Similarities and Differences Between NPV and IRR
In this guide, we look in depth at the similarities and differences between NPV and IRR. We look at how these similarities and differences inform investors’ decision-making.
Table of Contents
What is NPV?
Net Present Value are both negative and positive cash flows projected in the future and discounted presently. In other words, NPV is the difference between a project or investment’s discounted future cash flows and the sum invested now.
If the calculation of the Net Present Value of an investment or project is positive, it implies such a project is feasible. On the contrary, a negative NPV indicates that an investment is not worth the risk.
What is IRR?
The internal rate of return is quite similar to the net present value, only that the discount rate reduces the value of the net present value to zero. IRR creates the break-even point in this case. The internal rate of return is intrinsic as it excludes factors like inflation and risk-free rates in order to be calculated appropriately.
A suitable internal rate of return is generally considered to be positive. ThisThis means that the rate is above the working capital, which is usually taken as the base or the hurdle rate.
Similarities Between NPV and IRR
1. Both are discounting methods
The NPV and the IRR are discounting methods used to evaluate the profitability of an investment or project undertaken by a firm.
2. Both consider time value of money
NPV and IRR are concerned with discounting future cash flows to obtain their present values since time loses value with time.
3. Used to decide whether to accept or reject an investment
Both methods are involved with decisions on whether to accept or reject a project or investment given the analysis outcome. Positive NPVs are acceptable, while any rate above the hurdle rate is acceptable for the internal rate of return.
4. They are capital budgeting techniques
The internal rate of return and net present values are techniques or methods of evaluating the suitability of an investment when conducting capital budgeting. Expansion of firms also requires these two techniques to provide insights into the same.
Differences Between NPV and IRR
The Net Present Value is the total of all future cash flows, both negative and positive, discounted now, while the internal rate of return is the rate at which the total sum of all discounted cash inflows is equal to the discounted cash outflows.
The net present value is expressed as a financial figure, while the internal rate of return is expressed in percentages. NPV shows the cash amount a company hopes to earn from an investment or project. In contrast, the internal rate of return gives us the percentage profitability of an investment.
3. Tenure of use
The internal rate of return is suitable for projects that will run for shorter periods, while the net present value is suitable for projects that take a longer period since it can factor in additional wealth.
4. Project evaluation
The net present value can be used even when projects have a constant movement of cash flows, while this cannot be applied to the evaluation of projects using the internal rate of return.
5. Evaluating mutually exclusive projects
Evaluating two or more projects to determine their viability can only be calculated using the net present value. Due to its simplicity in the interpretation of information, it provides a better insight into projects, and thus, deciding on which one to invest in is easy. This, however, does not apply while using the internal rate of return.
Net present value is quite flexible in calculating cash flow values and can cater to differences in cash flow movement. This, however, cannot be said of the internal rate of return since it is less flexible to allow such changes.
7. Evaluation of additional wealth
The net present value can be used to evaluate any additional, whereas the internal rate of return cannot.
8. Discounting rates
In any case, the discount rate of a net present value changes, it generates different results for a particular project or investment, while the internal rate of return generates the same result even if the discount rate changes for a particular project or investment.
The general public can easily understand and interpret the net present value of a project or investment. On the other hand, the internal rate of return is complex, with negative rates difficult to interpret.
10. Acceptance of the project
In the case of net present value, a project is acceptable when the net present value is positive. Using the internal rate of return, a project is acceptable when the rate is higher than the hurdle rate.
11. Purpose of evaluation
The purpose of a project’s net present value concerns itself with any surplus on the project, while the internal rate of return is concerned with the break-even points of cash flows of a single project.
Why Would an Investor Choose NPV Over the IRR?
- IRR assumes that the discount rate will be the same throughout, which is not the case. NPV will defer over the years, given the cash inflows and outflows.
- The internal rate of return may offer several solutions that may be difficult to analyze and confusing.
- IRR can generate a negative answer which may be difficult to analyze and offer sufficient interpretation.
- A positive net present value indicates wealth maximization for shareholders, while a negative present value implies a reduction in shareholders’ wealth. This, however, does not apply to the internal rate of return.
The internal rate of return is still applicable in certain cases since the Net present value is inherently complex and has assumptions to consider at almost every stage.