Teaching Notes sessions no.

Project IRR and Equity IRR

The internal rate of return (IRR) is defined as the rate of return that makes the net present value
(NPV) of all cash flows equal to zero.

Calculation of the internal rate of return considering only the project cash flows (excluding the
financing cash flows) gives us the project IRR.

Consider a project with construction cost of $ 1,000,000 and annual rental income of $ 120,000.
Assume the property will be sold in the 10 th year for $ 1,607,023. We can construct the project cash
flows and calculate the project IRR by using the Excel IRR formula as under:-

Equity IRR

Calculation of the internal rate of return considering the cash flows net of financing gives us the
equity IRR. It means the project is funded by a mix of debt and equity. If the project is fully funded by
equity, the project IRR and Equity IRR will the same. If the project is fully funded by the debt, equity
IRR simply doesn’t exist.

Now consider the same example again. Assume 30% of the project cost is funded by the equity and
remaining 70% by the debt. Assume the cost of equity to be 14% and the cost of debt 8%. The
weighted average cost of capital (WACC) will be 9.8%. Note that the weighted average cost of
capital will not affect equity IRR. It is only the cost of debt which matters. Assume the term of debt is
10 years.

We can construct the project cash flows and calculate the Equity IRR by using the Excel IRR formula
as under:-