IRR Vs WACC

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Cuong Nguyen 02133524

BUS 212
David Plisco
May 12, 2015
Difference between WACC and IRR
Investment analysis and cost of capital are two of the most important aspects
of financial management. We have my investment analysis tools and techniques
that are used to evaluate the profitability and feasibility of a project. Cost of capital
aims to explore the various sources of capital and how costs are calculated. Its also
used together with investment appraisal techniques to come up with the viability of
projects. Lets takes a closer look at IRR (internal rate of return) and the concept of
weighted average cost of capital (WACC), and when to use them appropriately.
IRR, sometimes referred to as "economic rate of return (ERR), is a financial
analysis tool thats used mainly to determine the attractiveness of a particular
project or investment. Its also used to choose between possible projects or
investment opportunities 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 other words, IRR is the rate of growth that an
investment is estimated to generate. It is true that an investment might actually
generate a rate of return that is different to the estimated IRR. When an investment
with a relatively higher IRR, its more likely would end 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
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two projects that have different IRR numbers it is best 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 firms 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.
The formula IRR can be very complex depending on the timing and variances
in cash flow amounts. One of the disadvantages of using IRR is that all cash flows
are assumed to be reinvested at the same discount rate, although in the real world
these rates will fluctuate, particularly with longer term projects. IRR can be useful,
however, when comparing projects of equal risk, rather than as a fixed return
projection.
WACC (Weighted Average Cost of Capital) is a bit more than just the cost
of capital. WACC is the expected average future cost of funds and is calculated by
giving weights to the companys debt and capital in proportion to the amount in
which each is held (the firms 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 T)
E is the market value of equity and D is the market value of debt and V is the total
of E and D.
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Re is the total cost of equity and Rd is the cost of debt. T is the tax rate applied to
the company.
A company's assets are financed by either debt or equity. WACC is the

average of the costs of these sources of financing, each of which is weighted
by its respective use in the given situation. By taking a weighted average, we
can see how much interest the company has to pay for every dollar it
finances.
A firm's WACC is often used internally by company directors to
determine the economic feasibility of expansionary opportunities and
mergers. It is the appropriate discount rate to use for cash flows with risk
that is similar to that of the overall firm
When do we use which? 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. Another use of IRR is in the computation of
portfolio, mutual fund or individual stock returns. In most cases, the advertised
return will include the assumption that any cash dividends are reinvested in the
portfolio or stock. Therefore, it is important to scrutinize the assumptions when
comparing returns of various investments. 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 projects rate of return is
greater than the cost of the capital that was invested and should be accepted.
Securities analysts employ WACC all the time when valuing and selecting
investments. In discounted cash flow analysis, for instance, WACC is used as the
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discount rate applied to future cash flows for deriving a business's net present
value. It also plays a key role in economic value added (EVA) calculations.
Investors use WACC as a tool to decide whether to invest. The WACC
represents the minimum rate of return at which a company produces value for its
investors. By contrast, if the company's return is less than WACC, the company is
shedding value, which indicates that investors should put their money elsewhere.
WACC serves as a useful reality check for investors, and they should know the
meaning of WACC when they see it in brokerage analysts' reports.

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Cuong Nguyen 02133524

A company's assets are financed by either debt or equity. WACC is the

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