The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows.
Let’s look at an example:
Blue Ocean is evaluating a proposed capital budgeting project (project Vulcan) that will require an initial investment of $800,000.
Blue Ocean has been basing capital budgeting decisions on the project’s NPV but recently they acquired a new CEO who wants the finance team to use IRR method for capital budgeting decisions. The new CEO explains that the IRR is a better method because it shows returns in percentage form and are easier to understand and compare to required returns. Blue Ocean’s WACC is 7%.
The IRR is solved by setting the NPV equation equal to zero and solving for the interest rate as follows:
We found that Vulcan’s IRR 31.09%. But what does that exactly mean?
It means the project has an NPV of $0 because the IRR is greater than Blue Ocean’s WACC of 7%. The returns from the project (IRR) exceed the WACC and the excess value will go to shareholders.
In summary, the two rules you should note are:
- Independent projects whose IRR is greater than the WACC should always be accepted.
- If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the firm should accept the project with the greatest IRR