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NPV vs IRR: What are the similarities and differences between NPV and IRR?
NPV (Net Present Value) and IRR (Internal Rate of Return) are widely used in the finance world when we talk about the profitability and feasibility of projects that require investment and are expected to generate cash flows in the future. While the core concepts of NPV and IRR are simple to understand, sometimes they can confuse some people. In this article, we will discuss NPV vs IRR in detail to provide more clarity on the subject.
What is NPV or Net Present Value?
We have already discussed what NPV or Net Present Value is in Finance here. Let’s understand what NPV is.
NPV stands for Net Present Value in Finance.
Before we understand what NPV is, let’s understand a few basic concepts of finance.
Conceptually, a dollar today (say in 2023) is worth more than a dollar 10 years in the future. Why? Because I can invest this dollar somewhere and in 10 years have much more than a dollar with me. Essentially, there is some ‘time value of money’.
Time Value of Money
The time value of money is a financial concept that refers to the idea that money available today is worth more than the same amount of money in the future. The basic premise is that a dollar received today is worth more than a dollar received in the future because of its potential to earn interest or increase in value over time.
Now that we know that a dollar today is worth more than the same dollar 10 years in the future. Directionally we understand that the value of money decreases with the passage of time.
When a business or an investor plans out a business, they also project the cash flows of the business, i.e., how much money they expect to earn in year 1, year 2, year 3, year 4, year 5, etc. However, they have to make an upfront investment today to start the business. Now, we have money in various years – year 0 through year 5. How do we compare them all?
With the knowledge of ‘time value of money’, we can estimate the ‘Present Value’ of money from the future in today’s dollar value.
All future cash flows are adjusted by a factor to estimate their current value or present value. The adjustment factor is called ‘discount rate’.
A discount rate is not a one-size-fits-all solution. Depending on the context, the discount rate for calculating the present value can vary.
A good way to think about a discount rate is this: “What is the alternative place where I can put this money and what is the return I can expect with a similar amount of risk”
For example, a common investor can use the expected returns of investing in a S&P500 Index ETF. A venture capital fund might have different risk tolerance and their discount rate would be different for their calculation purposes.
The discount rate is used on future cash flows to approximate their value in today’s dollar terms.
Okay, now we know that there is something called time value of money and discount rate can be used as a tool to determine the time value of money and approximate the future cash flows into Present Value.
So, we make an investment today – we already know the Present Value of that investment.
We use the Discount Rate to calculate the Present Value of all future cash flows.
Now we have all dollar amounts in today’s value. To calculate the Net Present Value, we add all the Present Values (of future cash flows) and subtract the investment made today.
Voila, we have our Net Present Value with us.Finlightened.com
Let’s say I am buying a business and the business costs me $50,000 today. I have the cash with me right now, and if chose not to buy the business, I can invest the money in the stock market expecting 8% average annual return on investment.
So, for the NPV calculation, my initial investment is $50,000, and the discount rate is 8%.
My business expects to generate cash flow (profits) for me for the next 4 years.
- year 1: 15000
- year 2: 25000
- year 3: 22000
- year 4: 20000
In the NPV Calculator, I can input all of these values, and press the ‘Calculate’ button to see the NPV of the business acquisition.
The NPV is $17,487.27. Since the NPV is a significant positive number, I can decide to go ahead with the plan to purchase the business (as it is expected to give me better returns than just investing in stock market @8% annual returns).
What is IRR or Internal Rate of Return?
We have already discussed what IRR or Internal Rate of Return is here. Let’s understand IRR.
IRR stands for Internal Rate of Return in Finance.
IRR is the return on investment at the project’s breakeven point (i.e., the project is barely justified as valuable).
To understand IRR, you must understand NPV or Net Present Value.
When NPV is positive, the project is expected to be valuable, and the management will give a green light to the project. When NPV is negative, the management will most likely not proceed with the project.
IRR is the rate of return when the NPV of the project is 0 (i.e. when the NPV just breaks even).finlightened.com
Let’s take the same example of acquiring a business for $50,000 as discussed above.
So, I have $50,000 cash with me and I want to buy a business. I have projected the cash flows from the business for the next 4 years.
- year 1: 15000
- year 2: 25000
- year 3: 22000
- year 4: 20000
Let’s do the IRR Calculation and find the IRR or Internal Rate of Return on this investment.
In the IRR Calculator, I can input all the values for initial investment and projected cash flows, and hit ‘Calculate’ to view the result.
Here, I see that the IRR is 22.24%. This rate or return looks much better than the 8% return I am expecting in the stock market. So, I can go ahead with my plan of buying the business.
NPV vs IRR: Differences
Here are the four key differences between NPV and IRR:
NPV or Net Present Value is represented in money terms, for example in Dollars, Euros, Yen, Yuan, Rupee, etc.
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IRR or Internal Rate of Return is represented in percentage terms.
2. Help With Decision Making
NPV is represented in money terms, so it proves to be a better metric to make decisions. For example, a project with NPV of $1 Million will be preferred to a project with NPV of $100,000, all else being equal. Even for dissimilar projects and investment requirements, NPV is helpful in deciding which project is more profitable.
IRR is represented in percentage terms, so it can appear a little vague at first. Especially for dissimilar projects with different investments, it can be confusing to understand whether a 20% IRR project is better than an 18% IRR project.
(Maybe the 18% IRR project has a better NPV due to different investment requirements – so, it is difficult to tell without gathering more information)
3. Requirements For Calculation
To calculate NPV, we require – initial investment, a discount rate, and the cash flows.
To calculate IRR, we require – initial investment and cash flows.
We don’t require the discount rate for calculating IRR but it can be helpful for comparing against the IRR (once we have calculated IRR)
4. Single vs Multiple Results
For a given set of inputs, we get one single result for NPV
In some cases that involve irregular cash flows (some positive and some negative cash flows), there can be multiple results for IRR.
NPV vs IRR: Similarities
Here are the three key similarities between NPV and IRR
- Both NPV and IRR Calculation results enable financial decision-making in their own way.
- Both NPV and IRR require information regarding initial investment and future cash flow projections.
- Both NPV and IRR are considered better directionally – i.e. the higher the better.
NPV Calculator Online
You can calculate the Net Present Value online on this site, using this link: NPV Calculator
Alternatively, you can calculate the Net Present Value online on our partner site, using this link: NPV Calculator
IRR Calculator Online
You can calculate the Internal Rate of Return online on this site, using this link: IRR Calculator
Alternatively, you can calculate the Internal Rate of Return online on our partner site, using this link: IRR Calculator
NPV Calculator App
You can download our NPV Calculator app on the Apple App Store for your iOS devices.
IRR Calculator App
You can download our IRR Calculator app on the Apple App Store for your iOS devices
To Wrap Up The NPV vs IRR Discussion
We hope this article on NPV vs IRR helped you better understand the similaries and differences between NPV and IRR. Typically, project owners, investors, and decision makers calculate both NPV and IRR to see the complete picture and then make a ‘go’ vs ‘no-go’ decision.
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