How to use WACC for IRR Analysis?
The Weighted Average Cost of Capital (WACC) is a method of estimating the cost of capital for an asset or a company, representing the opportunity cost of capital. The cost of capital includes both the cost of equity and debt. They are weighted by the company’s financing structure when calculating the WACC. While the WACC is mainly used as the Discount Rate in Discounted Free Cash Flow Analysis, it can also be used as a benchmark figure in analyzing the expected Internal Rate of Returns (IRRs) in investment analysis.
The WACC is primarily a measure of risk. Expressed as a percentage annual return figure, it reflects the required return for the asset or company risk. Therefore, each company shows a different risk profile and will have a different WACC. WACC analysis uses stock market research from the capital markets which allows for a quantification of investor risk. The riskier an investment, the higher the resulting WACC and vice versa. Higher risk asks for higher returns.
Please refer to this article for further details on how to calculate WACC.
The Internal Rate of Return (IRR) is an annual return estimation based on a project’s expected future free cash flow. Calculating IRR allows to compare investment projects of all sizes and rank them by their expected returns. This article explains the relationship between the WACC and IRR as it is essential to understand how to use those two financial metrics in professional financial decision-making.
WACC serves as the Hurdle Rate in Investment Analysis
The WACC defines the minimum annual return a company needs to generate to cover its cost of capital. In terms of accounting, the company will show a level of profits needed to cover its cost for debt financing while also leaving a decent return to compensate the equity investors. However, generating such a return is not sufficient from an economic perspective. The alternative would be to invest the money in a diversified portfolio of stocks with similar risks. Therefore, it would be easier to do this without all the hassle of executing an investment project by ourselves. Therefore, from an economics perspective, we would only be interested in pursuing an investment project when we can be sure that such a project will generate a return that is above its cost of capital.
For example, if a company’s WACC is 9.0%, the investment needs to return more than 9.0% IRR. An investment showing an expected IRR greater than the WACC becomes profitable in economic terms, meaning it will create excess returns above its cost of capital. Focusing on securing such projects helps the company to constantly exceed its cost of capital reflected in a company’s WACC.
We now can use this relationship to our advantage when looking at how to make financial decisions based on IRR analysis. All we need to do is to calculate the WACC as well. Let’s look now at what our decision-making framework will look like.
When the IRR is greater than the WACC
If the projected IRR (unlevered) is greater than the computed WACC, a project should create excess returns above the company’s cost of capital. Therefore, the company will benefit from this investment from an economic point of view.
Proceeding with an investment opportunity would be the recommended decision to capture this excess return. Therefore, the investment will add value to the business. The recommendation will be to proceed.
When IRR is lower than the WACC
When the projected IRR is lower than a company’s WACC, we cannot generate adequate returns to compensate capital providers for funding our company or project. This means we are destroying value because capital providers would be better off investing their funds in assets with similar risk, as there, they should be able to generate a return corresponding to the WACC.
This means it would be financially unwise to proceed with the investment as it would be in our best interest to invest the funds elsewhere. The recommended course of action would be to abort and invest our funds in a project with a better IRR.
Comparing IRR vs. WACC helps make Better Investment Decisions
Although most companies will not make financial decisions based on this comparison alone, as the images above show, WACC analysis is a valuable tool to help guide making profitable investment decisions as it sets a threshold in terms of the minimum required IRR for any investment project. An investment can add value to the company as long as the IRR (unlevered) is greater than the company’s WACC. This will allow the company and its investors to ensure that value is created as returns will be higher than the cost of capital. Therefore, WACC analysis is an essential addition to IRR analysis.
For a deeper understanding of IRR, check out our many financial model templates. We also made WACC computations easier for you in a spreadsheet format, so you can check out and download our FREE WACC Excel Calculator.
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