Investment Banking by Pearl Joshua Rosenbaum Joshua & Joshua Pearl

Author:Pearl, Joshua, Rosenbaum, Joshua & Joshua Pearl
Language: eng
Format: epub
ISBN: 9781118715864
Publisher: Wiley
Published: 2013-05-07T16:00:00+00:00

ECONOMICS of LBOs

Returns Analysis—Internal Rate of Return

Internal rate of return (IRR) is the primary metric by which sponsors gauge the attractiveness of a potential LBO, as well as the performance of their existing investments. IRR measures the total return on a sponsor's equity investment, including any additional equity contributions made, or dividends received, during the investment horizon. The IRR approach factors in the time value of money—for a given amount of cash proceeds at exit, a shorter exit timeline produces a higher IRR for the sponsor. In contrast, if the investment proceeds take longer to realize, the IRR will decrease.

IRR is defined as the discount rate that must be applied to the sponsor's cash outflows and inflows during the investment horizon in order to produce a net present value (NPV) of zero. Although the IRR calculation can be performed with a financial calculator or by using the IRR function in Microsoft Excel, it is important to understand the supporting math. Exhibit 4.4 displays the equation for calculating IRR, assuming a five-year investment horizon.

EXHIBIT 4.4 IRR Timeline

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