WACC vs IRR
Investment analysis and cost of capital are two important sections of financial management. Investment analysis introduces a number of tools and techniques that are used to evaluate the profitability and feasibility of a project. Cost of capital, on the other hand, explores the various sources of capital and how costs are calculated, and are used together with investment appraisal techniques to determine the viability of projects. The following article takes a closer look at IRR (internal rate of return – a technique in investment appraisal) and the concept of weighted average cost of capital (WACC). The article clearly explains each, how they are calculated and points out the close relationship between the two.
What is IRR?
IRR (Internal Rate of Return) is a tool used in financial analysis to determine the attractiveness of a particular project or investment, and can also be used to choose between possible projects or investment options that are being considered. IRR is mostly used in capital budgeting and makes the NPV (net present value) of all cash flows from a project or investment equal to zero. In simple, IRR is the rate of growth that a project or investment is estimated to generate. It is true that a project might actually generate a rate of return that is different to the estimated IRR, but a project that has a comparatively higher IRR (than the other options being considered) will have a greater chance of ending up with higher returns and stronger growth. In instances in which the IRR is used to make a decision between accepting and rejecting a project, the following criteria must be followed. If the IRR is equal to or greater than the cost of capital the project should be accepted and if the IRR is less than the cost of capital the project should be rejected. These criteria will ensure that the firm earns at least its required return. When deciding between two projects that have different IRR numbers it is desirable to pick the project that has the highest IRR.
IRR can also be used to compare between rates of return in financial markets. If the firm’s projects do not generate an IRR higher than the rate of return that can be obtained by investing in the financial markets, it is more profitable for the firm to reject the project and make an investment in the financial market for a better return.
What is WACC?
WACC (Weighted Average Cost of Capital) is a bit more complex than the cost of capital. WACC is the expected average future cost of funds and is calculated by giving weights to the company’s debt and capital in proportion to the amount in which each is held (the firm’s capital structure). WACC is usually calculated for various decision making purposes and allows the business to determine their levels of debt in comparison to levels of capital. The following is the formula for calculating WACC.
WACC = (E / V) × Re + (D / V) × Rd × (1 – Tc)
Here, E is the market value of equity and D is the market value of debt and V is the total of E and D. Re is the total cost of equity and Rd is the cost of debt. Tc is the tax rate applied to the company.
IRR vs WACC
WACC is the expected average future cost of funds, whereas IRR is an investment analysis technique that is used to decide whether a project should be followed through. There is a close relationship between IRR and WACC as these concepts together make up the decision criteria for IRR calculations. If the IRR is greater than WACC, then the project’s rate of return is greater than the cost of the capital that was invested and should be accepted.
Summary:
Difference Between IRR and WACC
• IRR is mostly used in capital budgeting and makes the NPV (net present value) of all cash flows from a project or investment equal to zero. In simple, IRR is the rate of growth that a project or investment is estimated to generate.
• WACC is the expected average future cost of funds and is calculated by giving weights to the company’s debt and capital in proportion to the amount in which each is held (the firm’s capital structure).
• There is a close relationship between IRR and WACC as these concepts together make up the decision criteria for IRR calculations.