Internal rate of return and Leverage Ratio: Difference between pages

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(IRR).
''Bank regulation''


(LR).


=== Definition of IRR ===
A requirement under Basel III regulations for regulated institutions to hold a minimum ratio of capital to absolute balance sheet outstandings (plus certain other items).


The internal rate of return 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 NIL.
It is calculated as:


For an investor, the IRR of an investment proposal therefore represents their expected rate of [[return]] on their investment in the project.
LR = Tier 1 capital / Leverage Ratio Exposure (LRE)




<span style="color:#4B0082">'''Example 1'''</span>
The leverage ratio is the long term capital ratio for banks by which their Tier 1 capital should in due course be at least 5% of their assets.


A project requires an investment today of $100m, with $110m being receivable one year from now.
This will generally be that their shareholders funds will be >=5% of their loans although the definitions may be subject to domestic practices.  


The IRR of this project is 10%, because that is the cost of capital which results in an NPV of $0, as follows:


Domestic regulators can set higher ratios and the USA has set higher ratios for eight Systemically Important Financial Institutions (SIFIs) than for non-SIFIs.


[[PV]] of Time 0 outflow $100m


= $(100m)
'''Leverage Ratio Exposure'''


 
The [[Leverage Ratio Exposure]] (LRE) - for the purposes of calculating the Leverage Ratio - includes certain other risk exposures, in addition to on-balance sheet assets.
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 surplus from the project to repay the borrowing and interest, with neither a deficit nor a surplus.
 
This is another way to define the IRR.
 
 
 
=== 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'''</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.
 
 
 
=== IRR project analysis decision making ===
 
 
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).




== See also ==
== See also ==
* [[CertFMM]]
* [[Basel III]]
* [[Effective interest rate]]
* [[Countercyclical leverage ratio buffer]]
* [[Hurdle rate]]
* [[G-SII ALRB]]
* [[Implied rate of interest]]
* [[Leverage]]
* [[Interpolation]]
* [[Leverage Ratio Exposure]]
* [[Iteration]]
* [[Liquidity Coverage Ratio]]
* [[Linear interpolation]]
*[[LRT]]
* [[Market yield]]
* [[Net Stable Funding Ratio]]
* [[Net present value]]
* [[Off balance sheet risk]]
* [[Present value]]
*[[Systemically Important Financial Institution]]
* [[Shareholder value]]
*[[Tier 1]]
* [[Weighted average cost of capital]]
* [[Yield to maturity]]

Revision as of 16:44, 29 January 2020

Bank regulation

(LR).

A requirement under Basel III regulations for regulated institutions to hold a minimum ratio of capital to absolute balance sheet outstandings (plus certain other items).

It is calculated as:

LR = Tier 1 capital / Leverage Ratio Exposure (LRE)


The leverage ratio is the long term capital ratio for banks by which their Tier 1 capital should in due course be at least 5% of their assets.

This will generally be that their shareholders funds will be >=5% of their loans although the definitions may be subject to domestic practices.


Domestic regulators can set higher ratios and the USA has set higher ratios for eight Systemically Important Financial Institutions (SIFIs) than for non-SIFIs.


Leverage Ratio Exposure

The Leverage Ratio Exposure (LRE) - for the purposes of calculating the Leverage Ratio - includes certain other risk exposures, in addition to on-balance sheet assets.


See also

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