Most of the investments like capital infusions and bonds are designed in such a way that they return certain cash flows over a given period of time. In order to measure the investment’s success and make a comparison with others, it is useful to apply an interest rate of calculation which determines the return on investment.
YTM and IRR are normally used in measuring different things even if the calculations are alike. When evaluating the financial outcome the investment of a project or financial statements, corporations normally use IRR. Businesses and individuals use YTM in estimating various bond investments value. An organization will decide to carry on with a project if the IRR equals or exceeds the cost of capital of an organization. The results of YTM which meets the goals of the investment are ideal investment decisions.
Yield to Maturity
YTM or Yield to Maturity is a measure that is used in the determination of the generated annual rate through coupons or interest payment of a bond. For instance, suppose a $ 1,000 bond whose rate of bond is 6% and has semi- annual coupons paying $ 30 after every six months. Therefore, since you will earn 3% after every 6 months, the YTM in this example will be 1.03^2 – 1 =6.09 %. The yield to maturity is higher than the rate of bond since you will receive coupon payments after every 6 months instead of one time each year.
Features of YTM
YTM is used in evaluating features of bonds including maturity time, early price redemption, current interest coupon rates and frequency of payment of interest. Due to the fact that bonds are governmental debt instruments or else corporate, issuers normally build in options of early redemption maturity which enable them to have their bonds redeemed before the maturities stated in order to avert making interest payments. To calculate estimates of YTM, a bond value table can be used. This is also known as an online calculator, spreadsheet software or programmable calculator.
IRR is an abbreviation of Internal Rate of Return used in measuring the infusion interest rate of capital that has to be earned for break- even depending on cash flows projected. This is the rate of interest where the future cash flows expected will equal to the current injection of capital.
In case IRR is in excess of cost of capital, cash or assets required in funding a project, management will reject the project. The general rule is that a project becomes acceptable if the IRR exceeds the cost of capital. Even then, if IRR exceeds the cost of capital and it fails to meet the company’s financial objectives, the project can still be rejected.
How to Calculate IRR
Suppose one has invested $ C in a business whose anticipated cash flows are CF(1), CF(2), CF(3) and CF(4) after 4 years. IRR would be calculated by determining the i value where C = CF(1)/(1+i) + CF(2)/(1+i)^2 + CF(3)/(1+i)^3 + CF(4)/(1+i)^4. For example, the IRR of $ 1,000 capital investment whose projected cash flows are $300 in all the four consecutive years is 7.72 %.
Similarities of YTM and IRR
Yield to maturity and IRR are alike because their calculations appreciate the time value of money concept. The two methods assume that bond investments and projects are financial commitments that are long term in nature unlike purchasing and selling investments that are short term in nature such as mutual funds and stocks. Both of these methods are intended to help individual and organization investors settle on the best investment decisions depending on pertinent facts which allow precise projection of earnings and value.