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IRR vs WACC in modern financial industry.

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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.

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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