What Does Internal Rate of Return (IRR) Mean?
The internal rate of return (IRR) is the rate at which the net present value (NPV) of a project's cash inflows and outflows, measured over the project's life, equals zero. This IRR that yields a net present value of zero is also called the discount rate in the NPV calculation.
Divestopedia Explains Internal Rate of Return (IRR)
Strategic and financial buyers use the internal rate of return as one of the primary measures to assess the attractiveness of an investment. Sophisticated buyers look for a minimum IRR of 25% for their investment in mid-market companies due to the risk and more limited liquidity options available.
Using a simple calculation, investors would need to triple the value of their investment over 5 years in order to earn at 25% IRR. Therefore, if a $10 million equity investment is made, the investor would need to realize $30 million after five years in order to realize the target IRR of 25%.
A 25% IRR target is not easy to achieve. Therefore, some investors use debt to amplify the IRR on investments since debt reduces the amount of equity required in a deal. However, a highly leveraged investment runs the risk that its cash flow may not be able to service the debt's principal and interest requirements. Therefore, smart investors should always weigh the realization of a higher IRR vs. the additional risk that results from adding debt to realize such high IRR.