NPV vs IRRA Breakdown Between the Differences of Internal Rate of Return and Net Present Value

Written By:
Lisa Borga

Reviewed By:
FundsNet Staff

What are IRR and NPV?

The internal rate of return (IRR) is a financial metric used by investors or managers to evaluate investments or projects for potential investment.

On the other hand, net present value (NPV) is a measurement of the present value of cash inflows minus all cash outflows for a specific time period.

Both of these are valuable measurements for companies when they are making decisions on capital budgeting, which is the process of deciding whether a particular project or investment would be worthwhile to pursue.

Whenever a company is presented with a given investment opportunity, management has to make a decision on whether or not it will generate a worthwhile profit or potentially even result in a loss for the company.

Calculating NPV

In order to calculate NPV (net present value), a company will make estimates of a project’s future cash flows and then use a discount rate to discount these cash flows into present value.

This discount rate will represent the capital and risk involved in a project.

Next, all of the positive discounted cash flows are combined, and the initial investment costs are subtracted from this number.

What remains is the NPV of the investment.

Here is the formula for calculating NPV:

Let’s consider an example of NPV.

Lion Bucket Manufacturers (LBM) is considering buying a smaller pail manufacturing company.

However, they want to know if they will make money on the deal.

LBM determines that based on all the factors involved, they have a 10% discount rate, and taking that times their estimated future earnings of $20 million from the new acquisition, they will acquire a present value of $18 million.

Now subtract the $15 million which the current owners of the pail manufacturing company are willing to sell for, and we are left with a net present value of $3 million for the investment.

Calculating IRR

Lion Bucket Manufacturers now knows that they would have an NPV that would be positive should they buy the smaller company; however, it is always wise to consider the IRR for a given investment as well.

Here is the formula for calculating the IRR:

Luckily this can easily be found simply by recalculating the equation for net present value.

For this calculation, the NPV should be set to zero.

Then, the discount rate can be solved for.

This will be the IRR for the investment.

For this investment, if the projected cash flows gave an IRR of 15%, then Lion Bucket Manufacturers would likely choose a different project if it had a higher internal rate of return.

This is the type of situation in which IRR is particularly useful.

It makes it possible to see an investment’s potential return and compare it with other possible investments.

Example of Using NPV and IRR When Preparing a Capital Budget

Let’s consider a situation where a new investment would return cash flows of:

Year 1 = $70,000

Year 2 = $125,000

Year 3 = $ 90,000 (cost of new plans to improve project)

The IRR is the discount rate necessary for a project to break even with a certain initial investment.

This investment would not have a single IRR because the market conditions do not remain the same.

It could have several IRRs.

With long projects that have additional investments and changing cash flows, there may be multiple IRRs.

Another problem with the IRR is that it is not an effective evaluation method unless a discount rate is available.

An IRR needs to be compared to a discount rate for a project or investment.

Then, if the IRR is below the discount rate, the investment opportunity should be rejected.

Whereas, if the IRR is above the discount rate, the investment is a good deal.

But, without the discount rate, it is better to use NPV.

If the NPV for an investment is above zero, the investment is a good choice.

Conclusion

NPV and IRR are both powerful tools to analyze an investment.

IRR measures this by using a percentage, whereas NPV measures it in a dollar value.

Many use IRR as their chosen measurement for making capital budgeting decisions, but there are some issues that can arise with this metric.

These are due to the fact that this measurement does not account for shifting factors such as multiple discount rates, and when this occurs, it is better to choose NPV to analyze investments instead.

Key Highlights

• Both NPV and IRR are methods of determining whether projects or investments are worthwhile, which take into account the time value of money.
• IRR is used to measure the profitability of a particular investment and assigns a percentage value to represent it.
• NPV measures the current value of the future cash flows of a project. If the NPV for an investment is greater than zero, it is regarded as financially worthwhile.