IRR and WACC Explanation and Application – Corporate Finance
People usually get confused between IRR (internal rate of return) and WACC (weighted average cost of capital). In this post, we will explain the difference between IRR and WACC.
IRR – Internal rate of return
IRR is the discount rate that makes NPV =0. IRR tells us the annualized rate of return for a given investment and is generally used by managers to determine the attractiveness of a project. For example, a manager might determine that a project that has an IRR of 25% is more attractive than a project that has an IRR of 20%. Though an easy way to determine and understand project attractiveness, IRR has a few issues.
IRR might not be reliable when there are negative cash flows in a project, leading to multiple IRR or no IRR. Negative cash flows can occur when a project requires the cash outflow such as construction of facilities that are built at different times in the future. Additionally, IRR does not account for discount rates that might change over time. Hence, it’s not appropriate for longer-term projects with discount rates that are expected to vary.
To calculate IRR, we can use formula, excel, financial calculator or extrapolation method.
IRR Formula:
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WACC – Weighted Average cost of capital
WACC is a calculation of a firm’s discount rate or cost of capital where the cost of capital used are proportionately weighted. Capital includes equity or debt where equity can include common stock or preferred stock whereas debt can include debentures, bonds, long term debt etc. Cost of capital includes dividend for equity and interest rate for debt.
Cost of equity can be calculated using CAPM or dividend yield + capital gain yield. Cost of debt can be calculated using yield to maturity.
To calculate WACC, you can use a WACC table.
WACC is used to discount the free cash flow in the company to find the valuation and stock price of the firm.
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