Sometimes calculating project IRR and equity IRR can be tricky, and in this post we will discuss the reasons for the same.
The internal rate of return (IRR) can be defined as the rate of return that makes the net present value (NPV) of all cash flows equal to zero. In a previous post I have discussed the basic concepts and calculation of IRR and NPV. If you want to refer back, click here for the IRR-NPV post.
Calculation of the internal rate of return considering only the project cash flows (excluding the financing cash flows) gives us the project IRR.
Consider a project with construction cost of $ 1,000,000 and annual rental income of $ 120,000. Assume the property will be sold in the 10th year for $ 1,607,023. You can construct the project cash flows and calculate the project IRR by using the Excel IRR formula. You can also download the excel spreadsheet for this calculation. The download link is at the end of this post.
Calculating Equity IRR
Calculation of the internal rate of return considering the cash flows net of financing gives us the equity IRR. It means the project is funded by a mix of debt and equity. If the project is fully funded by equity, the project IRR and Equity IRR will the same. If the project is fully funded by the debt, equity IRR simply doesn’t exist.
Now consider the same example again. Assume 30% of the project cost is funded by the equity and remaining 70% by the debt. Assume the cost of equity to be 14% and the cost of debt 8%. The weighted average cost of capital (WACC) will be 9.8%. Note that the weighted average cost of capital will not affect equity IRR. It is only the cost of debt which matters. Assume the term of debt is 10 years.
You can project the cash flows for equity holders and calculate the equity IRR using the same Excel formula as above. This is demonstrated below:
Wasn’t it simple? It is.
Can equity IRR be lower than project IRR?
Some readers often ask me if the equity IRR can be lower than the project IRR. And I always say the same thing – yes, it can be.
So, in what circumstances the equity IRR will be lower than project IRR?
The equity IRR will be lower than the project IRR whenever the cost of debt exceeds the project IRR. Note it is the cost of debt and not the weighted average cost of capital. See below the relationship between the cost of debt and equity IRR.
In the above chart, did you notice that when the cost of debt is equal to the project IRR, the equity IRR is equal to the project IRR?
Note that the cost of equity doesn’t impact either the project IRR or the equity IRR. Cost of equity affects the weighted average cost of capital (WACC) and hence the NPV calculation. It affects both project NPV and NPV for the equity holders.
If you are looking for the relation between project NPV and equity NPV, refer this post Net Present Value and Returns to the Equity Holders.
You can download the project IRR and equity IRR calculation spreadsheet for FREE. It also has this interactive graph and the loan amortization schedule.
Hope you enjoyed this post on project IRR and equity IRR. What do you think, use the comment section below.