Internal rate of return and Outright Monetary Transactions: Difference between pages

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(IRR).  
(OMT).


Part of the [[open market operations]] of a central bank in which the central bank buys or sells securities outright - i.e. without the re-sale or re-purchase legs of [[reverse repurchase agreement]]s or [[repurchase agreement]]s.


== Definitions of internal rate of return (IRR) ==
This was a new tool for the European Central Bank in 2012 - and controversial, especially in Germany - though its use by other banks has not been so dogged by controversy.


IRR is a percentage summary of the cash flows of a project, for example, an IRR of 10%.
[[Category:Risk_frameworks]]
 
The IRR summarises the timing, as well as the amounts, of the cashflows.
 
 
For an investor, the IRR of an investment proposal represents their expected rate of [[return]] on their investment in the project.
 
A greater IRR is normally more attractive for an investor.
 
 
The IRR is driven by the expected future cash flows from the project.
 
 
The IRR of a set of cash flows is:
 
:the [[cost of capital]] which,
 
:when applied to discount all of the cash flows,
 
:including any initial investment outflow at Time 0,
 
:results in a [[net present value]] (NPV) of 0.
 
 
<span style="color:#4B0082">'''Example 1: IRR'''</span>
 
A project requires an investment today of $100m, with $110m being receivable one year from now.
 
The IRR of this project is 10%, because that is the cost of capital which results in an NPV of $0, as follows:
 
 
[[PV]] of Time 0 outflow $100m
 
= $(100m)
 
 
PV of Time 1 inflow $110m
 
= $110m x 1.10<sup>-1</sup>
 
= $100m
 
 
NPV = - $100m + $100m
 
= '''$0'''.
 
 
If the project had been funded by borrowing all the required money at the IRR of 10%, there would have been exactly the right amount of profit from the project to repay the borrowing and interest, with neither a deficit nor a surplus.
 
This is another way to define the IRR.
 
 
== Project decision making with IRR ==
 
 
Target or required IRRs are set based on the investor's [[weighted average cost of capital]], appropriately adjusted for the risk of the proposal under review.
 
In very simple IRR project analysis the decision rule would be that:
 
(1) All opportunities with above the required IRR should be accepted.
 
(2) All other opportunities should be rejected.
 
 
However this assumes the unlimited availability of further capital with no increase in the cost of capital.
 
 
A more refined decision rule is that:
 
(1) All opportunities with IRRs BELOW the required IRR should still be REJECTED; while
 
(2) All other opportunities remain eligible for further consideration (rather than automatically being accepted).
 
 
== Determining IRR ==
 
Unless the pattern of cash flows is very simple, it is normally only possible to determine IRR by trial and error (iterative) methods.
 
 
<span style="color:#4B0082">'''Example 2: Straight line interpolation'''</span>
 
Using straight line interpolation and the following data:
 
First estimated rate of return 5%, positive NPV = $+4m.
 
Second estimated rate of return 6%, negative NPV = $-4m.
 
The straight-line-interpolated estimated IRR is the mid-point between 5% and 6%.
 
This is '''5.5%'''.
 
 
Using iteration, the straight-line estimation process could then be repeated, using the value of 5.5% to recalculate the NPV, and so on.
 
The IRR function in Excel uses a similar trial and error method.
 
 
== See also ==
* [[Effective interest rate]]
* [[Hurdle rate]]
* [[IBR]]
* [[Implied rate of interest]]
* [[Interpolation]]
* [[IRI]]
* [[Iteration]]
* [[Linear interpolation]]
* [[Market yield]]
* [[Net present value]]
* [[Present value]]
* [[Return on investment]]
* [[Shareholder value]]
* [[Weighted average cost of capital]]
* [[Yield to maturity]]
 
[[Category:Investment]]
[[Category:Cash_management]]

Revision as of 19:06, 28 August 2014

(OMT).

Part of the open market operations of a central bank in which the central bank buys or sells securities outright - i.e. without the re-sale or re-purchase legs of reverse repurchase agreements or repurchase agreements.

This was a new tool for the European Central Bank in 2012 - and controversial, especially in Germany - though its use by other banks has not been so dogged by controversy.