NPV vs IRR

Updated on March 21, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Difference Between NPV and IRR

The Net Present Value (NPV) method calculates the dollar value of future cash flows which the project will produce during the particular period of time by taking into account different factors whereas the internal rate of return (IRR) refers to the percentage rate of return which is expected to be created by the project.

Planning to make an investment decision? Confused about how to know its profitability? Well, there are two most important approaches which are used, and they are Net Present Value and Internal Rate of ReturnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more.

You can download the NPV vs IRR Excel Template from below –

You can download this NPV vs IRR - Excel Calculation Template here – NPV vs IRR - Excel Calculation Template

Let assume that your organization has asked you to do an analysis – Whether the new project will be beneficial?

NPV-vs-IRR

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In this scenario, you would first analyze the project cost and try to evaluate its cash inflows and outflows (Free cash flows). Next, you will check in how many years the cost of the project would be recovered, and by what period of time that project will start providing the benefits. In order to measure the lucrativeness of the project or long term investmentTerm InvestmentLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets.read more plans, there are capital budgeting tools used by many organizations and individuals to find out the profitability of the project.

The most common tools used are NPV & IRR. Both the tools are majorly used to evaluate the profits from the investments, and they both have their own pros and cons. But the primary question is – Which tool is better? There is a lot of debate you must have read, which states NPV is a better measurable tool well other states IRR. In this article, I will be guiding you through the difference between the two and also which tool has more relevance.

NPV vs IRR Infographics

NPV-vs-IRR-info

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NPV vs IRR Video

Advantages and Disadvantages of NPV

Net Present Value is the calculation of the present value of cash inflows minus the present value of cash outflows, where present value defines what will be the worth of the future sum of money as of today.

  • If you are investing in certain investments or projects, if it produces positive NPV or NPV>0, then you can accept that project. This will show the additional value to your wealth.
  • And in case of negative NPV or NPV<0, you should not accept the project.

Advantages

Disadvantages

  • It might not give you accurate decision when the two or more projects are of unequal life.
  • It will not give clarity on how long a project or investment will generate positive NPV due to simple calculation.
  • NPV method suggests to accept that investment plan which provides positive NPV, but it doesn’t provide an accurate answer at what period of time you will achieve positive NPV.
  • Calculating the appropriate discount rate for cash flows is difficult.

Advantages and Disadvantages of IRR

You can use this approach as an alternative method for NPV. This method entirely depends on estimated cash flows as it is a discount rate that tries to make NPV of cash flows of a project equal to zero.

If you are using this method to make a decision between two projects, then accept the project if the IRR is greater than the required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more.

Advantages

  • This approach is mostly used by financial managers as it is expressed in percentage form, so it is easy for them to compare to the required cost of capital.
  • It will provide you excellent guidance on a project’s value and associated risk.
  • IRR method gives you the advantage of knowing the actual returns of the money which you invested today.

Disadvantages

Example of NPV vs IRR

XYZ Company is planning to invest in a plant. It generates the following cash flows.

YearCash Flow
0(50,000.00)
115,000
217,000
318,000
410,000
510,000

From the given information, calculate NPV & IRR & the discounting rate is 10%. And suggest whether XYZ Ltd. should invest in this plant or not.

#1 – NPV Formula Calculation

NPV = CF/(1+r)t – Cash Outflow

Where:

  • CF = cash inflow
  • r = discount rate
  • t = time
  • Cash outflow = total project cost

Step 1: Project the Cash Flows, Expected discount Rate and apply the NPV formula in Excel

NPV step 1

Step 2: Add the Cash Outflow to the NPV Formula

NPV Step 2

Step 3: Sum total to find the Net Present ValueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more

NPV Step 3

#2 – IRR Formula Calculation

Cash Outflow = CF /(1+IRR)t

Where:

  • CF = cash inflow
  •  t = time

Step 1: Populate the Cash Flows

Step 1 - Populate Cash Flow

Step 2: Apply the IRR formula

Step 2 - Apply Formula

Step 3: Compare the IRR with the Discount Rate

Step 3 - Compare
  • From the above calculation, you can see that the NPV generated by the plant is positive and IRR is 14%, which is more than the required rate of return
  • This implies when the discounting rate will be 14%, NPV will become zero.
  • Hence, the XYZ company can invest in this plant.

Conclusion

As I can conclude that if you are evaluating two or more mutually exclusive projectsMutually Exclusive ProjectsMutually Exclusive Projects is a term that is commonly used in the capital budgeting process where companies choose a single project based on certain parameters from a set of projects where acceptance of one project results in rejection of the other projects.read more, so better go for the NPV method instead of the IRR method. It is safe to depend on the NPV method for selecting the best investment plan due to its realistic assumptions & better measure of profitability. Even you can make use of the IRR method, it is a great complement to NPV and will provide you accurate analysis for investment decisions. Also, NPV finds its usage in DCF Valuations to find the present value of Free Cash Flows to the firmFree Cash Flows To The FirmFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more.

This has been a guide to NPV vs IRR. Here we discuss the difference between NPV and IRR using infographics along with its example advantages and disadvantages. You may also look at the following articles –

Reader Interactions

Comments

  1. Ose says

    Thank you for breaking this concept into comprehensible bits.

  2. Dmitri says

    A clear and simple explanation of NPV and IRR difference, with a comprehensible numerical support.

    Great explanation!

  3. dev says

    Hi Dheeraj,

    Nice to see the clear explanations of concepts.
    Great work.
    Keep it up ..!

  4. Sameer Suresh Sawant says

    Dheeraj, You are making finance interesting and simple to learn. I appreciate the way you make things simple it indicates the amount of knowledge and wisdom you have gained over years. You are an excellent teacher. Thanks.
    Regards
    Sameer

    • Dheeraj Vaidya says

      Thanks for your kind words!

  5. axay says

    CapEx then cash flows plus operations cost and tax rebate and at end final selling price. Your post cleared my mind on how to see it. Thanks

  6. Deepika says

    Such a very helpful explanation .thanks

  7. Olaoluwa says

    I am wowed …Thank you for breaking it down so well.

    Thumbs up

  8. curtis mohommed says

    This is very clear. NPV, IRR are only as good as the assumptions. With NPV the discount rate seems to be a guess as well.

  9. Alfred Obina says

    you are making learning interesting

  10. Dinesh says

    Clear definitions with examples
    Thank you

  11. Tahera Akter says

    Wishing that you gave us GMAT Tutorial in the same way. (though absurd statement of me)

    • Dheeraj Vaidya says

      Hi Tahera, GMAT is not yet in the pipeline as of now.

  12. Tahera Akter says

    YOUR WEBSITE IS MY PRIMARY STUDY REFERENCE. So many concepts are getting more cleared than it had been all these years. Thank you Dheeraj. You are GEM.

    • Dheeraj Vaidya says

      thanks Tehera! Great to see that you like the resources at wallstreetmojo. :-)

  13. Andrew says

    thank you, nice lesson.

    • Dheeraj Vaidya says

      thanks Andrew!

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