### Effective Rate & Internal Rate of Return Applications for Everyone!

As promised in my previous post, I will share 2 simple methods (Effective Rate, and Internal Rate of Return) that we can use to determine the return of an investment. It can be performed by almost everyone and it is a free application for smart phone ~ (EZ) Financial Calculators.

## EFFECTIVE RATE

We will first discuss about Effective Rate. Refer to below definition as defined by investopedia.com.

One of the simple applications of effective rate is to compare actual yield for Fixed Deposit Savings. As illustrated in the list below, banks provide list of different interest rates for different tenure of deposits. Which will give the highest return if interest is added to principal upon maturity for compounding effect?

Which will be your guess for above example? If you have RM 100,000 and you decided to place them in a Fixed Deposit Account for a year, what will be your choice?

Simply choose the Compound Interest Calculator from the mobile application and key in all the necessary information, i.e Principal Amount, Period (number of months), Annual Interest Rate, Compounding options. Once all the parameters entered, click on [CALCULATE]. APY (Annual Percentage Yield) is equivalent to the Effective Rate in our discussion.

You can try with the example provided above and decide which options give you the highest return. (*Answer : 3.02% @ 6 mths gave us highest effective rate = 3.0428%*) You can also use it for hire purchase/credit card loan effective rate calculation.

## INTERNAL RATE OF RETURN (I.R.R.)

This definition of IRR is also quoted from Investopedia.

Not every investment scheme or plan is easy for us to compare like Fixed Deposit Saving which we have discussed earlier. Examples are valuations of a bond, or something that we encounter more often such as insurance savings/annuity plan. Both provide interim pay outs and maturity value. For our discussion, we will use an example of insurance savings plan as below.

Above is an example of summary for an Insurance Savings Plan. You need to save for 10 years and the plan matures at the end of 20 years. After 2 years, you will receive your first interim payout of RM 1,082 (equivalent to 10% of your annual savings) for 3 times. Subsequently you will receive RM 2,163 (equivalent to 20% of your annual savings) for 3 times and RM 3,245 (30%) for 3 times. Finally, at the end of 20 years, the plan matures and you expect to receive RM176,900 (*Note: This is an estimated amount in most of the plan*.) How do we determine what is the actual annual rate of return for this plan?

If we assume that we deposited RM 108,150 for 20 years at 3% p.a. fixed deposit, provided interest rate maintains and interest earned left compounded, we should receive RM 195,331 at the end of 20 years. Since RM 196,300 is very close to RM 195,331, can we say that the return of the plan above is approximately 3%? We have to agree that we can’t make that assumption since the plan is not a lump sum deposit plan. Hence, we can utilise IRR calculation.

First we need to list the cash flow from the summary we saw earlier. It is important to note that we start at Year 0 and end at Year 20. We start at Year 0 because you have to pay the amount early of the year and will only receive your pay at the end of the year. We will structure the stream of cash flow in a way that we assign -ve sign for net outflow and +ve sign for net inflow. As you can see at Year 2, you need to add RM1,082, the amount you shall receive (+ve) and subtract RM 10,815, the amount you shall pay (-ve). Once you are ready with the cash flow chart, you can use the mobile application.

By referring to above picture, first, you should choose [IRR NPV Calculator]. Then, I will suggest that you click on [ADD ROW] button until you see Cash Flow 20. After that, you can start to insert the cash flow as listed in the cash flow chart. Please be reminded to follow the +ve or -ve signs and insert [Zero] for Years where there will be neither inflow nor outflow (Cashflow : 11, 13, 15 & 19). Finally click on [CALCULATE].

You will get the Internal Return Rate as 4.1457%. This will be the rate that is more representative compared to our initial assumption. We can utilise this tool when we have few investment options offering different cash flow throughout the plan.

Feel free to email me at ask@ethanteh.com for further discussion or if you need confirmation for any of your calculation. You can email me summary of your scheme and cash flow chart for discussion.

Disclaimers:

Content of this blog is for informational purposes only. We shall not be liable for any errors, omissions, or any losses or damages arising from its display or use.Information is based on writer's personal opinion and experience.

It should not be considered as professional advice. Please consult a professional adviser personally prior to decision making.

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