Evaluating a business proposal or an investment decision is part of the ordinary course of business. Therefore, it is essential to understand the key concepts to evaluate its profitability and make the right decision. The terms NPV and IRR are part of the profitability analysis for a project or a capital budgeting decision or an investment decision. These terms, however, seem quite complicated for an average person. Read on to understand them in a simplified manner and also learn the critical differences between them.
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What is NPV?
NPV, which stands for “Net Present Value,” is a financial tool used to evaluate the profitability of an investment or project. It considers both positive and negative future cash flows that an investment generates throughout its life cycle.
The NPV calculation involves finding the difference between the project’s cost (cash outflows) and the income from the project (cash inflows). To calculate NPV, you will first have to calculate the WACC (weighted average cost of capital) of the business. This involves evaluating the average cost of funds from debt and equity which is further used as the benchmark or the minimum rate required by a company to undertake an investment project.
Using NPV for investment analysis is more common than other methods like IRR (Internal Rate of Return) because it provides a more detailed analysis. NPV discounts individual cash flows from the project separately, considering the time value of money. This means it accounts for the fact that money today is more valuable than the same amount of money in the future due to inflation and other factors.
Interpretation of NPV
The rule of thumb when using NPV is to accept projects with a positive NPV as they are expected to generate more value than the initial investment. On the other hand, projects with a negative NPV are typically rejected as they may result in losses. When the NPV is zero, it indicates a situation of indifference. In such cases, the total costs and profits of the investment options are equal, making them equally viable choices.
Formula for NPV
The formula to calculate NPV is given here.
NPV = [cash flow / (1+i)^t] – initial investment
Where, i = discount rate and t = the number of time periods
Let us understand the calculation and interpretation of NPV using the following example.
Consider a project with an initial investment of Rs. 1,00,000 and the project is expected to generate varied cashflows over the period of 5 years. This rate of return or the discount rate applicable for this project is 10%. The NPV for this project is calculated as under.
| Year | Cashflow | Discount Rate | Calculation | Present value of cash flow. |
| 0 | (1,00,000) | 0.10 | [-1,00,000 / (1+0.10)^0] | (1,00,000) |
| 1 | 20,000 | 0.10 | [20000 / (1+0.10)^1] | 18,182.82 |
| 2 | 25,000 | 0.10 | [25,000 / (1+0.10)^2] | 20,661.16 |
| 3 | 30,000 | 0.10 | [30,000 / (1+0.10)^3] | 22,539.44 |
| 4 | 35,000 | 0.10 | [35,000 / (1+0.10)^4] | 23,905.47 |
| 5 | 40,000 | 0.10 | [40,000 / (1+0.10)^5] | 24,836.85 |
| NPV | 10,124.74 |
The project has a positive NPV and, therefore, can be accepted by the company.
What is IRR?
IRR, which stands for “Internal Rate of Return,” is a significant financial metric used to evaluate the profitability of an investment or project. It represents the rate at which the total discounted cash inflows from the project equal the discounted cash flows. In other words, it is the rate at which the investment breaks even, where the present value of all future cash inflows equals the present value of all future cash outflows.
The IRR is expressed as a percentage and helps estimate the potential profit generated by an investment. It allows financial planners and investors to assess the return on investment in relative terms rather than just considering dollar values. The IRR can be seen as the cost of capital required to make a project turn a profit. It is also known as the “discounted flow rate of return” or the “economic rate of return.”
When evaluating a potential investment or project, if the IRR is equal to or greater than the initial capital invested, it indicates that the project is expected to generate a profit, and financial planners often proceed with it. On the other hand, if the IRR is lower than the cost of capital or the expected rate of return, it suggests that the project may not be financially viable, and financial planners may choose not to proceed with it as it could result in losses.
The calculation of IRR is quite complicated and is through a trial and error method. As mentioned earlier, At IRR the NPV of a project is equal to zero,
Therefore, at IRR, the Present value of cash outflows / the Present value of cash inflows = 1
Consider the following example to understand the calculation of IRR for a company.
Company A has a project that requires an initial investment of Rs. 1,00,000. Over the next four years, the project generates cash flows of Rs. 30,000, Rs. 35,000, Rs. 40,000, and Rs. 45,000, respectively.
The calculation of the IRR for this project will be done using the trial and error method.
| Year | Cashflows | DCF @ 17% | PV of Cash flows | DCF @ 18% | PV of Cash flows | DCF @ 17.1% | PV of Cash flows |
| 0 | (100000) | 0 | (100000) | 0 | (100000) | 0 | (100000) |
| 1 | 30000 | 1.17 | 25641.03 | 1.18 | 25423.73 | 1.17 | 25619.13 |
| 2 | 35000 | 1.37 | 25567.97 | 1.39 | 25136.46 | 1.37 | 25524.32 |
| 3 | 40000 | 1.60 | 24974.82 | 1.64 | 24345.23 | 1.61 | 24910.89 |
| 4 | 45000 | 1.87 | 24014.25 | 1.94 | 23210.50 | 1.88 | 23932.33 |
| NPV | 198.07 | -1884.08 | (13.33) |
Using the trial and error method, we can know that the NPV is almost zero between 17% and 17.1%. Therefore, it can be concluded that the IRR is approximately 17%.
The above method of trial and error is quite cumbersome, especially in the case of longer time frames and varied cash flows. Therefore, it is better to use the MS Excel formula of IRR to get the results in an efficient and quicker manner.
What are the key differences between NPV and IRR?
| Category | NPV | IRR |
| Definition | NPV represents the total value of future cash flows, whether positive or negative, brought back to the present time using a discount rate. | IRR represents the rate at which the total discounted cash inflows equal the discounted cash outflows, representing the break-even for a project. |
| Calculation | NPV involves using a discount rate to calculate the present value of cash flows and then subtracting the initial investment to determine the net gain or loss. NPV is represented in absolute terms | IRR involves finding the discount rate that makes the sum of cash inflows equal to the sum of cash outflows, expressed as a percentage rate of return. IRR is the profitability of a project or the business in general and hence is represented in the form of a percentage rate of return |
| Interpretation | The project is accepted if NPV is positive (NPV > 0), as it indicates the investment is expected to generate more value than the initial cost. | The project is accepted if IRR is greater than the required rate of return or cost of capital as the investment is then to be considered profitable. |
| Ease of understanding | NPV is easier to understand and calculate as compared to IRR | The computation of IRR is through a trial and error method which can be quite cumbersome and tedious as compared to NPV. |
| Suitability | The net present value method is more appropriate for projects with longer durations. | The internal rate of return method is more suitable for projects with shorter durations. |
| Flexibility | NPV is relatively flexible compared to IRR. It will provide a different result with the change in the discounting rate for the same projects. | IRR is not as flexible compared to the NPV |
Conclusion
NPV and IRR are important concepts in financial planning and budgeting decisions for a business. The use of NPV or IRR will however depend on the nature of evaluation or analysis, for example, when the business has to decide among two mutually exclusive projects, NPV will be more suitable as it will provide results in absolute terms and can be easily calculated as well as interpreted. This will further help in making realistic capital budgeting decisions for long-term projects.
FAQs
NPV is easier to compute as well as interpret as compared to IRR.
The Internal Rate of Return (IRR) is often referred to as the breakeven point because it is the discount rate at which the Net Present Value (NPV) of an investment or project becomes zero. In other words, the IRR is the rate of return at which the total discounted cash inflows are equal to the total discounted cash outflows.
Yes, IRR can be used for long-term projects to assess their profitability and compare the potential returns with the required rate of return or cost of capital. However, IRR may have its limitations, especially when dealing with projects that have unconventional cash flow patterns or multiple solutions as this could lead to ambiguity in investment decisions.
If a project produces negative NPV, it refers to a net loss from such a project and therefore should not be accepted.
