Project IRR and Equity IRR – Is there a Connection?

Sometimes calculating project IRR and equity IRR can be tricky. 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. 

The 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 say, $ 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.

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 be the same. If the project is fully funded by debt, the equity IRR simply doesn’t exist (or it’s infinite, since you didn’t put any money!)

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

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, when the cost of debt is equal to the project IRR, the equity IRR is equal to the project IRR.

What is this article about? There is some confusion for those in Government or some clients on the question of project and equity IRR for a project. If you are an investor, you may also find this article somewhat helpful.

Reference:

Project IRR and Equity IRR: a curious connection, Naiyer Jawaid, Feasibility Pro, 15 June 2013