The amount of money an investor needs to start up a firm is known as initial investment. This money is usually sourced through borrowing, savings, or other sources that can provide such amount. Also, when a person decides to put money in some sort of capital investment, that money is known as initial investment. Since it is the money needed to start up a business, it is also referred to as the capital. In every investment, the capital plays a very important role, not just for when starting the business, but also for making financial analysis about the project in future. The cost of capital (the cost of obtaining money to finance a business) is also considered when making reference to initial investments. In most cases, this can be in the form of interest to be paid after a specified period of time.

Since initial investment is the capital needed to start a business, it is not wrong to say that it equals the amount needed for capital expenditures. This includes machinery, tools, labor, installation, shipments, etc. This, in addition to any increase in working capital with no after cash tax flows results to the practical initial investment value. It is calculated thus
Initial investment = Capital expenditures + Increase in working capital – Disposal inflows

THE INTERNAL RATE OF RETURN OF AN INITIAL INVESTMENT

Internal rate of return refers to a method of measuring the profitability of potential investments as can be seen in capital budgeting. Investors take a look at the internal rate of return of a business to help them decide whether to go for it or not to. It is what shows the attractiveness of a business. However, all that the IRR represents are on the papers and not in reality. This is to say that there is a likelihood that things will not go the way they were proposed in the project, but all the same, the IRR gives one an idea of what to expect.
To calculate the IRR of an investment, the following formula can be used

0 = P0 + P1 /(1 + IRR) + P2/(1 + IRR)2 + P3/(1 + IRR)3 . . . + Pn/(1 + IRR)n

Where

P = cash flow

n = period

IRR = Internal rate of return

Here is an example

An investment company is faced with the decision to buy a manufacturing machine that will last for three years, and generate an additional annual profit of \$150 000 to \$300 000 that is the cost price. The machine can be sold for \$10 000 as crap after the period of its usefulness, but there is another investment that will return 10% profit to the company.

Which of the two should the firm go for?

0 = -\$300,000 + (\$150,000)/(1+.2431) + (\$150,000)/(1+.2431)2 + (\$150,000)/(1+.2431)3 + \$10,000/(1+.2431)4

From the calculation, this investment will return 21.31% profit to the company. Therefore, this is better than the investment with 10% return with the same amount of money and time.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

Live Chat
Leave feedback