Internal rate of return

The internal rate of return of a bond is essentially the rate of return implied by its total cash flows. If, for example, you are offered a three-year bond for £90 that pays a 5% annual coupon in arrears based on its £100 nominal value, you are paying £90 now to get £5 in a year, another £5 a year later and £105 back when the bond is redeemed.The internal rate of return can be estimated at 8.95% – £5/1.0895 is £4.59, £5/(1.0895 x 1.0895) is £4.21 and £105/(1.0895 x 1.0895 x 1.0895) is £81.20. Combine £4.59 + £4.21 + £81.20 and you get £90, or exactly the original investment. So, if you can get a better rate, say 10%, from a less risky investment such as a cash deposit, all other things being equal, you wouldn’t invest your £90 in the bond.

• See Tim Bennett’s video tutorial: Five ways companies can cook cash flow.

Merryn

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