NPV vs IRR

NPV compares investment costs with returns to show profit or loss, while IRR calculates the percentage return. Secondly, NPV reveals money outcomes, while IRR focuses on profitability percentage.
NPV vs IRR
3 min
10-June-2024

Net Present Value (NPV) and Internal Rate of Return (IRR) are methods to assess investment profitability. NPV compares the money you'll receive from an investment with what you initially invest. It shows whether you'll make a profit or loss in actual currency. On the other hand, IRR calculates the percentage return an investment will generate over its lifespan. Both NPV and IRR are crucial for evaluating whether an investment is financially beneficial or not.

In this blog, we’re going to explore the key differences between Net Present Value (NPV) and Internal Rate of Return (IRR).

What is an IRR?

The Internal Rate of Return (IRR), on the other hand, is essentially a financial metric for calculating the net return from a given investment. It is also the rate at which the NPV of cash flows is zero. IRR finds use when potential investments, business opportunities, and projects are compared. Moreover, it helps to analyse several capital budgeting exercises and to compare capital costs. If the IRR exceeds the capital cost, then the project will most likely be profitable. Conversely, should the IRR be less than the capital cost, the project may not be a lucrative investment option. IRR, however, by itself is not usable for evaluating an opportunity for investment and other assorted qualitative and quantitative factors need to be evaluated also before taking a final decision on investing in a project.

In the IRR, since NPV is always zero, this implies that a project’s cash inflows and outflows are equal. IRR is always a percentage, which makes it easier in comparing investments. Moreover, a Required Rate of Return (RRR) is also used with IRR, and should the latter be more than the RRR, then a business may consider investing in a project.

What is an NPV?

NPV in basic terms, is a technique for capital budgeting to calculate the probable profitability of an investment, and is the quantitative difference between the current value of all cash outflows in future and the investment’s value. The time value of funds forms the basis of NPV, which supports the view that money is more valuable today than the next day.

A probable investor uses NPV for ascertaining the investment’s profitability. Similarly, businesses also apply NPV to select the appropriate project. In the case of NPV, an investment’s cash flows in the future can be calculated. Subsequently, they are discountable to work out a value by using the rate of discount. Finally, the investment value is deducted from it. A positive NPV indicates a profitable investment or business. On the contrary, a negative NPV indicates a non-profitable investment.

Net Present Value vs Internal Rate Of Return - Explore Key Differences

While discussing the concept of net present value vs internal rate of return, it may be said that even though Net Present Value and Internal Rate of Return are both financial metrics to ascertain an investment’s profitability, there are several differences between the two concepts in terms of their usage, representation, and implementation.

Definition: NPV denotes the difference between the current value of all cash inflows in future and the current value of all cash outflows. The IRR, on the flip side, is a rate at which the current cash inflow’s net value equals the net cash outflow’s current value.

  • Representation: NPV is always represented in absolute terms, whereas IRR is calculated as a percentage.
  • Indicates: NPV denotes the surplus arising from a project or investment; IRR is an investment or project’s break-even point, which is a no-profit-no-loss situation.
  • Reinvestment Rate: NPV is the capital rate cost, whereas IRR is the internal return rate
  • Variable Cash Outflow: This does not impact the NPV. In the case of IRR, it gives a negative result or leads to multiple IRRs.

The above in a nutshell, are the differences between net present value vs internal rate of return.

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Frequently asked questions

Define NPV?
NPV is an acronym for Net Present Value, and may be defined as a financial metric for evaluating a project or investment through a comparison of the current value of future cash inflows with the current value of probable cash outflows in future.

What is the definition of IRR?
IRR is expandable to Internal Rate of Return, and is also a financial metric for calculating a project or investment’s potential profitability. The IRR denotes the rate of discount at which the NPV of all cash flows from a given investment is nil. In other words, it is a rate of return that makes the current value of all cash inflows equal to all cash outflows at current value.

How do IRR and NPV influence decision-making?
In terms of decision-making, a positive NPV signals that a given project will most likely generate more value than its capital costs, thus making it more acceptable overall. On the other hand, if the IRR is more than the hurdle rate or required rate of return, the project will most likely generate returns that will be higher than its overall capital cost and would be considered acceptable.

Is a project with negative IRR and positive NPV possible?
Yes, it is possible for a project to have a positive NPV, provided the rate of discount used for calculating the NPV is lesser than the IRR. Hence, the project can be financially viable since it generates a higher value than its capital cost. Even then, the IRR can be negative if the cash flows of the project do not adequately compensate for the invested capital, in spite of the project's value being positive.

Is it possible for NPV and IRR to give conflicting results?
Both IRR and NPV have their respective limitations, when used separately or in particular scenarios. Hence, it becomes essential to study both metrics simultaneously to comprehend their implications, particularly when it comes to taking investment decisions or the evaluation of investment alternatives.

What are the differences between NPV net present value and IRR internal rate of return?
Both NPV and IRR differ in terms of their definition, method of calculation, interpretation, scale sensitivity to the investment, reinvestment assumption, and opportunities for multiple investment.

Which is better: higher NPV or higher IRR?
Neither a higher IRR nor a higher NPV is inherently better. Choosing between IRR and NPV depends on the investment’s specific circumstances and the decision-maker’s objectives.

What is the conflict between IRR and NPV?
The conflict arises in situations where unconventional patterns of cash flow or differences in project scale result in conflicting rankings or even ambiguous criteria for decision-making. The conflict between NPV and IRR occurs in situations with non-conventional cash flows, scale differences, assumptions for reinvestment, and cash flow timing.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.