more profitable investments? Compute for Internal Rate of Return!

Learn how to compute the Internal Rate of Return to indicate the profitability of your investments and achieve better results.