The weighted average cost of capital (WACC) and the internal rate of return (IRR) can be used together in various financial scenarios, but their calculations individually serve very different purposes.
What Is WACC?
WACC is the average after-tax cost of a company’s capital sources and a measure of the interest return a company pays out for its financing. It is better for the company when the WACC is lower, as it minimizes its financing costs.
Some of the capital sources typically used in a company’s capital structure include common stock, preferred stock, short-term debt, and long-term debt. These capital sources are used to fund the company and its growth initiatives.
By taking a weighted average, the WACC shows how much average interest the company pays for every dollar it finances. From the company’s perspective, it is most advantageous to pay the lowest capital interest that it can, but market demand is a factor for the return levels it offers. Generally, debt offerings have lower-interest return payouts than equity offerings.
Companies use the WACC as a minimum rate for consideration when analyzing projects since it is the base rate of return needed for the firm. Analysts use the WACC for discounting future cash flows to arrive at a net present value when calculating a company’s valuation.
The Formula for WACC
WACC=E+DE⋅r+E+DD⋅q⋅(1−t)where:E=EquityD=Debtr=Cost of equityq=Cost of debtt=Corporate tax rate
What Is IRR?
An internal rate of return can be expressed in a variety of financial scenarios. In practice, an internal rate of return is a valuation metric in which the net present value (NPR) of a stream of cash flows is equal to zero.
Commonly, the IRR is used by companies to analyze and decide on capital projects. For example, a company may evaluate an investment in a new plant versus expanding an existing plant based on the IRR of each project. The higher the IRR the better the expected performance of the project and the more return the project can bring to the company.
The Formula for IRR
There is no specific formula for calculating IRR. It's actually the formula for NPR set to equal zero.
NPV=t=1∑T(1+r)tCt−Co=0where:Ct=Net cash inflow during the period tCo=Total initial investment costsr=Discount ratet=Number of time periods
When to Use WACC and IRR
The WACC is used in consideration with IRR but is not necessarily an internal performance return metric, that is where the IRR comes in. Companies want the IRR of any internal analysis to be greater than the WACC in order to cover the financing.
The IRR is an investment analysis technique used by companies to determine the return they can expect comprehensively from future cash flows of a project or combination of projects. Overall, IRR gives an evaluator the return they are earning or expect to earn on the projects they are analyzing on an annual basis.
When looking purely at performance metrics for analysis, a manager will typically use IRR and return on investment (ROI). The IRR provides a rate of return on an annual basis while the ROI gives an evaluator the comprehensive return on a project over the project’s entire life.