Investment Banking: How to Calculate Internal Rate of Return - dummies

Investment Banking: How to Calculate Internal Rate of Return

By Matt Krantz, Robert R. Johnson

Rates of return are central concepts in the investment banking world. Investors often compare their performance to that of other investors, other investments and stock indexes by comparing rates of return. In the private equity world, rates of return are calculated by computing the internal rate of return (IRR) of an investment.

The IRR is simply defined as the discount rate (or rate of return) that equates the present value of the projected costs (cash outflows) of an investment with the present value of the projected cash inflows from the investment. Another way of looking at IRR is that it’s the interest rate that equates the present value of all cash flows to zero.

To compute the IRR of an investment, you simply solve for the term IRR in the following equation:

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For instance, if an investment required an initial cash outlay of $100 million the projected cash flows were $30 million in each of the next three years and $150 million four years from today, the equation for calculating the IRR is:

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In this case, the IRR for this investment is 33.1 percent. Not a bad rate of return. (By the way, IRR can be computed using any standard financial calculator or via an Excel spreadsheet.)

Expected returns for private equity deals are substantially higher than expected returns in the public equity markets. This reflects the fact that private equity deals are generally riskier than public equity investments on several fronts. They’re generally much more highly leveraged than public companies, and they’re less liquid than investment in public equities. Thus, to induce investors to commit funds to private equity, they must expect higher returns.

The exact percentage returns expected by private equity investors varies widely depending upon market conditions. For instance, when long-term U.S. government bonds are yielding 6 percent to 8 percent and publicly traded stock returns are in the 10 percent to 12 percent range, it would not be uncommon for LBO investors to expect returns in excess of 20 percent, perhaps in the mid 20 percent range.

But if expected returns on other asset classes in the market are much lower, returns expected by private equity investors will generally be commensurately lower. The expected returns in the private equity markets are largely influenced by a combination of current market conditions and investors’ appetites for risk.