IRR vs WACC
I'm unsure if this is the right forum to be discussing this but would anyone be able to explain the following?
If the discount rate of a project you undertake is actually equal to its IRR, then won't the NPV of the project be zero and if that is the case doesn't that mean the rate of return is equal to the cost of capital?
Why is a project profitable if the IRR is greater than the WACC? Firstly it is a expected rate of return required not a guarantee rate when you do the project. Secondly if you do achieve the IRR doesn't that just mean your present value of future cash flows will be equal to the cost so how is the project profitable or NPV positive?
I believe that I am misunderstanding something here and would like to seek clarity on it.
Think your problem is you need to split the concept of IRR and WACC from each other. Your WACC is independent of the project or its projected return... IRR is the rate at which the NPV would be 0 if that rate was equal to the WACC. Think of the WACC as your cost, so to speak. So if the IRR is higher than the WACC the project is profitable because the rate of return exceeds the rate of the "cost".
As you said IRR is the rate at which NPV would be 0, it is the expected rate required not what is guaranteed when you undertake the project right?
If the IRR is the rate at which NPV would be 0, doesn't that mean it has to be equal to the WACC that is the cost of the project?
I understand that if IRR is greater than WACC, that means NPV is positive, but if IRR is suppose to be the rate at which NPV is zero, how can NPV be positive?
Think of the IRR as an output, not an input. It's the return of the project based on the cash flows, it's only expected return when it's a projection then once the project ends it's an actual rate.
NPV can be positive because IRR isn't the discount rate (that's the WACC), it's the return rate that's calculated. While you can calculate IRR by finding the rate where NPV equals 0, that doesn't mean in reality the IRR is the correct rate to discount at.
In finance—generally speaking—you can intuitively imagine IRR as a "theoretical rough estimate" of your "profit/return–percentage" that would accrue from having a set of cash flow projections become a reality. WACC is apparently an "objective BENCHMARK" for what counts as a MINIMUM-acceptable return on investment (hence the mathematical gymnastics implied by its formula). In summary, WACC counts as the bare minimum that makes an investment "worth it" (relative to "turning your brain off"—and just buying"risk-free" debt & the estimated "average/random" widely-available equity, as it were). IRR for a special project has to go HIGHER than this threshold in order to make it worth any investors' time (why engage in an investment (with sub-par IRR) when you could use your private/personal money to "effortlessly" invest in easily-available public debt/equity to get WACC-level RETURNS without exceptional risk?)
Imagine you’re a PE firm. Your target IRR is basically your cost of equity because by definition cost of equity is the return an equity investor require from an investment and the IRR you underwrite is the required return you’d like.
If the deal has no debt, then the WACC is your IRR. If there deal is leveraged, then the WACC is lower than your IRR.
echo the above, but lets dumb it down a bit more.
Think you’re getting IRR and DCFs and WACC confused. WACC is used in DCFs to discount cash flows in order to account for the time value of money and put those cash flows in todays dollars. You’re not backsolving to determine WACC. It’s calculated before you start discounting the CFs. IRR is used to determine the average annualized return of a project, and the way of doing that is by figuring out which rate will cause those positive future cash flows to equal todays investment, aka NPV is zero because the investment today is negative CF. You backsolve to get IRR. In short, WACC is predetermined, IRR is found.
The easiest way to think about this is to think of IRR as payoff and WACC as cost. If it cost you $1 to make $1 (or the present value equivalent of that) then your return is 0. Any IRR in excess of the WACC is positive to your return by the amount of the difference.
Of course in practice WACC is determined while IRR is probabilistic, so theoretically you’d demand an IRR in excess of WACC plus some buffer determined by the expected variance of your IRR probability.
People have said it a few times, but they are not related. A WACC is the costs associate with a deal, and IRR is the return you get on the deal. To simplify it, if you took out a loan from a bank at 5% interest rate because you think you can invest extremely well and want to increase your investment size, you wouldn't put it into a bond that paid out 5% or less, because you would AT BEST pay those interest payments from the bond straight to the bank, and at worst you'd give the interest payments to the bank and then some more out of your pocket. However, if the bond was 15%, then you would take those interest payments and pay back the bank every month and keep a nice profit.
In that situation, the IRR is the interest from the bond and the interest from the loan is the WACC. If the return you get from an investment is the same as the cost of capital, then it's a wash and there wasn't a point in doing it. But if the return is at least slightly higher then you'll be profitable.
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