NPV vs IRR

Last Updated on Feb 20, 2023 by

If you are not impulsive but a capital rational investor, you might find it difficult to pick a project among various alternatives. Companies can use several criteria to evaluate capital investment opportunities. In this article, let’s look into NPV and IRR better to understand the economic logic behind each investment decision criterion.

What is NPV?

NPV (Net Present Value) is the present value of all the negative and positive cash flows from a project or investment.

NPV=C0+C1(1+r)1+C2(1+r)2+C3(1+r)3+C4(1+r)4= t=0nCt(1+r)t

C₀   = Initial Investment (negative cash flow)
r    = Discount Rate or Required rate of return

C_t   = Net Cash Flow at time t

Points to remember  

• If NPV value is zero or positive, the project can be accepted as the present value of total cash inflow is greater than or equal to the present value of total cash outflow, and it meets the required rate of return.
• If the NPV value is negative, it means that the project is not fulfilling the expected rate of return, and it should not be accepted as the present value of total cash inflow is less than the present value of total cash outflow.

What is IRR? 

IRR (Internal Rate of Return) is the discount rate where the NPV of all cash flows (outflow and inflow) nets to zero.

0=NPV=C0+C1(1+IRR)1+C2(1+IRR)2+C3(1+IRR)3+C4(1+IRR)4= t=0nCt(1+IRR)t

Points to remember  

• IRR is a measure of the profitability of a project in percentage (%) terms.
• IRR is calculated using a trial-and-error procedure.
• If IRR > Required rate of return, accept the project.
• If IRR < Required rate of return, do not accept the project.
• IRR provides a better picture when used in comparative analysis. It is less effective when considered in isolation.
• IRR does not consider external factors such as financial risk, inflation, risk-free rate, or cost of capital.

NPV vs IRR

• Let’s assume that an investor has limited funds and needs to select one project between the two investment opportunities, i.e., they are MUTUALLY EXCLUSIVE PROJECTS, and the NPV and IRR are giving conflicting results. This may happen because of the following reasons:

Reason 1: Difference in size/scale of project

Reason 2: Difference in the timing of project’s cash flows

As you can observe in the above two tables, NPV and IRR are giving conflicting results. According to NPV, project B must be selected, and according to IRR, project A must be selected. In these types of cases:

• NPV is a strongly preferred criterion as it shows the actual wealth added to an investor.
• IRR assumes reinvestment at the IRR itself, whereas NPV assumes reinvestment of cash flows at the required rate of return. NPV is more realistic in terms of reinvestment assumption.
• If the investor has limitless funds, they can simply select a project if –  

1. NPV ≥ 0
2. IRR   > Required rate of return

• Which method to choose for evaluating and selecting an investment? It completely depends. For instance, 
• IRR is not useful for non-conventional projects [a project where cash flows have multiple changes in sign (+, -) over time] as it can have multiple IRR or no IRR. 

Multiple IRR                                          

No IRR 

In cases where it is difficult to determine the discount rates, IRR is a useful metric. NPV must be considered when there are multiple discount rates. 

In a nutshell 

Investors find IRR easier to calculate and understand, and therefore when companies use NPV to make an investment decision, they also state IRR for a better understanding. 

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Nikhil Sharma

Nikhil Sharma is a Commerce graduate from University of Delhi. He is an associate at EY. He is currently pursuing FMVA from CFI Institute and has cleared CFA Investment Foundations Program. He likes to analyze companies he considers of interest and he is a stock market investor with a modern risk appetite.

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