Interview question on IRR
Why consider both the Cash on Cash multiple and the IRR when evaluating investment performance? 💰
Today we study a classic interview question in Private Equity, Venture Capital and M&A. Before we dive into the answer, let’s review some fundamental concepts.
👉 The internal rate of return (IRR) is defined as the discount rate that makes the net present value (NPV) of an investment project equal to zero.
Note: The Net Present Value of an investment project represents the sum of all its inflows and outflows, discounted to present value.
👉 But when we take a little distance with this formula straight from the finance courses. We understand that IRR should be seen primarily as the average annual growth rate of the equity value in the investment project.
the concept, let’s consider only two cash flows:
- The initial investment
- A positive cash flow at exit, which represents the value of the securities sold at the end of the investment.
In this case, the IRR is calculated as follows:
IRR = (Exit Eq.V / Entry Eq.V)^(1/N) – 1
Eq.V: Equity Value (at entry or exit of the investment)
N : Number of years of investment
By looking at IRR from this perspective, it provides a clearer understanding of the investment goals of funds and the performance of an investment.
The IRR therefore serves as a gauge for the annual growth of the invested capital.
The Cash on Cash multiple, on the other hand, is calculated as: Multiple CoC = (Exit Value / Initial Value)
When we step back from the formula, we can see that:
IRR = (Multiple CoC)^(1/Number of Years) – 1
⌛So by incorporating the number of years into the calculation, IRR provides additional information: the notion of time in the investment.
Generally, the Cash on Cash multiple is less informative than the IRR as it doesn’t take into account the length of the investment.
💰 The Cash on Cash multiple only measures the return, ignoring the time factor.
Therefore, a 2x multiple may be attractive on a 3-year investment but much less so on a 50-year investment.
However, the multiple can still be useful for short-term investments. The IRR may appear high over a period of 6 months or 1 year, but the multiple provides a more nuanced view of the investment’s performance.
Both indicators complement each other as the multiple does not account for the time aspect of the investment, whereas the IRR may be too sensitive to time considerations over short periods.
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