Investment Analysis Methodologies - Internal Rate of Return

Time value of money is one of the most important yardstick used by Venture Capitalists before investing. The internal rate of return (IRR) method of analyzing an investment utilizes the time value of money. This parameter provides you an option of calculating interest rate that is equivalent to the dollar returns that you expect from an investment. This helps you in comparing to the rate you can earn by investing in projects of similar merits.

Lower Internal Rate of Return with respect to cost of borrowing indicates a money losing proposition. So typically a Venture Capitalist will be looking for reasonably high Internal Rate of Return when compared with Cost of borrowing. This is expected as Venture Capitalist is in the market to make money for the risk taken, time spent and trouble taken.

Let us consider an example. A venture capitalist is studying an investment where initial cost of the project is $750,000 and expected return is $200,000 per year for next 5 years or $1,000,000 in total. So Internal Rate of Return here is 10%. Suppose cost of borrowing is 2%. That gives the Venture Capitalist has a margin of 8% which may be worth his while to invest in the project.

Cash flow evaluation and not income from investment is the goal of Internal Rate of Return Analysis, as Income from investment is a skewed figure as it includes depreciation etc.

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