The Difference Between the IRR & the Yield to Maturity
The internal rate of return, or IRR, and the yield to maturity, or YTM, measure different things, although the calculations are similar. Corporations use IRR to evaluate the financial outcomes of projects or investments the organizations are considering. Individuals and businesses use YTM to estimate the value of different bond investments. When IRR meets or exceeds a corporation's cost of capital, the organization often decides to do the project. YTM results that meet your investment goals are attractive bond investments.
YTM evaluates bond features, including time to maturity, early redemption prices, current coupon interest rates and the frequency of interest payments. Since bonds are corporate or government debt instruments, issuers often build in early maturity redemption options that allow them to redeem their bonds before stated maturities to save them the cost of making interest payments. To calculate YTM estimates, you can use a bond value table, also called a bond yield table, a programmable or online calculator or spreadsheet software.
Corporate finance departments decide to recommend or reject a project if the IRR exceeds the cost of the capital, cash or other assets needed to fund the project. Senior management then decides whether to agree to the project if estimated results meet or exceed their strategic IRR financial objectives. Should the IRR estimate be higher than the cost of needed capital, senior executives may still reject the project if the IRR falls short of their financial objectives.
IRR and yield to maturity are similar in their concept of the time value of money. They also both assume that projects and bond investments are longer-term financial commitments than simply buying and selling shorter-term investments, such as stocks or mutual funds. Both methods are designed to help organizations or individual investors like you make the best investment decisions, based on relevant facts that permit accurate projections of value and earnings.
Cash flows are vital to both IRR and YTM calculations. For analysis purposes, projected cash flows are expressed as interest rates, which are determined based on the original investment in projects or bonds. For instance, assume you're consider buying a $1,000 bond paying 5 percent interest, meaning you will receive $50 per year until it matures. If the current market rate is 6 percent, the bond is not attractive at face value. But discounting future cash flows by 6 percent -- $50 = .06(x), where x equals the bond price -- means you should pay no more than $833.33 -- $50 divided by 6 percent -- for the $1,000 bond to earn a 6 percent annual yield to maturity.