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Home > Mergers and Acquisitions Checklists > Using IRR for M&A Financing

Mergers and Acquisitions Checklists

Using IRR for M&A Financing


Checklist Description

This checklist considers the strengths and weaknesses of using the internal rate of return as a yardstick when financing mergers and acquisitions.

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Definition

Also known as the economic rate of return, the internal rate of return (IRR) is an indication of the level of growth that can be expected from a project or acquisition. The calculation generates a percentage figure by comparing the value of the proposal’s cash outflows with its cash inflows as they vary over the lifetime of the investment.

IRR is frequently used to help assess the outright viability of a project or acquisition by taking into account the cost of capital or the investor’s required rate of return. The latter is sometimes referred to as the hurdle rate and is frequently adjusted to take into account the risk levels of different projects.

Acquisitions that are expected to generate returns greater than the cost of capital or the required rate of return are generally accepted, with those falling short typically rejected. IRR is also regularly employed as a means of comparing the expected returns from a number of alternative options, helping to steer investment toward the venture that offers the prospect of the highest returns. In practice, the returns from projects or acquisitions can differ substantially from the levels predicted by the IRR calculation, but the method has retained favor among many potential investors looking for a tool to help decide between alternative investment options.

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Advantages

  • IRR generates a relatively simple percentage figure for a project. The method provides a quick and easy way to assess the viability of a project by comparing the projected IRR with the company’s risk-adjusted hurdle rate. IRRs can also help investors to select between various options.

  • The practical value of the IRR calculation is further underlined by the fact that the calculation takes into account all cash flows, subject to discounting for time.

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Disadvantages

  • The IRR method does not take into account possible changes in interest rates during the lifespan of the venture. Such changes could significantly alter a company’s required hurdle rate given the potential impact on the firm’s cost of capital. For short-term projects this limitation can often be overlooked, but the large scope for movements in interest rates over the lifespan of a 10-year project is considerable, compromising the value of the IRR for longer-term projects.

  • IRR can sometimes be confused with return on capital employed, as both calculations express results in percentage terms. Care needs to be taken to differentiate between these cash-based and profit-based methods.

  • The IRR calculation is based on a presumption that cash generated during the project is subsequently put to work to generate the same return as the average IRR over the lifetime of the project. Although this reinvestment is entirely feasible, in practice reinvested cash often generates lower subsequent returns.

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Action Checklist

  • To calculate the IRR, we need to establish the various parameters at which the net present value (NPV) of a proposed M&A deal is zero (i.e. the exact level at which the proposed venture is neither a winner nor a loser in dollar terms).

  • Typically, this involves guessing a projected rate of return, r, from the investment, and then performing the following calculation:

NPV = (Initial investment + 1st year’s income) ÷ (1 + r)2 + 2nd year’s income ÷ (1 + r)2 + 3rd year’s income ÷ (1 + r)3+ …

  • Should the resulting NPV figure be positive, the calculation is then repeated using a lower value of r. If the NPV is negative, a larger r is used. Clearly, the operation is more efficiently performed using a computer spreadsheet than by hand.

  • After repeated calculations, a level of r that generates a NPV of zero will be established. This equates to the projected IRR of the deal.

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Dos and Don’ts

Do

  • Consider the possibility that any merger or acquisition could involve risks that are difficult or impossible to foresee. To help compensate for such uncertainties, consider how much of a premium a project’s IRR should have over the cost of funding.

  • Remember that the IRR methodology can accommodate variations in projected annual incomes from proposed deals but does not offer the facility to model changes in funding costs throughout the lifespan of the deal. This can be a major drawback for longer-term project calculations.

Don’t

  • Don’t interpret IRR as the be all and end all of project financing. Recognize its uses, but at the same time understand its limitations.

  • Don’t ignore the costs and expenses involved in the acquisition process. Care should be taken to evaluate the costs in terms of management time and resources, as well as in purely financial terms.

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Further reading

Books:

  • Reed, Stanley F., Alexandra R. Lajoux, and H. Peter Nesvold. The Art of M&A: A Merger Acquisition Buyout Guide. 4th ed. New York: McGraw-Hill, 2007.
  • Siegel, Joel G., and Jae K. Shim. Accounting Handbook. 5th ed. Hauppauge, NY: Barron’s Educational Series, 2010.

Articles:

  • Hartman, Joseph C., and Ingrid C. Schafrick. “The relevant internal rate of return.” Engineering Economist 49:2 (2004): 139–158. Online at: dx.doi.org/10.1080/00137910490453419
  • Steele, Anthony. “A note on estimating the internal rate of return from published financial statements.” Journal of Business Finance and Accounting 13:1 (March 1986): 1–13. Online at: dx.doi.org/10.1111/j.1468-5957.1986.tb01169.x

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