Question

The current WACC is 16% and you calculated that a newly proposed project that is of similar risk to an average project the firm undertakes (with an upfront investment in Year 0 followed by cash inflows in subsequent years) has an NPV of $266,000. The IRR of this project is:

-16%

-lower than 16%

-higher than 16%

Answer 1

Hello there,

Let us first understand the significance of the terms WACC and IRR.

Weighted Average Cost of Capital ("WACC") represent the average after tax cost of company 's source of capital. Source of capital includes here prefered stock, debts, common stock, bonds and other long term debts. The WACC represent the average rate at which the company's capital is arranged or how much amount of interest is paid on capital financed by the company.

Internal Rate of Return ("IRR"), represent the discount rate at which the Net Present Value ("NPV") of all cash flows in capital budgeting equals to zero.

Therefore it is required to be understood that where the WACC rate is higher than IRR, the preject need not to be accepted as, the borrowing cost is more than the rate of return and vice versa. That is the relationship between IRR and WACC is that if the NPV is more than 0, than IRR is higher than WACC and vice versa.

in the given case, since the WACC is 16% and NPV of the project is $266,000 it means that IRR is much more than WACC, thats why NPV is higher than 0.

Therefore in the given case, the IRR rate is higher than 16%.