The internal opportunity rate is the rate of return on the investment that is applied to the present value calculation. In other words, it would be the expected minimum rate of return if an investor chooses to accept an amount of money in the future, when comparing it to the same amount today.
The internal opportunity rate that is chosen for the present value calculation is highly subjective, because it is the minimum rate of return that you would expect to receive if today’s dollars were invested over a period of time.
Therefore, it is the sum of a remarkable interest rate and the value of time. This mathematically increases the future value in absolute or nominal terms.
Rather, the internal opportunity rate is used to calculate future value as a function of present value. This allows a capital provider or lender to settle the sensible amount of any future obligation or gain, relative to the present value of the principal.
What is the internal opportunity rate?
The internal opportunity rate is a critical component in the discounted cash flow calculation. It is an equation that determines how much a series of future cash flows is worth as a single current value of the lump sum.
For investors, this calculation can be a powerful tool to value businesses or other investments with predictable earnings and cash flows.
For example, suppose a company has a large and consistent market share in its industry.
If the company’s earnings can be forecast in the future, the discounted cash flow can be used to estimate what the valuation of that company should be today.
This process is not as simple as just adding the cash flow amounts and arriving at a value. That’s where the internal opportunity rate comes into play.
Factors to consider
The cash flow tomorrow will not be worth as much as today, due to inflation. As prices increase over time, money will not buy as much in the future compared to what it can buy today.
Second, there is uncertainty in any projection of the future. It is simply not known what will happen, such as an unforeseen decline in a company’s profits.
These two factors, the time value of money and the risk of uncertainty, combine to form the theoretical basis for the internal opportunity rate.
The higher the internal opportunity rate, the greater the uncertainty. This is the lower the present value of the future cash flow.
The internal opportunity rate is a refined estimate and not a scientific certainty. With the calculation you can obtain an estimate of the value of the company.
If the analysis estimates that the company will be worth more than the current price of its shares, it means that the shares could be undervalued and it would be worth buying.
If the estimate shows that the stocks will be worth less than the currently listed stocks, then they may be overvalued and a bad investment.
It is expressed as a percentage. It depends on the cost of principal (current compound interest rate) and the time interval between the investment date and the date the returns begin to be received.
The formula is: 1 / (1 + r) ^ n. Where ‘r’ is the required rate of return (interest rate) and ‘n’ is the number of years. Also called the discount rate.
Weighted average cost of equity is one of the best concrete methods and a great place to start. However, even that will not give the perfect internal opportunity rate for every situation.
Discounted cash flow analysis
It is a valuation method commonly used to estimate the value of an investment based on its expected future cash flows.
Based on the concept of the time value of money, discounted cash flow analysis helps evaluate the viability of a project or investment. This is by calculating the present value of expected future cash flows using an internal opportunity rate.
In simple terms, if a project needs a certain investment now, and also in the coming months, and there are predictions available about the future returns it will generate, then using the internal opportunity rate it is possible to calculate the present value of all these cash flows .
If the net present value is positive, the project is considered viable. Otherwise, it is considered financially unviable.
In this context of discounted cash flow analysis, the internal opportunity rate refers to the interest rate used to determine the present value.
For example, $ 100 invested today in a savings plan that offers a 10% interest rate will increase to $ 110. In other words, $ 110 (future value) when discounted at a rate of 10% is worth $ 100 (present value).
If one knows, or can reasonably predict, all of those future cash flows, such as the future value of $ 110, then using a particular internal opportunity rate, the future value of that investment can be obtained.
An investor may have $ 10,000 to invest and wants to receive at least a 7% return in the next 5 years to meet his goal. This 7% rate would be considered your internal opportunity rate. It is the amount that the investor requires to make the investment.
The internal opportunity rate is most often used to calculate the present and future values of annuities. For example, an investor can use this rate to calculate the value of his investment in the future.
If he puts in $ 10,000 today, it will be worth about $ 26,000 in 10 years with an internal opportunity rate of 10%.
Conversely, an investor can use this rate to calculate the amount of money he will need to invest today to meet a future investment objective.
If an investor wants to have $ 30,000 in five years and assumes that he can get an internal opportunity rate of 5%, he will have to invest about $ 23,500 today.
Companies use this rate to measure return on equity, inventory, and whatever else they invest money in.
For example, a manufacturer that invests in new equipment may require a rate of at least 9% to offset the purchase to be made.
If the 9% minimum is not met, you would have to change your production processes as a consequence.
- My Accounting Course (2019). What is a Discount Rate ?. Taken from: myaccountingcourse.com.
- Business Dictionary (2019). Discount rate. Taken from: businessdictionary.com.
- Will Kenton (2019). Discount Rate. Investopedia. Taken from: investopedia.com.
- The Motley Fool (2019). What Is the Discount Rate? Taken from: fool.com.
- CFI (2019). Discount Rate. Taken from: corporatefinanceinstitute.com.