WACC vs IRR
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- Опубліковано 26 чер 2024
- Are the Weighted Average Cost of Capital and the Internal Rate of Return the same thing? Well, they are related, but not the same. Let me show you how that works, in words, in formulas, and in numbers. I assume you already know the basics of how Net Present Value works. If you don’t, then please watch the video "NPV and IRR explained" first: • NPV and IRR explained
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0:00 Introduction
0:22 WACC and IRR definitions
0:56 WACC in NPV calculations
1:29 IRR in NPV calculations
1:46 NPV formula
2:05 WACC in NPV formula
2:22 IRR in NPV formula
2:43 NPV IRR WACC example
4:33 How to calculate IRR
The Weighted Average Cost of Capital is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. The riskier or more uncertain the company and the riskier or more uncertain the project, the higher the WACC. Internal Rate of Return is the discount rate at which the net present value of all cash flows from a particular project is equal to 0.
Here are the steps to use in the NPV formula when you use Weighted Average Cost of Capital. Step 1: start with the nominal cash flows. Step 2: apply the WACC as an input variable. Step 3: Calculate NPV.
Here are the steps to use in the NPV formula when you use Internal Rate of Return. Step 1: start with the nominal cash flows. Step 2: set NPV to zero. Step 3: Calculate IRR as the output variable.
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and #accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: UA-cam videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
![IRR vs. NPV - Which To Use in Real Estate [& Why]](http://i.ytimg.com/vi/hGw2J__2adU/mqdefault.jpg)
Enjoyed the video? Then subscribe to the channel now: ua-cam.com/channels/QQJnyU8fALcOqqpyyIN4sg.html and watch the related video on NPV IRR payback scenarios next: ua-cam.com/video/1ZTIwmn1Cm0/v-deo.html
Ok . will do.
Gosh you and your channel are a godsend. I think I've said this twice. I'm trying to learn with books but your explanations are way better! Much thanks!
That compliment makes my heart sing!!! Thank you so much. Please repeat it as many times as you'd like! ;-)
One of the best explanations! Thank you so much!
Wow, great to hear that, Pavel. Thanks for the compliment. I have a few more videos for you around these topics (approaching it from different angles), including a deep dive into WACC and hurdle rate: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
The simpliest explanation ever!!!! Thank you...
Glad it was helpful! Wonderful to hear that. Please share with friends and colleagues. More examples, as well as discussion of related concepts, in this playlist: ua-cam.com/video/aS8XHZ6NM3U/v-deo.html&pp=gAQBiAQB
thanks for the information, very well explained, great!
Thanks, Nicolas! :-)
Amazing explanation! Thanks so much.
Glad it was helpful, Stephen!
so easy to understand!! dankjewel
Graag gedaan, Nomad!
very simple and easy to understand explanation. Thanks!
Glad it was helpful! I have place all related videos on NPV, IRR, WACC, hurdle rate, etc. into a playlist: ua-cam.com/video/N-lN5xORIwc/v-deo.html Hope there are more useful videos for you in there!
Thank you for explaining it, its very useful for my PMP study
Great! Thank you for watching.
Bless you, kind sir. You are a good man.
Thank you very much!
This is the video I needed to help everything click. Thank you.
I am so happy to hear that, Jonah! Videos about related topics can be found in this playlist: ua-cam.com/video/N-lN5xORIwc/v-deo.html
Wow thank you so much for the easy explanation. I was confused for a while which was frustrating me but this video helped me understand it.
Glad it helped, Andrew! Related videos in this playlist: ua-cam.com/video/N-lN5xORIwc/v-deo.html
Great explanation, thanks a lot.
You're welcome, Claudio! Please subscribe to the channel, and here's the link to a playlist with all NPV IRR WACC payback related videos: ua-cam.com/video/N-lN5xORIwc/v-deo.html
very useful!
Thank you for the feedback, that is nice to hear! :-)
Thank you so much!!!!!!!!!!!!!!!!!!!!!!
You're welcome!!!!!!!!!!!!!!!!!!!!!! :-)
Very well done, thank-you...any idea why Excel says NPV is $30, when I use the embedded function "NPV" and the exact same #'s?
No idea, unless i would see the spreadsheet in front of me. A related video of mine covers working with the NPV function in Excel: ua-cam.com/video/jQ_NDQ2qVVA/v-deo.html
Thanks for the informative video. I understand the numerical explanation behind IRR and WAC. However, what is the relevance of IRR?
In IRR calculations, the question is: what is the discount rate that makes the NPV equal to zero? So if we are reviewing many different investment proposals, and trying to "force rank" them from most attractive to least attractive, you could either summarize the project example in the video by saying "this is a project with $1000 upfront investment, and NPV of $35" (which is a good thing, as we are looking for NPVs bigger than zero) or "this is a project with $1000 upfront investment, and IRR of 22%" (which is a good thing, as we are looking for IRRs exceeding the WACC of 20%). NPV focuses on absolute amount of value created, IRR focuses on relative value created. See also my video on IRR: ua-cam.com/video/aS8XHZ6NM3U/v-deo.html
do you have to take into account wacc first when determining discount rate ?
Hello Timothy! Most people would use WACC as a synonym for discount rate. I personally prefer the concept of hurdle rate, it seems to make more business sense: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
Hello. Thanks for the video. Is WACC also known as the discount rate?
Yes, that is often the case. Even though WACC is a much more specific term than the generic term discount rate. If you want to dive deeper into WACC, then this video is for you: ua-cam.com/video/1O-DbtVueMw/v-deo.html On the more conceptual level, here is a discussion of WACC vs hurdle rate: ua-cam.com/video/8EyFLdOTuHU/v-deo.html
@@TheFinanceStoryteller thanks for your reply
To find the cost of debt through wacc, will I have to calculate corporate's tax?
Yes, take that data from the income statement (statement of operations) in the annual report. The cost of debt equals the interest rate that the company pays on its interest-bearing debt, minus the tax benefit of interest expense being deductible. So if the interest rate is 5%, and the corporate tax rate 20%, then the after-tax cost of debt is 4%. By the way, the cost of debt is an input into the WACC formula, not an output.
why does NPV after Year 1 decrease over time? From 333 to 193 USD for example
Hello Alfonso! The $333 and the $193 are present values of expected future cash flows. Nominal expected benefits per year are $400. If that future value of $400 is only one year away, then at 20% WACC the present value equivalent is $333. If that future value of $400 is four years away, then at 20% WACC the present value equivalent is only $193. The longer you have to wait for the benefit, the lower the present value equivalent. See also my video specifically on NPV: ua-cam.com/video/N-lN5xORIwc/v-deo.html Hope this helps!
Thanks for the Video. Can I actually compare my project irr from my entity free CF (which doesnt take into account a tax shield) and my WACC (which takes it into account)? I want to find out weather my new founded project has the ability to cover the total cost of capital.
In other words, I have to my planned project the Free CF without considering tax shield and the initial investment. How can I evaluate the profitability of my project if the financing structure is unknown?
I know that my return on equity must be 15% and my interest on debts must be 5%. Reference projects have a structure of 80% debts.
Hello! Your question sounds a bit cryptic to me, but what I think you are trying to do is similar to an EVA (Economic Value Added) analysis: ua-cam.com/video/LHXOIHQcyOw/v-deo.html
Hello, thank you very much for the answer. I will try to specify my question again. :)
I am creating a project company where I have not yet determined the financing structure. But I know my sales and other operating costs, so I can make a free cash flow calculation. However, this does not yet take into account a possible tax shield, so I get the unlervered CF. From this unlevered CF I can calculate the IRR, but I don't know how to interpret it.
Could I for example take the WACC of a reference project to compare it with my IRR or would that not make sense?
Thanks for the clarification! I think the way forward is to stay with the risk profile to determine the discount factor (hurdle rate, WACC) in the denominator of the free cash flow calculation (DCF), rather than going through a financing structure calculation. In the end, it actually gets you to the same result. The more risky the venture, the higher the required return on equity is going to be in a WACC calculation.
Have a look at my video on hurdle rate vs WACC ua-cam.com/video/8EyFLdOTuHU/v-deo.html and you will find some of the business factors that push up the hurdle rate. I learned this from a professor in valuation who spends only limited time in academia but most of his time in real world cases of takeovers, divorce proceedings, settlements, etc. It opened my eyes to some of the major risks (on a generic level).
Actually, I am much more excited about using a "rule of thumb" based hurdle rate than the pseudo-science of WACC as I argue in my video on WACC: ua-cam.com/video/1O-DbtVueMw/v-deo.html
Come to think of it, have you gone through a sensitivity analysis, to see how fragile, robust or antifragile your project company is? ua-cam.com/video/o6-HCOG1Cp4/v-deo.html This will move you away from wanting to get to "THE number" (which is based on a lot of assumptions anyway), to knowing what the tipping points are for the company to be viable or not viable.
Hope this helps!
what happens if wacc is higher than irr, but npv is a positive number. should the business still be pursued?
Hello Ken! That sounds like a logical impossibility. IRR is the rate of return that makes NPV zero. If WACC is higher than IRR, then NPV will be negative.
Why do we take wacc value 20%??
Hi Adithya! 20% is very high compared to what is normally used in real life, but it does make for a more dramatic impact of discounting expected future benefits into today's equivalents. See also my videos on WACC ua-cam.com/video/1O-DbtVueMw/v-deo.html and hurdle rate ua-cam.com/video/8EyFLdOTuHU/v-deo.html
How the hell do I calculate the IRR , how do i come to the solution of 22% ? , Thx for the video ;)
I used to share your frustration until I figured it out. ;-) See my videos on NPV and IRR ua-cam.com/video/Fw5-wccViOM/v-deo.html and how to calculate IRR in Excel ua-cam.com/video/L0JCg5TXudc/v-deo.html