Our advisors would like to use this simple IRR instead of the ones I am used to. Am I using year 5 net income for the money returned portion of the formula? Am I using the net income of each 5 years added together? Am I using the year 5 valuation?
An IRR incorporates all distributions, including the distribution resulting from the sale of the company (which I think you're mentioning as the "year 5 valuation").
So "Year 0" is the initial equity investment. In subsequent years, include whatever you project that you will distribute to your investors out of operating profits (and if more capital is needed, you'll need to include that as well). Then your exit proceeds (projected valuation, less debt and sale costs/fees) need to be added to the operating cash flow distribution in the year you're projecting (I'm assuming Year 5 based on your post).
Then you can use the simple IRR function to show your IRR incorporating all cash flow.
If you're doing a quarterly or monthly projection, the xIRR function is the easiest. But you can also use =((1+irr(range))^(1/4))-1 for quarterly. Substitute (1/12) for (1/4) for monthly.
IRR depends on actual cashflows and this approach seems faulty. However as the advisors want to see it in their format, my advice is to show whatever comes closest to the FCFE (cash flow to equity). if there arent equity cashflows u can use the cash flow to firm.. or Ebitda.. bascially be as close to cash as possible. A sum of whatever u choose over five years would be fine.
Chad Buchanan's answer is good and comprehensive.
I would add that if the investor wants an 'investor IRR', keep in mind that the cash flows used to calculate IRR need to reflect any terms specific to that investor, such as liquidation preferences.
Since your question mentions 'simple', I assume that won't be a factor here, but it's worth mentioning in case those terms exist.
Hey Laura, can you give a little more context about the situation... Is this focused on a particular project our is it buyout of your company? Whats the stage of your company (e.g. Series B software startup, etc)?
Generally speaking if they are looking at IRR I assume its a later stage (not venture) investor. Without knowing more info I'd do the following formula and target around 20%+ IRR:
(exit year equity proceeds / initial equity value) ^ (1 / number of years to exit) -1
So I wouldn't look at net income. I'd also be careful to specify what we're talking about when you say "valuation." For example if we assume you're starting with zero cash then initial equity value is your enterprise value (EV) less any debt on the balance sheet. Exit year equity is the exit EV plus the cash you've generated in the business since year 0 of that investment. Hope that helps!
Chad Buchanan answer is really comprehensive. Plus what you have written in your statement is not correct. You had stated net income, The IRR is based on the free cash flow of the projects + the exit amount of the project (Which is normally the earnings multiples based on your industry type earnings) which Chad wants to explain to you.
You can use the net income approach but in that case, you are assuming that there are no debts and receivables. People use to do that to make the calculations fast by using the yearly PL so once you have finalized the PL figure you don't need the free cash flows and you can use the EBTDA (stricter version) to calculate it the same. (As suggested by Abhijeet)
This Chad statement include whatever you project that you will distribute to your investors out of operating profits
This statement of chad is explaining that if you would like to work out the IRR for the individual investor. Let's suppose you are an accountant of one investor who only has 20% of the interest in the project then you only consider that dividend amount when you are calculating the IRR of that investor but if you are calculating the IRR of the full project then you need the full free cash flows. Dividends are always paid from free cash flows
This Chad statement (and if more capital is needed, you'll need to include that as well).
If this would be the case then the calculation scenario would be totally different and it would no longer remain the simple IRR. Normally the simple IRR comprise of one-off cash injection in the project.
Basically IRR, or internal rate of return is used as a threshold in which to judge the worthiness of a project. It is not the calculation of a forward-looking return that is NPV.
Formulas are already provided by chad.
Any Query ping me.
Calculate through trial and error the rate that will make cash inflow equal to cash out flow.It is simple compared to others.
eg buy machine $ 1000, and wish to recoup cash in 4 yrs, then IRR will be