Unlevered IRR in DCF

Ah, diving into the nitty-gritty of DCF, are we? Let's swing through the jungle of financial modeling together!

When you're calculating the IRR in the context of a DCF, you're looking to find the rate of return that sets the net present value (NPV) of all cash flows (including the terminal value) to zero. Here's how you'd typically approach it:

• Unlevered Free Cash Flow (FCF): You should run the IRR analysis using the unlevered FCF. This is because unlevered FCF represents cash flows before the impact of debt financing, giving you a clearer picture of the performance of the underlying business.

• Discounting: The IRR is calculated using the actual cash flows, not the discounted ones. You're essentially looking for the discount rate at which the present value of cash flows equals the initial investment.

• Terminal Value: The terminal value represents the value of the company at the end of the explicit forecast period and is a critical part of the DCF. It can be calculated using two main methods:

  • Perpetuity Growth Method: Here, you assume the company will grow at a steady rate forever. You calculate the terminal value by taking the final year's unlevered FCF, multiplying it by (1 + the perpetual growth rate), and then dividing by the difference between the discount rate (WACC) and the perpetual growth rate.
  • Exit Multiple Method: This method involves applying an industry-appropriate multiple (like EV/EBITDA) to a financial statistic of the final forecasted year (usually EBITDA).

• Inclusion of Terminal Value in IRR: To include the terminal value in the IRR calculation, you add it to the cash flow of the final year of your projection period. If you're using the perpetuity growth method, you'll also need to discount the terminal value back to its present value as of the start of the projection period.

Remember, the IRR you calculate will be the unlevered IRR since you're using unlevered FCF. If you were to consider the effects of financing (debt), you'd be looking at the levered IRR, which includes the cost of debt and thus is typically higher.

Now, don't forget to swing through the sensitivity analysis to see how changes in assumptions like the discount rate or perpetual growth rate affect your IRR. It's a jungle out there, and you want to be prepared for every scenario!

Sources: Corp Dev LBO returns question: Levered and Unlevered IRR, Walk me through a DCF, Rough mental return calculations?, DCF Modeling Course ~ Pre-training text.pdf, Is there an ideal spread between Unlevered and Levered IRRs?