Linking DCF to IRR analysis

Hi guys,

I need a help!

i just finished building my dcf model. My boss asked me what is the IRR return?
How can i calculate that?
the purpose of my DCF model is to find out how much i should pay for that company. but i dont know how to figure the IRR return.

is the Cost of the equity is the IRR return?

or i should do a separate IRR analysis? if i need to do a separate IRR analysis, what is the input?

should i just take the exit multiple times terminal ebitda? and using my current entry price to figure out the irr analysis?

Thank you in advance.

 

i assume entry valuation will be the price i get using DCF model.

what about the exit? is it the terminal ebitda x whatever multiple that i am using?

so we disregard all the free cash flow in year 1 , 2 , 3 ,4 and 5?

isnt the required equity return is the IRR return?

thanks,

 
Best Response

Isn't it just the cost of equity you would have used to build your WACC?

Assuming they want to see the Equity IRR. The total company IRR would just be the WACC.

Thats assuming you actually enter at the valuation given by your DCF analysis.

So its saying: After coming up with a valuation of $X using Y% WACC, and cash flows in the following years of $A,$B,$C + terminal year cash flow of $Z, the WACC = Firm IRR (and the cost of equity used in WACC = Equity IRR).

 

Think the idea is to buy the company/entity for less than the value given by the DCF analysis, in which case IRR>0.

Although as people above have said, it doesn't really make sense to do an IRR calculation on a whole company acquisition (which is usually when DCF is used). IRR makes more sense when you have an exit horizon, ie LBO or any other type of financial investment.

The DCF valuation may help in determining the entry valuation of the investment, but unless there is an exit, IRR seems irrelevant.

 
F. Ro Jo:
You could project IRR for each purchase price... ie. negative figure at the start of DCF followed by positive (or negative, as the case may be) cash flows. Then you set up a sensitivity table to get an IRR for each price.
Thanks for clarifying.

Anyway, does it mean that: i) Equity IRR - Calculated based on Cash Flow to Equity ii) Company IRR - Calculated based on Cash Flow to the Firm

  • I would agree curlyarmstrong's point that IRR analysis is relevant if you have the view on the purchase & exit price. DCF normally I would use to determine the value of the company at the PV.

Please feel free to add or comment

 

This is a really common analysis and one of the most basic technical things you will do in PE. Obviously it's critical to have an idea of what your return will be before you make an investment.

You might have an assumed purchase price (or a range of prices) and a set of exit values implied by a range of EBITDA multiples, and you can calculate an IRR (and multiple of capital) for each one. You are interested in calculating the IRR for the security in which you're actually investing, which is typically the equity, though it could be mezz or senior or a combination of whatever. You need to come up with expected amounts for your initial investment(s), any interim cash dividends/interest/fees/etc and an exit value, and then computing the IRR with the built in excel function is trivial. Calculating the exit value may require building a "waterfall" of payouts that could be extremely complex depending on the capital structure of the company. If that's the case, you will be digging through legal documents for a few hours to figure out how proceeds are to be distributed.

You can sensitize or create scenarios based on entry multiple, revenue growth, margin growth, exit multiple, or anything else you can think of that's specifically relevant to your investment. It's extremely easy to do the calculations, but choosing how to sensitize and/or creating realistic scenarios to analyze requires a deep knowledge of the company/industry and good judgment.

I am wise because I know that I know nothing -Socrates
 

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