The Difference Between NPV and IRR

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

What is NPV?

Net present value, or NPV, is one of the calculations business managers use to evaluate capital projects. A capital project is a long-term investment or improvement, such as building a new store. The NPV calculation determines the present value of the project’s projected future income. In the calculation, the present value of the project’s cost is subtracted from the present value of future income. A positive net present value usually means you should accept or implement the project. Business owners who compare two or more projects tend to favor the one with the higher net present value.

• Advantages of Net Present Value (NPV)

1. NPV gives important to the time value of money.
2. In the calculation of NPV, both after cash flow and before cash flow over the life p of the project are considered.
3.  Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm’s value.

• Disadvantages of Net Present Value (NPV)

1. NPV is difficult to use.
2. NPV cannot give an accurate decision if the amount of investment of mutually exclusive projects is not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give a correct decision when the projects are of unequal life.

Internal rate of return is a discounting cash flow technique which gives a rate of return that is earned by a project. We can define internal rate of return as the discounting rate which makes total of initial cash outlay and discounted cash inflows equal to zero. In other words, it is that discounting rate at which the net present value is equal to zero.

IRR is a prominent technique for evaluation of big projects and investment proposals widely used by management of the company, banks, financial institution etc. for their various purposes. The calculation of an IRR is a little tricky. It is advantageous in terms of its simplicity and it has certain disadvantages in the form of limitations under certain special conditions.

Advantages of Internal Rate of Return (IRR)

• Perfect Use Of Time Value Of Money Theory

Time value of money means interest and it should high because we are a sacrifice of money for a specific time. IRR is nothing but shows the high-interest rate which we expect from our investment. So, we can say, IRR is the perfect use of time value of money theory.

• All Cash Flows Are Equally Important

It is a good method of capital budgeting in which we give equal importance to all the cash flows not earlier or later. We just create its relation with different rate and want to know where is present value of cash inflow is equal to present value of cash outflow.

Uniform Ranking

There is no base for selecting any particular rate in internal rate of return.

Maximum Profitability Of Shareholder

If there is only project which we have to select, if we check its IRR and it is higher than its cut off rate, then it will give maximum profitability to shareholder

Disadvantages of Internal Rate of Return (IRR)

• To understand IRR is difficult

It is difficult to understand it because many student cannot understand why are calculating different rate in it and it becomes more difficult when the real value of IRR will be two experimental rate because of not equalize present value of cash inflow with present value of cash outflow.

• Unrealistic Assumption

for calculating IRR we create one assumption. We think that if we invest our money on this IRR, after receiving profit, we can easily reinvest our investments profit on the same IRR. It is an unrealistic assumption.

• Hurdle Rate Not Required

In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at which investors agree to fund a project. It can be a subjective figure and typically ends up as a rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of determining the wrong rate. Once the IRR is calculated, projects can be selected where the IRR exceeds the estimated cost of capital.

Why Do NPV and IRR Methods Produce Conflicting Rankings?

When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.

While NPV and IRR are useful metrics for analyzing mutually exclusive projects – that is, when the decision must be one project or another – these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of project sizes.

Conclusion

NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages.

Advantages:

With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders. With the IRR method, the advantage is that it shows the return on the original money invested.

Disadvantages:

With the NPV method, the disadvantage is that the project size is not measured. With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The “multiple IRR problems” can also be an issue, as discussed below.