NPV vs IRR – Planning to make an investment decision? Confused how to know its profitability? Well there are two most important approaches which are used and they are NPV (Net Present Value) and IRR (Internal Rate of Return).
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 project would be recovered and by what period of time the that project will start providing the benefits. In order to measure the lucrativeness of the project or long term investment plans, there are capital budgeting tools used by many organizations and individuals to find out the profitability of the project.
The most common tool used is 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 NPV or IRR is better? There are lot of debate you must have read which states NPV is 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.
Please go through the infograph of NPV vs IRR to know the difference between net present value and internal rate of return.
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Advantages and Disadvantages of NPV
Net Present Value is the calculation of present value of cash inflows minus present value of cash outflows, where present value defines what will be the worth of 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 of NPV
- Time Value of Money is given more importance i.e. value of money today is more than the value of money received a year from now.
- Projects profitability & risk factors are given high priority.
- It helps you to maximize your wealth 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.
Disadvantages of NPV
- It might not give you accurate decision when the two or more projects are of unequal life.
- Will not give the clarity 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 accurate answer at what period of time you will achieve positive NPV.
- Calculating appropriate discount rate for cash flows is difficult.
Advantages and Disadvantages of IRR
You can use this approach as an alternative method to NPV. This method entirely depends on estimated cash flows as it is a discount rate which 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 return.
Advantages of IRR
- 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 an 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 of IRR
- IRR tells you to accept the project or investment plan where the IRR is greater than weighted average cost of capital but in case if 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 too IRR is not effective.
NPV vs IRR Example
XYZ Company planning to invest in a plant, it generates the following cash flows.From the above information calculate NPV & IRR & the discounting rate is 10%. And suggest whether the XYZ Ltd. Should invest in this plant or not.
You can download the excel example – NPV vs IRR Calculation
CF = Cash inflow, r = discount rate, t = time
Cash outflow = total project cost
NPV Step 1 – Project the Cash Flows, Expected discount Rate and apply the NPV formula in Excel
NPV Step 2 – Add the Cash Outflow to the NPV Formula
NPV Step 3 – Sum total to find the Net Present Value
CF = Cash inflow, t = time
IRR 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, XYZ company can invest in this plant.
As I can conclude that if you are evaluating two or more mutually exclusive projects so better go for NPV method instead of IRR method. It is safe to depend on NPV method for selecting the best investment plan due to its realistic assumptions & better measure of profitability. Even you can make use of 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 firm.