Confused about IRR
I'm a bit confused about IRR. I understand that it's a break-even rate, but am confused as to why it's considered a rate of return similar to ROI. Does IRR tell you what the actual estimated rate of return is going to be given a certain set of cash flows? Or does it simply tell you the rate of return at which you would break even? When people say they use IRR for a project's rate of return, is the IRR their actual estimate for the return on the project?
I'm just trying to understand it intuitively -- thank you!
In Accademic finance IRR is such that NPV=0=SUM(CFn/(1+IRR)^n). This is effectively the break even rate that can be used to calculate the floor value in an LBO with a set IRR
In real life IRR is : Value at Entry = Value at Exit / (1+IRR)^Holding period. This is the IRR of a PE shop after they are done with their investment - effectively the yearly compounded ROI.
EDIT: in the second case, I am assuming only one cashflow (sale of the PortCo), so no dividends, dividends recap to simplify things.
It may help to think of IRR as the simplest form of return. It is absolute, while other concepts like NPV are relative to hurdle rate. IRR has no regard for what your rate of return should be.
It's just the % of your investment you get back per year. If I invest a dollar and end up with $1.20 a year later, my IRR is 20%. Notice how there's no discussion of hurdle rate, breakeven or anything like that. Its just the absolute dollar return per year.
NPV is effectively a judgment on whether your IRR is good enough given the rate you should earn. I think that's the "breakeven" concept you refer to. So again lets say I invest a dollar and end up with $1.20, but it was a very risky project. Maybe the hurdle rate was 30%, lets say, because the project was so risky that it needed a high return potential to compensate for the risk. My IRR is still 20%, but my NPV is negative because I'm discounting that $1.20 cash flow at 30% and the present value is now less than the dollar I invested.
Real life example: typical LBO situations expect IRR of at least 20-25% because LBOs are generally pretty risky with all the debt involved. So if you build an LBO model that shows an IRR of 10%, that's still a real return in dollars. It's 10% per year in absolute terms. But its also a no-go, because the appropriate discount rate is probably around 20-25% and thus your 10% IRR will yield a negative NPV.
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