What Is the Relationship Between Interest Rates, NPV and IRR?
Internal rate of return (IRR) is the amount expected to be earned on a capital invested in a proposed corporate project. However, corporate capital comes at a cost, which is known as the weighted average cost of capital (WACC). If the IRR exceeds the WACC, the net present value (NPV) of a corporate project will be positive. Thus, if interest rates rise, the WACC will also rise, thereby reducing the expected NPV of a proposed corporate project.
Internal rate of return (IRR) is the amount expected to be earned on a corporate project over time. Based on the expected cash flows from a proposed project, such as a new advertising campaign or investing in a new piece of equipment, the internal rate of return is the discount rate at which the net present value (NPV) of the project is zero. All else being equal, the higher the IRR, the higher the NPV, and vice versa.
The weighted average cost of capital (WACC) represents the combined cost of equity and debt capital. Debt capital typically carries interest expense, and equity capital bears the opportunity cost of foregone capital gains to outside investors. Accordingly, it is important to calculate the WACC so that proposed corporate projects can be evaluated for financial feasibility. All else being equal, as interest rates rise, the WACC will rise since its debt and equity components will each increase as a result.
The net present value (NPV) of a corporate project is an estimate of its value based on the projected cash flows and the weighted average cost of capital. With a higher WACC, the projected cash flows will be discounted at a greater rate, reducing the net present value, and vice versa. As interest rates rise, discount rates will rise, thereby reducing the NPV of corporate projects. Notably, a proposed corporate project can either have a positive or negative NPV based on its expected cash flows and the relative cost of capital.
Interest rates are periodically set by central banks, and they fluctuate in the marketplace on a daily basis. Changing interest rates affect the cost of capital for companies and, as a result, impact the net present value of their corporate projects. Occasionally, interest rate changes can be predicted, and, accordingly, they can be built into valuation models for evaluating proposed long-term corporate capital expenditures. Given the impact of interest rates on valuation and net present value, it is important for management to be aware of interest rate exposure and the various ways to manage the related risks, such as hedging and diversification.