Internal rate of return and Private equity: Difference between pages

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''Investment and funding appraisal.''
1.


(IRR).  
Equity and other forms of capital for privately owned firms with high growth potential.




== Overview of internal rate of return (IRR) ==
2.


IRR is an accounting method for calculating the return forecast to be achieved on a (potential) investment by equating the net present value (NPV) of its cash outflows and inflows over time to zero.
Firms or individuals who make investments in such firms, sometimes abbreviated to PE.




IRR is a percentage summary of the cash flows of a project, for example, an IRR of 10%.
3.


The IRR summarises the ''timing'', as well as the ''amounts'', of the cashflows.
The equity of a privately owned company.
 
 
For an investor, the IRR of an investment proposal represents their expected rate of [[return]] on their investment in the project.
 
A greater IRR is normally more attractive for an investor.
 
 
The IRR is driven by the expected future cash flows from the project.
 
 
The IRR of a set of cash flows is:
 
:the [[cost of capital]] which,
 
:when applied to discount all of the cash flows,
 
:including any initial investment outflow at Time 0,
 
:results in a [[net present value]] (NPV) of 0.
 
 
<span style="color:#4B0082">'''Example 1: IRR - single period 10%'''</span>
 
A project requires an investment today of $100m, with $110m being receivable one year from now.
 
The IRR of this project is 10%, because that is the cost of capital which results in an NPV of $0, as follows:
 
 
[[PV]] of Time 0 outflow $100m
 
= $(100m)
 
 
PV of Time 1 inflow $110m
 
= $110m x 1.10<sup>-1</sup>
 
= $100m
 
 
NPV = - $100m + $100m
 
= '''$0'''.
 
 
<span style="color:#4B0082">'''Example 2: IRR - single period 5%'''</span>
 
A project requires an investment today of $100m, with $105m being receivable one year from now.
 
The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
 
 
[[PV]] of Time 0 outflow $100m
 
= $(100m)
 
 
PV of Time 1 inflow $105m
 
= $105m x 1.05<sup>-1</sup>
 
= $100m
 
 
NPV = - $100m + $100m
 
= '''$0'''.
 
 
<span style="color:#4B0082">'''Example 3: IRR - two periods 5%'''</span>
 
A project requires an investment today of $100m, with $5m being receivable one year from now, and $105m two years from now.
 
The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
 
 
[[PV]] of Time 0 outflow $100m
 
= $(100m)
 
 
PV of Time 1 inflow $5m
 
= $5m x 1.05<sup>-1</sup>
 
= $4.76m
 
 
PV of Time 2 inflow $105m
 
= $105m x 1.05<sup>-2</sup>
 
= $95.24m
 
 
NPV = - $100m + $4.76m + $95.24m
 
= '''$0'''.
 
 
<span style="color:#4B0082">'''Example 4: IRR - three periods 5%'''</span>
 
A project requires an investment today of $100m, with $5m being receivable one year from now, a further $5m two years from now, and $105m three years from now.
 
The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
 
 
[[PV]] of Time 0 outflow $100m
 
= $(100m)
 
 
PV of Time 1 inflow $5m
 
= $5m x 1.05<sup>-1</sup>
 
= $4.76m
 
 
PV of Time 2 inflow $5m
 
= $5m x 1.05<sup>-2</sup>
 
= $4.54m
 
 
PV of Time 3 inflow $105m
 
= $105m x 1.05<sup>-3</sup>
 
= $90.70m
 
 
NPV = - $100m + $4.76m + $4.54m + $90.70m
 
= '''$0'''.
 
 
== Project decision making with IRR ==
 
 
Target or required IRRs for ''investment'' are set based on the investor's [[weighted average cost of capital]], appropriately adjusted for the risk of the proposal under review.
 
In very simple IRR investment project analysis the decision rule would be that:
 
(1) All opportunities with above the required IRR should be accepted.
 
(2) All other opportunities should be rejected.
 
 
However this assumes the unlimited availability of further capital with no increase in the cost of capital.
 
 
A more refined decision rule is that:
 
(1) All opportunities with IRRs BELOW the required IRR should still be REJECTED; while
 
(2) All other opportunities remain eligible for further consideration (rather than automatically being accepted).
 
 
For ''borrowing'' or ''funding'' opportunities, the appropriate comparator rate is the organisation's cost of borrowing, for borrowings of comparable risk.
 
The IRR decision rule for evaluating borrowing opportunities is the opposite of that for investments, as described above.
 
For borrowing opportunities, a ''lower'' IRR indicates a potentially more cost-effective borrowing, that warrants further consideration.
 
 
== Excel's =IRR() function ==
 
Excel's =IRR() function returns the IRR for a block of cells within a single row or column, specified as a range.
 
 
<span style="color:#4B0082">'''Example 5: =IRR() function'''</span>
 
Cell A1 contains -100.
 
Cell A2 contains 110.
 
=IRR(A1:A2)
 
will return '''10%'''.
 
(This is the result we saw in Example 1 above.)
 
 
== Determining IRR manually ==
 
Unless the pattern of cash flows is very simple, it is normally only possible to determine IRR manually by trial and error (iterative) methods.
 
 
<span style="color:#4B0082">'''Example 6: Straight line interpolation'''</span>
 
Using straight line interpolation and the following data:
 
First estimated rate of return 5%, positive NPV = $+4m.
 
Second estimated rate of return 6%, negative NPV = $-4m.
 
The straight-line-interpolated estimated IRR is the mid-point between 5% and 6%.
 
This is '''5.5%'''.
 
 
Using iteration, the straight-line estimation process could then be repeated, using the value of 5.5% to recalculate the NPV, and so on.
 
The IRR function in Excel uses a similar trial and error method.




== See also ==
== See also ==
* [[Compound Annual Growth Rate]]
* [[3i]]
* [[Cost of capital]]
* [[Alternative Credit Council]] (ACC)
* [[Cost of debt]]
* [[Association for Financial Markets in Europe]] (AFME)
* [[Discount]]
* [[Business angel]]
* [[Discount rate]]
* [[Capital markets union]] (CMU)
* [[Discounted cash flow]]
* [[Co-investment]]
* [[Effective interest rate]]
* [[Entrepreneur]]
* [[Funding]]
* [[Equity]]
* [[Hurdle rate]]
* [[General partner]]
* [[Implied rate of interest]]
* [[Industry agnostic]]
* [[Incremental borrowing rate]]
* [[Limited partner]]
* [[Interest rate implicit in a lease]]
* [[Liquidity event]]
* [[Interpolation]]
* [[Listed company]]
* [[Investment appraisal]]
* [[Listing]]
* [[Iteration]]
* [[PIPE]]
* [[Linear interpolation]]
* [[Private]]
* [[Market yield]]
* [[Private equity house]]
* [[Net present value]] (NPV)
* [[Taking private]]
* [[Opportunity cost]]
* [[Trade sale]]
* [[Payback period]]
* [[Venture capital]]
* [[Present value]] (PV)
* [[Profitability index]]  (PI)
* [[Return on investment]]
* [[Shareholder value]]
* [[Time value of money]]  (TVM)
* [[Total shareholder return]]  (TSR)
* [[Weighted average cost of capital]]
* [[Yield]]
* [[Yield to maturity]]


[[Category:The_business_context]]
[[Category:Corporate_finance]]
[[Category:Investment]]
[[Category:Investment]]
[[Category:Long_term_funding]]
[[Category:Long_term_funding]]
[[Category:Cash_management]]
[[Category:The_business_context]]
[[Category:Financial_products_and_markets]]
[[Category:Liquidity_management]]
[[Category:Trade_finance]]

Revision as of 03:47, 6 February 2024

1.

Equity and other forms of capital for privately owned firms with high growth potential.


2.

Firms or individuals who make investments in such firms, sometimes abbreviated to PE.


3.

The equity of a privately owned company.


See also

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