How do you decide which projects to invest in? Some companies look at the expected profit as a percentage of expected revenue. This approach, however, does not take into account the size of the investment, how long your money is tied up, or the risk of the investment.
Many companies look at their expected Internal Rate of Return, or IRR. This is a measure of the cash flow of the investment over its expected life, and gives the annual percentage return on the actual cash invested. Some companies informally call this their Return on Investment, although ROI is technically a different measure.
Companies in different industries have their own criteria for a minimum acceptable IRR. Retailers, for example, often look for a 16% return after tax, while homebuilders might look for 18% before tax. The differences are based on the risk involved in the investment. Profit projections are less reliable for a new retail store than for building houses in an established development – under normal circumstances, of course. Retailers also expect their investment to last at least 10 years, while a housing development can often be completed in 2 or 3 years. A lot of things can change in 10 years.
What is the appropriate IRR target for your investments?