The difference between NPV and IRR

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What is Net Present Value?

Net present value (NPV) discounts the stream of expected cash flows associated with a proposed project to their current value, which presents a cash surplus or loss for the project. It is used to evaluate a proposed capital expenditure. A desirable investment is one that yields a positive net present value, which implies that a business will receive excess cash over time as a result of the investment. A negative net present value indicates that a company will lose money on a proposed investment.

What is Internal Rate of Return?

The internal rate of return (IRR) calculates the percentage rate of return at which the cash flows associated with a project will result in a net present value of zero. It is used to evaluate a proposed capital expenditure, where the IRR of a proposed investment should be higher than an entity's cost of capital before the investment will be accepted.

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Capital Budgeting

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Comparing NPV and IRR

The two capital budgeting methods have the following differences:

  • Outcome. The NPV method results in a dollar value that a project will produce, while IRR generates the percentage return that the project is expected to create.

  • Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project.

  • Decision support. The NPV method presents an outcome that forms the foundation for an investment decision, since it presents a dollar return. The IRR method does not help in making this decision, since its percentage return does not tell the investor how much money will be made.

  • Reinvestment rate. The presumed rate of return for the reinvestment of intermediate cash flows is the firm's cost of capital when NPV is used, while it is the internal rate of return under the IRR method.

  • Discount rate issues. The NPV method requires the use of a discount rate, which can be difficult to derive, since management might want to adjust it based on perceived risk levels. The IRR method does not have this difficulty, since the rate of return is simply derived from the underlying cash flows.

In summary, you should use NPV when you need a clear measure of wealth creation, or when you are comparing projects with different sizes, durations, or cash flow patterns. You should use IRR when simplicity and percentage returns are more relevant for your decision-making, or when projects have conventional cash flows (initial outflow followed by inflows). For robust decision-making, it’s often recommended to use both methods together, supplemented by other analyses like payback period or profitability index.