Question

Should a financial manager pursue projects whose expected returns are less than the firm’s weighted average cost of capital (WACC)? Explain your answer.

Answer 1

Financial Manager should not pursue the project with expected return less than firms weighted average cost of capital.

What is the 'IRR Rule'

The IRR rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return (IRR) on a project or an investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.

BREAKING DOWN 'IRR Rule'

The higher the IRR on a project and the greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. The IRR rule is used to evaluate projects in capital budgeting, but it may not always be rigidly enforced. For example, a company may prefer a project with a lower IRR over one with a higher IRR because the former provides other intangible benefits, such as being part of a bigger strategic plan or impeding competition. A company may also prefer a larger project with a lower IRR to a much smaller project with a higher IRR because of the higher cash flows generated by the larger project.