The post about Project IRR and Equity IRR became one of the most commented posts on this blog. Apart from the comments, I still receive tons of email asking me what the other circumstances are when the equity IRR will be lower than project IRR.
In that post we considered a simple project with one year gestation period and concluded that the equity IRR will be lower than the project IRR whenever the cost of debt exceeds the project IRR. We noted that it is the cost of debt and not the weighted average cost of capital, which impacts the equity IRR.
Now let’s consider the same example and increase the construction duration to four years. Other assumptions remain the same:
The project cash flow and financing cash flow will look like this:
You will notice that the equity IRR (11.52%) is lower than the project IRR (13.27%), although the cost of debt (12%) is lower than the project IRR.
If you plot the project IRR and equity IRR for different costs of debt, you will notice the relation between them:
You can also notice that the equity IRR is still inversely related to the cost of debt, although it doesn't follow the same relation as we have concluded in the previous post.
So, can Equity IRR be lower than Project IRR?
Yes, in many cases – including, when the cost of debt is more than project IRR and also when the project has a long gestation period.
Hope you enjoyed this post. If you have any question, use the comment section below.
You can download the project IRR and equity IRR calculation spreadsheet for FREE.