Key takeaways
- Project IRR measures the quality of the project before capital structure. Equity IRR measures what equity holders actually receive after debt obligations.
- Leverage lifts Equity IRR when the project's return is higher than the cost of debt, and pushes it down harder when returns fall.
- A high Equity IRR does not mean a good project. Read it alongside Project IRR, NPV, MOIC and Peak Funding.
Definitions
IRR is the discount rate at which the NPV of the cash flows equals zero.
Project IRR (Unlevered)
Project CF = revenue − project costs − tax
- Excludes loans, interest and principal repayments
- Used to compare projects
- Banks and hotel operators use it to assess potential
- Sensitive to revenue and costs
Equity IRR (Levered)
Equity CF = Project CF + loan drawdowns − interest − principal repayments
- The cash flow that equity holders actually put in and receive back
- Used to communicate with investors and directors
- Additionally sensitive to the interest rate and the amount of debt
- More leverage means a higher IRR, but also higher risk
Worked example
Hypothetical example A project sells out over 4 years, in THB million, using annual periods. The loan carries 7% interest per year, calculated on the opening balance for the year. Figures are before tax so that the mechanics are clear.
| Item | Year 0 | Year 1 | Year 2 | Year 3 | Total |
|---|---|---|---|---|---|
| Project CF | (100.0) | (60.0) | 50.0 | 190.0 | 80.0 |
| Loan drawdown | 60.0 | 40.0 | – | – | 100.0 |
| Repaying principal | – | – | (20.0) | (80.0) | (100.0) |
| Interest at 7% | – | (4.2) | (7.0) | (5.6) | (16.8) |
| Equity CF | (40.0) | (24.2) | 23.0 | 104.4 | 63.2 |
Opening loan balance: Year 1 is 60, Year 2 is 100 and Year 3 is 80, so interest is THB 4.2 million, THB 7.0 million and THB 5.6 million. Equity profit of 63.2 equals Project CF of 80.0 less interest of 16.8 exactly, which serves as a basic accuracy check.
| Indicator | Project | Equity |
|---|---|---|
| Total investment (THB m) | 160.0 | 64.2 |
| IRR | 18.2% | 32.2% |
| Profit (THB m) | 80.0 | 63.2 |
| MOIC | 1.50x | 1.98x |
The IRR spread is 14 points because the project returns 18.2%, higher than the 7% cost of debt, so the difference accrues to equity holders.
Leverage works both ways
If revenue in Years 2–3 falls by 20%, from 50 and 190 to 40 and 152, with debt and interest unchanged:
| Case | Project IRR | Equity IRR | Equity profit (THB m) |
|---|---|---|---|
| Base Case | 18.2% | 32.2% | 63.2 |
| Revenue −20% | 7.8% | 9.0% | 15.2 |
Project IRR falls by more than half, to only slightly above the 7% cost of debt. Equity IRR falls by more than 23 points and equity profit falls by more than 75%, because interest and principal must still be paid in full. The benefit of leverage almost disappears when the project's return approaches the cost of debt.
Limitations of IRR
- It assumes cash flows can be reinvested at the IRR, which is often unrealistic.
- It does not reflect scale: 20% of THB 100 million is not the same as 20% of THB 1,000 million.
- It can have multiple solutions if the cash flows change sign several times.
- It can be pushed higher by changing the timing of cash flows, without increasing profit.
Typical Project IRR is around 15–25% and Equity IRR around 20–35%, depending on risk and capital structure. The IRR spread is commonly around 5–15 points. A very wide spread should be read as a sign of high leverage, not of success.
Points to watch when reading a model If the model includes capitalised interest in project costs and then calculates "Project IRR" from that cash flow, the figure is not truly unlevered. Strip out the interest and its tax effects before comparing it with other projects. The SARARN SUK case study shows the impact of this in numbers.