Why is the Internal Rate of Return (IRR) typically higher than the Weighted Average Cost of Capital (WACC)?

Why is the Internal Rate of Return (IRR) typically higher than the Weighted Average Cost of Capital (WACC)?

• A. IRR represents project's rate of return exceeding WACC
• B. WACC includes fixed expenses, while IRR does not
• C. IRR includes unrealized profits that WACC excludes
• D. WACC is based on historical costs, while IRR is actual returns

Answer: (A)

The Internal Rate of Return (IRR) is a crucial financial metric used to evaluate the profitability of potential investments or projects. It represents the interest rate at which the net present value (NPV) of all cash flows (both incoming and outgoing) from the project equals zero. When IRR is higher than the Weighted Average Cost of Capital (WACC), it indicates that the project is expected to generate a return that exceeds the average cost of financing it. The correct answer highlights that IRR reflects the project's rate of return exceeding WACC. When a project's IRR surpasses the WACC, it signifies that the project is likely to add value to the firm and provides a return to stakeholders that exceeds what the firm must pay in financing costs. Thus, investors and decision-makers view such projects as favorable investments. In the context of the other choices, while WACC does incorporate fixed expenses, pertains to historical financing costs, and does not take into account unrealized profits in the same way IRR may be viewed, these elements do not pivotally explain why IRR is typically portrayed as higher than WACC. The key takeaway is that the primary purpose of calculating IRR is to assess the project's yield in comparison to the cost of capital, and

The Internal Rate of Return (IRR) is a crucial financial metric used to evaluate the profitability of potential investments or projects. It represents the interest rate at which the net present value (NPV) of all cash flows (both incoming and outgoing) from the project equals zero. When IRR is higher than the Weighted Average Cost of Capital (WACC), it indicates that the project is expected to generate a return that exceeds the average cost of financing it.

The correct answer highlights that IRR reflects the project's rate of return exceeding WACC. When a project's IRR surpasses the WACC, it signifies that the project is likely to add value to the firm and provides a return to stakeholders that exceeds what the firm must pay in financing costs. Thus, investors and decision-makers view such projects as favorable investments.

In the context of the other choices, while WACC does incorporate fixed expenses, pertains to historical financing costs, and does not take into account unrealized profits in the same way IRR may be viewed, these elements do not pivotally explain why IRR is typically portrayed as higher than WACC. The key takeaway is that the primary purpose of calculating IRR is to assess the project's yield in comparison to the cost of capital, and