What are the NPV and the IRR?
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. Rather, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.
Both measures are used primarily in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worth it. Given an investment opportunity, a business must decide whether making the investment will generate net economic gains or losses for the business.
- The NPV and the IRR are two discounted cash flow methods used to evaluate investments or capital projects.
- NPV is the difference in dollars between the present value of discounted cash inflows minus outflows during a specified period of time. If the NPV of a project is greater than zero, it is considered to be financially worth it.
- The IRR estimates the return on potential investments using a percentage value rather than a dollar amount.
- Each approach has its own advantages and disadvantages.
Determination of NPV
To do this, the company estimates the future cash flows of the project and discounts them in present value amounts using a discount rate that represents the cost of capital of the project and its risk. Then all future positive cash flows from the investment are reduced to a present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value of the investment.
Let us illustrate with an example: suppose that JKL Media Company wants to buy a small publishing company. JKL determines that future cash flows generated by the publisher, when discounted at an annual rate of 12 percent, yield a present value of $ 23.5 million. If the publisher owner is willing to sell for $ 20 million, then the NPV of the project would be $ 3.5 million ($ 23.5 – $ 20 = $ 3.5). The NPV of $ 3.5 million represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition.
Determination of the IRR
So JKL Media’s project has a positive NPV, but from a business perspective, the company must also know what rate of return this investment will generate. To do this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate. The rate that the solution produces is the project’s internal rate of return (IRR).
For this example, the IRR of the project could, depending on the timing and proportions of the cash flow distributions, be equal to 17.15%. Thus, JKL Media, given its projected cash flows, has a project with a profitability of 17.15%. If there was a project that JKL could undertake with a higher IRR, it would probably go for the highest performing project.
Therefore, you can see that the usefulness of IRR measurement lies in its ability to represent the potential return of any investment opportunity and compare it to other alternative investments.
Example: IRR vs NPV in capital budgeting
Let’s imagine a new project that has the following annual cash flows:
- Year 1 = – $ 50,000 (initial capital outlay)
- Year 2 = $ 115,000 return
- Year 3 = – $ 66,000 in new marketing costs to review the look of the project.
In this case, a single IRR cannot be used. Remember that the IRR is the discount rate or interest necessary for the project to break even given the initial investment. If market conditions change over the years, this project may have multiple IRRs. In other words, long projects with fluctuating cash flows and additional capital investments can have multiple different IRR values.
Another situation that causes problems for people who prefer the IRR method is when the discount rate for a project is unknown. For IRR to be considered a valid way of evaluating a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible. If it is below, the project is considered not feasible. If a discount rate is not known or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If the NPV of a project is greater than zero, it is considered to be financially worth it.
The bottom line
Both IRR and NPV can be used to determine how desirable a project will be and whether it will add value to the business. While one uses a percentage, the other is expressed as a dollar figure. While some prefer to use IRR as a measure of the capital budget, it presents problems because it does not take into account changing factors, such as different discount rates. In these cases, it would be more beneficial to use the net present value.