Return on Equity (ROE) and Internal Rate of Return (IRR) are two very important tools which can be used in decision making in expanding and investing in overseas projects. Return on Equity (ROE) tells how much profit company is generating with shareholder's money. ROE is calculated as:
ROE = Net Income/Shareholder's equity
This net income is income after paying tax and preferred stock dividend but before paying common stock dividend.ROE measures profit generating efficiency of the company. (McClure, 2010) Higher the ROE, better the investment opportunity company is offering.
Advantage of using ROE for investment decision is, it is easy to calculate and it tells how much profit company is generating for share holders. Ultimate goal of a company is to create value for shareholders. Thus, ROE is the right measure to find out if company is efficient in generating profit on its equity (and asset) or not.
However, ROE is not the absolute indicator of ...view middle of the document...
To calculate IRR, NPV is equated to zero and r is determined.
NPV = C0 + C1/(1+r) + C2/(1+r)^2 + …. + Cn/(1+r)^n
When we make NPV = 0, value of r is the IRR
Hit and trial method is used to calculate IRR. Even in excel, IRR calculation using formula IRR, gives approximate value.
A project is accepted if its IRR is greater than minimum acceptable return. IRR is investment decision because of its simplicity. In IRR, no assumption is made. It itself provides a rate of return project would offer. IRR is preferred because a single entity Rate of Return is calculated without making any assumption. If this return is higher than required rate of return (hurdle rate), project is accepted otherwise project is rejected. As company has limited cash company compares IRR of different projects are select the project which gives highest IRR. (Anthes, 2003)
However, IRR method t is not the best method to use in investment decisions. IRR method has some limitations. This method should not be used to compare two mutually exclusive projects. Also, IRR calculation is very complex. IRR method produces multiple rates which can be confusing. Another disadvantage of IRR method is, it assumes that all intermediate cash flows are reinvested at the IRR which is not true in real life projects.
Wal-Mart Stores Inc. and Target Corporation are two companies in retail business. Based on Financial Statements of FY 2011, ROE of these two companies are calculated below:
Wal-Mart Stores Inc.:
Net Income = $15,959 million
Shareholder’s equity = $ 68,542 million
Hence, ROE = Net Income/Shareholder’s equity = 23.28%
Net Income = $ 2,920 million
Shareholder’s equity = $ 15,487 million
Hence, ROE = Net Income/Shareholder’s equity = 18.85%
(Source: MSN Money)
Anthes G. (2003). "ROI Guide: Internal Rate of Return". Retrieved on July 5th, 2011. From: http://www.computerworld.com/s/article/78524/ROI_Guide_Internal_Rate_of_Return?taxonomyId=074
McClure B. (2010). "How Return On Equity Can Help You Find Profitable Stocks". Retrieved on July 5th, 2011. From: http://www.investopedia.com/articles/fundamental/03/100103.asp#axzz1QySeeSaK
MSN Money. Financial Statements of Wal-Mart and Target Corp. Retrieved on July 5th, 2011. From: http://moneycentral.msn.com