Rate of Return
The rate of return is the rate at which the project's discounted profits equal the upfront investment. Consider a project that requires an upfront investment of $100 and returns profits of $65 at the end of the first year and $75 at the end of the second year. When $65 and $75 are discounted at 25 percent compounded annually, the sum is $100. In this case, the internal rate of return equals 25 percent.
The interest rate is the rate charged by a lender on a loan for the project. The interest rate is based on the borrower's credit rating and the bank's assessment of project feasibility and profits.
Loan financing makes sense if the internal rate of return is higher than the interest rate. If the rate of return is 25 percent and the bank charges 15 percent, the project will be profitable even after paying off interest expenses.
Use rate of return to select projects competing for investment dollars. If a company has a budget of $100 and can only undertake one of three projects, it could pick the project with the highest internal rate of return.
Banks require information on a project's investment, profits and rate of return before approving loans. Banks are more likely to lend money if the rate of return is higher than the bank's interest rate.