IRR, or the Internal Rate of Return, is one of the most popular and effective ways to evaluate the viability of long-term projects. Basically, it is the rate at which the NPV (net present value) of any project is o (zero). Usually, a project involves using both debt and equity, and we calculate the IRR for the whole project. But, there could be different types of IRR depending on the component for what we are calculating IRR. Two such types of IRRs are Project IRR and Equity IRR. Many people believe the two terms to mean the same thing, and thus, use them interchangeably. However, the two terms are very different. Hence, it is extremely crucial to understand the differences between Project IRR and Equity IRR.
Let us understand what the two concepts mean and the difference between Project IRR vs Equity IRR.
Project IRR vs Equity IRR – Meaning
As the name suggests, a project IRR gives information on the return for a specific project. So, this IRR does not consider the financing structure and thus, calculates IRR assuming 100% equity financing. Moreover, this IRR does not show any leveraging effect as it does not consider debt. Thus, we can also call this IRR as ‘unlevered IRR’ or ‘unleveraged IRR.’ Though while calculating the Project IRR, financing structure is not taken into consideration, however, irrespective of the structure, the Project IRR will remain the same. Because it is specific to the project and not to the capital structure or a mix thereof.
On the other hand, equity IRR takes the cash flows that pertain exclusively to the equity shareholders. So, equity IRR assumes that a project involves both debt and equity but focuses only on the equity cash flows and returns. We can say that this IRR calculates the return that equity shareholders earn on the funds that they invest in a project. In the actual world, the project may have a mix of debt and equity, or it could be totally funded by equity or debt alone.
Project IRR vs Equity IRR – Calculation
For calculating the equity IRR, we need to deduct the financing expenses from the total revenue. Since project IRR does not consider capital mix, we do not take into account financing expenses when calculating the project IRR.
Another point to note is that initially, when the project starts and when the management is not sure about taking debt, they usually calculate only the project IRR. Later, if they take on debt, they may want to calculate equity IRR and project IRR separately.
Let us understand the two concepts with the help of a simple example:
Assume the total cost of a project is $10 million, including $7 million in debt and $3 million in equity. The project IRR is 15%, and the equity IRR is 20%.
In this case, the project IRR of 15% means the earning on the total project cost of $10 million. This earning of 15% belongs to both debt and equity holders. On the other hand, an equity IRR of 20% means the earning on the investment by the equity shareholders only.
Project IRR and Equity IRR – Relation
A single project, if it involves debt and equity components, then it would have both project IRR and equity IRR. And both the IRRs will be different. However, if a project involves only equity, then the project IRR and the equity IRR will be the same. And, if a project involves only debt, then there will not be any equity IRR.
Now, let us talk about the scenarios when the project IRR could be more (or less or equal) than the equity IRR and vice versa.
Usually, the equity IRR is more than the project IRR. This is because the cost of debt will be smaller than the project IRR due to tax deductibility, and then only the project could be preferred on financial parameters. It is only logical to pay interest payment less than what you expect to earn from the project.
However, in a certain scenario, equity IRR can be less than the project IRR. The equity IRR on a project will be less than the project IRR if and only if the cost of debt (or the interest on debt) is more than the project IRR. Simply put, if the interest that we are paying on debt is more than the rate that we are earning on the project, then, of course, the equity IRR will be less than the project IRR. It could mean that the company is paying some portion of the interest on the debt from the pocket of the shareholders. Such a situation is not desirable as the cost of debt is more than the earnings of the project.
And, in case the interest on debt is the same as the project IRR, then the project IRR will equal the equity IRR.
Both equity and project IRR is important for a project. Depending on the capital mix of the project, management can decide on the IRR that it wants to calculate. Moreover, it should review the IRRs from time to time to ensure the return is as per their expectations. And as a bottom line, the Project IRR should be greater than the debt cost, plus the Equity IRR should always be greater than the Project IRR to reward the shareholders for the risk they are taking by investing in the project.