The Importance of the Internal Rate of Return Calculation in Allocating the Fair Value of a Purchased Entity

Business Advisors|Business Valuation

By Christy Samek

An internal rate of return (IRR) calculation can be very useful in terms of evaluating whether or not to make an investment in equipment, or even in a business. This calculation is helpful in identifying whether or not the investment will yield a return that warrants the investment. However, there is another application of this calculation that is helpful: confirming the assumptions used in allocating the fair value of a business that was purchased. 

Accounting standards require that a company allocate the fair value of a purchased entity to the assets and liabilities purchased. An IRR calculation should be used to test underlying assumptions that are used in the calculation of the value of the intangible assets that were purchased, such as customer relationships, contract value, trade names, etc. Assumptions that can be tested by the IRR calculation include: projections, discount rates and whether or not the purchase price is the same as the fair value of the entity that was purchased. (In most instances, the fair value will be the purchase price; however, there may an instance in which a company overpaid or underpaid for a company.)

For example, if the IRR is 14% for a certain transaction and the weighted average cost of capital (discount rate) for this type of entity with similar business risks is 19%, then something is wrong in this analysis. It could indicate that the purchase price was too high, or it could indicate that the purchased company is actually expecting higher projections than were used in the IRR analysis. One possible scenario is that the purchased company might have a product that it thinks can generate significant sales, but there are no historical sales on which to base the projections for this product, and the projections are understated. All of those factors need to be addressed to determine the correct IRR analysis. 

The IRR calculation could also show the reverse situation, where the discount rate for this type of entity with similar business risks is 10% while the IRR calculation indicates that the return on the transaction will be 14%. This instance might indicate that Company Y got a great deal in purchasing Company X and might need to record a gain upon acquisition, or it may indicate that the projections are overstated. 

The fair value of a company, the projections and the discount rate are all very important assumptions in calculating the value of the intangible assets that were purchased. The IRR calculation is fundamental in determining whether or not the assumptions used in the calculation of the fair value to assign to the assets are reasonable assumptions. 

If you need assistance in the valuation of intangible assets, let Schneider Downs help you. Please contact Christy Samek of Schneider Downs at csamek@schneiderdowns.com.

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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