Chapter 17
INVESTORS AND MARKETS : The internal rate of return


As the value of an investment and the discount rate are fundamentally linked, we also looked at the concept of yield to maturity or IRR (which cancels out NPV). Making an investment is only worth it when the IRR is equal to or greater than the investor’s required return. At fair value, internal rate of return is identical to the required return rate. In other words, net present value is nil.

The internal rate of return should be handled with care, as it is based on the implicit assump- tion that intermediate cash flows will be reinvested at the same rate. It should only be relied on for an investment decision concerning a single asset and not for choosing from among several assets. NPV should be used for such decisions.

Finally, some financial mathematics helped us look at the link between the nominal interest rate and the yield to maturity of an operation. The apparent (annual) rate of a loan is the rate used to calculate interest in proportion to the period of the loan and the capital borrowed. However, one must use the yield to maturity, which may differ from the apparent nominal rate, when interest is not paid on an annual basis.

Two rates referring to two different time periods are equivalent if the future value of the same sum is the same at the same date. Finally, two rates are proportional if they are in the same proportion as the maturity to which they refer to. Proportional rates are just a means to compute the interest that is actually to be paid. They have no other use.