Internal Rate of Return (“IRR”)

What It Means

The Internal Rate of Return, commonly called IRR, is the implied interest rate return of an investment considering the timing and value of future cash flows. It is closely related to Discounted Cash Flow Analysis in that the IRR represents the Discount Rate where the net present value of all cash flows equals zero.

To calculate the IRR of a series of cash flows, set the discounted value of future cash inflows equal to the up front investment and solve for the interest rate as follows:

Because of the iterative nature of the equation, IRR is most easily solved using specialized spreadsheets or software programmed to calculate IRR.

Why It’s Important

Many Buyers and investors will use IRR as a measure to help them evaluate the attractiveness of a potential Acquisition. Weighing the investment against the expected future cash flows is an effective tool for comparing different opportunities they may be considering.

Example

A Buyer is considering two companies for a possible Acquisition. The two companies have similar characteristics and the Buyer has no preference between the two options, so the decision is going to be purely financial. Since the two companies have different expected cash flows, the Buyer wants to compare the IRR of the two choices. The expected Free Cash Flow over the next 5 years and equivalent IRR of the two options are as follows:

Using Microsoft Excel, we can easily calculate the cumulative net cash flow and IRR of the cash flows to be:

As you can see from the calculations above, Company 1 is expected to return more net cash flow over the 5 year period than Company 2, but it offers a lower IRR thanks to the time value of money. Company 2 expects to see higher cash returns in the early years, which carry more weight in the IRR calculation.

Related Terms

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