Net Present Value (NPV) is a capital budgeting technique used to determine an investment’s profitability. Internal Rate of Return (IRR) is a financial metric that estimates the return from an investment. Though both NPV vs IRR determine how profitable an investment is, they are quite different. This article covers NPV vs IRR in detail.
What is the Internal Rate of Return or IRR?
A financial metric that helps in estimating the profitability of a potential investment is the Internal Rate of Return or IRR. It is the rate at which the net present value of the cash flows is zero. In other words, it is the rate at which the NPV equals zero.
IRR is used for comparing potential investments, projects and business opportunities. It also helps in analysing various capital budgeting projects. Furthermore, IRR is often used to compare the cost of capital. If the internal rate of return exceeds the cost of capital, then the project is profitable. If the IRR is below the cost of capital, then the project shouldn’t be considered for investment.
However, IRR alone cannot be used to evaluate an investment opportunity. Other quantitative factors and qualitative factors also have to be evaluated before making a decision to invest in the project.
In IRR, NPV is always equated to zero. This means the cash inflows and outflows of a project is equal. The internal rate of return is in the form of a percentage, hence making it easier to compare investments. IRR is also used along with RRR or the required rate of return. If the IRR is greater than RRR, then the business can consider investing in the project. However, if there are multiple projects, the project with the highest difference between IRR and RRR should be considered for investment.
What is the Formula for Calculating Internal Rate of Return IRR?
The IRR method uses the Net Present Value formula.
NPV = (Cash flows /(1+r)^n) – Initial investment
Cash flows = All the cash flows during the time period of investment.
r = IRR
n = time period.
Initial investment – It is the first investment made into the project.
IRR is the rate at which the present values of all future cash inflows are equal to the cost of investment. In other words, at the IRR rate, all the cash inflows will be equal to cash outflows. Therefore, this is the ideal rate at which investors are profitable.
Always, to compute IRR, the NPV is set to zero. However, solving IRR manually is a time-consuming process and is done only on a trial and error basis. However, one can use software like Microsoft Excel to compute IRR.
Example of the IRR method
Let’s understand IRR better with an example. There are two mutually exclusive projects which require an investment of INR 7,00,000, and the company has to choose between these two projects to invest in. The cash inflows of project A for the next four years are INR 2 lakh, INR 2.5 lakh, INR 3 lakh and INR 5 lakhs. The cash inflows of project B for the next four years are INR 5 lakh, INR 3.5 lakh, INR 2 lakh and INR 1 lakh. One can calculate IRR in Excel using the IRR function.
The IRR formula in MS Excel is = IRR(cash flows)
Project A’s Internal Rate of Return
Following are the positive and negative cash flows for the project A:
Project B’s Internal Rate of Return is
Following are the positive cash flows and negative cash flows for project B:
If the company were to choose based on IRR, then it would choose project B. This is because the return of project B (32%) is higher than project A (24%).
What is Net Present Value or NPV?
A capital budgeting technique that estimates the profitability of investments NPV or Net Present Value. It is the difference between the present value of all future cash outflows and value of the investment. Time value of money is the basis of NPV. In this concept, money has more worth today than tomorrow.
Investors use NPV to determine investment profitability. Businesses also use NPV to determine which project to select. In NPV, the future cash flows from an investment are determined. Then, they are discounted to present value using the discount rate. Finally, the investment is subtracted from it. If the NPV is positive, then business or investment is considered as profitable. If it is negative, then the investment is not profitable. Incase, the NPV is zero, the investor will be indifferent towards it.
What is the Formula for Calculating Net Present Value (NPV)?
Net Present Value is computed by discounting all the future cash flows from an investment and subtracting the initial investment. Following is the formula for calculating NPV:
NPV = (C1/(1+r)^t1 + C2/(1+r)^t2 …. + Cn/(1+r)^tn) – Initial Investment
Where C1, C2, Cn are cash flow for time periods 1, 2, until n number of years.
r is the discount rate
t1, t2, tn are the different time periods.
The initial investment is the amount invested in the project.
The prospective investor is generally aware of the project cash flows. The discount rate is usually determined by the return on investment of an investment with a similar borrowing cost (interest) or similar risk.
Example of the NPV method
Let us understand Net Present Value NPV better with the help of an example. An investment has an initial cash flow of INR 753,000. The projected cash flows of the project for the next five years are INR 15,000, INR 20,000, INR 30,000, INR 45,000 and INR 50,000. The rate of return from a similar investment is 12%. Hence 12% is the discount rate. One can use the NPV method for calculating the Net Present Value of this investment.
NPV = (15000/(1+.12)^1 + 20000/(1+.12)^2 + 30000/(1+.12)^3 + 45000/(1+.12)^4 + 50000/(1+.12)^5) – 75000
NPV = 1,07,659.79– 75,000
Net Present Value = INR 32,659.79
Since the project’s NPV is positive, it is a profitable option for investment.
Difference Between NPV vs IRR, Net Present Value vs Internal Rate of Return
Net Present Value is the difference between the present value of all future expected cash inflows and the present value of the cash outflows. On the other hand, the Internal Rate of Return (IRR) is the rate at which the net present value of cash inflows is equal to the net present value of cash outflows. NPV vs IRR which is a better metric? While both have a few differences w.r.t. usage, what they represent and implementation. Following are the differences between NPV and IRR.
|Parameter||Net Present Value||Internal Rate of Return|
|Meaning||The present value of all cash flows of a project or investment is called NPV.||IRR is the rate at which the cash inflows are equal to cash outflows. In other words, it is the rate at which the Net Present Value of an investment is zero.|
|Representation||Represented in absolute terms||Represented in percentage terms|
|Indicates||Surplus from an investment or a project||It is the break-even point of an investment or a project – no profit or no loss scenario.|
|Rate for reinvestment||Cost of capital rate||Internal Rate of Return|
|Variable Cash outflows||It will not have an impact on the NPV.||Results in negative or multiple IRR|