The Daily Technical #95: Which of the valuation methodologies is the most variable in terms of output?

Good morning. Welcome to the 95th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
What is the difference between WACC and IRR?

When comparing WACC and IRR, it's crucial to understand their distinct roles in financial analysis.

The Internal Rate of Return (IRR) represents the rate of return on a project's investment. It’s essentially the interest rate that makes the net present value (NPV) of a project’s cash flows zero. Simply, it indicates how fast a project’s invested capital can grow over time.

The Weighted Average Cost of Capital (WACC) is the average rate a company expects to pay on its borrowed and equity capital. It serves as a benchmark for evaluating investment projects. Typically, a project with an IRR that exceeds the WACC is favorable, indicating potential profitability above the company’s cost of capital.

Common Mistakes

1. Calculating IRR and WACC the same way. IRR identifies the discount rate at which NPV of future cash flows equals zero, while WACC calculates the cost of the firm’s capital, weighted by each capital source.

2. Overlooking how IRR and WACC interact in project evaluation. Remember, a project is generally viable if its IRR exceeds its WACC. Ensure you compare these two to effectively assess project potential.
   

TL;DR

• IRR: Measures potential growth rate of invested capital; NPV reaches zero when IRR equals discount rate.

• WACC: Average cost company incurs from debt and equity; serves as profitability benchmark.

• IRR > WACC suggests project profitability and potential go-ahead.

TODAY’S QUESTION
Which of the valuation methodologies is the most variable in terms of output?

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