I would like to have your opinion on a question about the IRR I haven’t been able to answer for quite some time.
I am finishing my Master’s in International Financial Analysis and I recently got an analyst position for a Private Equity fund.
IRR is the discount rate which gives you a NPV of 0, and is an investment criterion as IRR > WACC = + NPV.
Where I am having issue getting my head around the concept of IRR is when it is used as a metric.
Indeed, when I first started working for the PE fund I am currently with, I was surprised to see that the return on an investment was measured by using the IRR.
The IRR is supposed to mean that you have earned $0 on your investment, so I don’t understand how this could explain/measure value creation.
Could someone please try explaining this to me?
That would be greatly appreciated!
Thank you and all the best to you all.
Hi - consider the IRR as the interest rate you’d have to earn to achieve the same cash flows as you did on your investment.
EG if you invest $100 in year 0, and receive pay-outs of $40 in year 1, $40 in year 2 and $40 in year 3 and your ending balance is $0, then the IRR is 9.7% (per financial calculator). The cash flow you achieved was 120 from an initial 100 investment. Using the rate of 9.7% makes the NPV of the investment equal to zero - but it is a metric that describes the return achieved over the time frame ($20 profit).
I think the reason why I’m struggling with understanding why and how IRR is used as a metric, is that I’m looking at an investment project from the very beginning.
Taking a case from work, where we would be on a LBO deal to takeover a company.
Say, I am calculating the Entreprise Value to get the Equity Value using the DCF approach.
I have worked out my WACC, modelled the expected cash flows, and calculated my NPV and IRR.
Now fast track to 5-7 years when we exit that deal and sell the equity purchased.
Using the DCF model previously established, what do I do to give me that new IRR?
I’m assuming I would need to input the actual FCFs in the model, or maybe confront the expected FCFs vs the actual ones.
Sorry if I might be overcomplicating this but I am just not getting the relationship with the actual model I would make before investing and the return once the sale is made, given that a WACC was given and used to settle on a minimum NPV.
I do however kind of get the concept of having the IRR used as a metric because it would equal the actual FCFs.
i’ve always seen actual irr achieved on investments calculated by using actual cash flows in the excel xirr function (and this result quoted to investors / reviewed by auditors). This will no doubt give you a different result to applying actual cash flows to your dcf model. So conceptually i think your assumption is correct but practically, in my experience, irr as a metric is taken from the xirr calc.