The rate of return is an internal measure of the return on money invested in a project. The interest rate is the external rate at which money can be borrowed from lenders.
Rate of Return
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The rate of return is the rate at which the project's discounted profits equal the upfront investment. Consider a project that requires an upfront investment of $100 and returns profits of $65 at the end of the first year and $75 at the end of the second year. When $65 and $75 are discounted at 25 percent compounded annually, the sum is $100. In this case, the internal rate of return equals 25 percent.
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Interest Rate
The interest rate is the rate charged by a lender on a loan for the project. The interest rate is based on the borrower's credit rating and the bank's assessment of project feasibility and profits.
Considerations
Loan financing makes sense if the internal rate of return is higher than the interest rate. If the rate of return is 25 percent and the bank charges 15 percent, the project will be profitable even after paying off interest expenses.
Function
Use rate of return to select projects competing for investment dollars. If a company has a budget of $100 and can only undertake one of three projects, it could pick the project with the highest internal rate of return.
Significance
Banks require information on a project's investment, profits and rate of return before approving loans. Banks are more likely to lend money if the rate of return is higher than the bank's interest rate.