Read this blog to understand the difference between NPV i.e Net present value and IRR i.e Internal rate of return, before making investment decisions using discounted cash flow methods.
Introduction:
Simply put NPV stands for Net Present Value and is a capital budgeting technique that will help you determine the profitability of your investment. However, the Internal Rate of Return or the IRR is a financial matric to determine the estimated return that one can make from an investment.
Even though both NPV and IRR are used to determine an investment’s profitability, there are some fundamental differences between the two. In this blog, we will understand these differences in detail and clear some common misconceptions.
Let us first understand the definition of NPV and IRR, we will later discuss their formula and will walk you through some examples for a better understanding of the topic.
Net Present Value (NPV)
Net present value (NPV) tells us the potential value of an investment by calculating the difference between the net present value of cash inflows and the net present value of cash outflows over a specific time period. In simple words, NPV helps an investor predict if they can achieve their target yield from a prospective investment opportunity, by calculating the total value of an investment opportunity by discounting all the future inflows and outflows of cash to the present day.
Some Important points to note:
NPV takes into consideration the time value of money and helps you calculate the present value of all cash inflows and outflows in the future.
If the NPV of a project is positive, it simply means a positive return on your investment, thereby making the prospective project more attractive for investors. However, if a project has a negative NPV, it needs to be avoided.
In order to calculate the NPV, one needs to accurately estimate the future cash flows and also come up with the correct discounted rate, as these are important to access the profitability of a project.
Net Present Value Formula :
Where,
Cn = Stands for cash flows during a period (n)
r = Stands for the discounted rate of return
n = Stands for the time period, and
N = Stands for holding period
Limitations of NPV Calculation:
- While calculating the NPV the duration of a project is not taken into consideration. As a result, when you compare two different projects with different tenure, NPV results may be biased towards the project having a longer duration.
- It is hard for an analyst to calculate the future cash flows and discount rates with 100% accuracy.
- The factors like the opportunity cost of a project and the scale of investment are not taken into account for the calculation of NPV.
Let us now discuss the definition and formula for IRR
Internal Rate of Return (IRR) Definition
IRR is a financial metric that helps one calculate the profitability of future investments. For the calculation of IRR, the NPV of an investment is set at “zero”. In simple words, IRR is the percentage of money earned on an investment, just like the interest that one receives on a fixed deposit in a bank. IRR gives the investor a tool to compare the investment opportunities based on the yields they can produce.
Here are some key points that one must remember when calculating IRR:
- The calculation of IRR does not take into consideration external factors like inflation, financial risk, cost of capital or risk-free rate.
- IRR calculates the annual growth that a business can generate. It is ideal for comparing the projects based on their returns over time.
Let us now take a look at the IRR formula:
Where,
CFn = Stands for net cash flow during time period n.
IRR = Stands for internal rate of return
N = Stands for time period
While calculating IRR using this formula, NPV is always taken as zero, all the cash outflows (like the intial investment in the project) are negative, whereas all cash inflows are shown as positive.
Limitations of IRR
While calculating IRR the cost of capital is not taken into consideration. Cost of capital is the major factor to determine the returns on a project.
When comparing two projects using IRR, the size and scope of the project are not taken into consideration, it only takes into account the inflows and outflows of money.
The biggest hurdle in IRR calculations is that it assumes the investment of future cash flows at the same IRR. In reality these numbers are quite high.
Now that we have talked about NPV and IRR, let’s understand which one is better in NPV vs IRR, while making an investment decision?
Well both these capital budgeting techniques are widely used by investors while making an investment decision. IRR is better if you are comparing two or more projects or investment opportunities where it is difficult to determine the accurate discounted rate. However, one must use NPV when the cash flows are constantly flipping between the positive and negative, or when multiple discount rates need to be taken into consideration.
Conclusion:
Sometimes the results of IRR and NPV can be drastically different from one another. In such cases the experts don’t rely only on the IRR and NPV calculations, rather they combine the results of IRR with scenario analysis, which shows different possible NPVs based on several different assumptions.
The IRR and NPV analysis is also done in conjunction with the Weighted Average Cost Of Capital (WACC) and the required rate of return, for further analysis.
Sometimes when the projects have different time lengths, there may be issues in IRR calculations. A project having a shorter duration may have a better IRR compared to a project that has a longer duration and gives steady returns. In such cases, one must consider the ROI metrics before coming to a conclusion.
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