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..
Let assume that your organization has asked you to do an analysis – Whether the new project will be beneficial?
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. 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
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.
- Time Value of MoneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment. is given more importance i.e., the value of money today is more than the value of money received a year from now.
- Project profitability & risk factors are given high priority.
- It helps you to maximize your wealthMaximize Your WealthWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits. as it will show are your returns greater than its cost of capital or not.
- It takes into consideration both before & after cash flow over the life span of a project.
- 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 Rate.
- 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.
- IRR tells you to accept the project or investment plan where the IRR is greater than the weighted average cost of capital, but in case if the discount rate changes every year, than it is difficult to make such comparison.
- If there are two or more mutually exclusive projects (they are the projects where acceptance of one project rejects the other projects from concern) than in that case, IRR is not effective.
Example of NPV vs IRR
XYZ Company is planning to invest in a plant. It generates the following cash flows.
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
- 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
Step 2: Add the Cash Outflow to the NPV Formula
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.
#2 – IRR Formula Calculation
- CF = cash inflow
- t = time
Step 1: Populate the Cash Flows
Step 2: Apply the IRR formula
Step 3: Compare the IRR with the Discount Rate
- 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.
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., 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..
NPV vs IRR Video
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 –