NPV vs IRR Methods

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include: NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recomendation. IRR vs NPV When the exercise of capital budgeting is undertaken to calculate the cost of a project and its estimated returns, two tool are most commonly used. These are Net Present Value (NPV) and Internal Rate of Return (IRR). When evaluating a project, it is generally assumed that higher the value of these two parameters, the more profitable the investment is going to be. Both the instruments are made use of to indicate whether it is a good idea to invest in a particular project or series of projects over a period of time which is normally more than a year. Net present value goes down well with those who are laymen as it is expressed in units of currency and as such preferred method for such purposes. There are however many differences between both parameters which are discussed below. IRR

To know whether a project is feasible in terms of returns on investment, a firm needs to evaluate it with a process called capital budgeting and the tool which is commonly used for the purpose is called IRR. This method tells the company whether making investments on a project will generate the expected profits or not. As it is a rate that is in terms of percentage, unless its value is positive any company should not proceed ahead with a project. The higher the IRR, the more desirable a project becomes. This means that IRR is a parameter that can be used to rank several projects that a company is envisaging. IRR can be taken as the rate of growth of a project. While it is only estimation, and the real rates of return might be different, in general if a project has a higher IRR, it presents a chance of higher growth for a company. NPV This is another tool to calculate to find out the profitability of a project. It is the difference between the values of cash inflow and cash outflow of any company at present. For a layman, NPV tells the value of any project today and the estimated value of the same project after a few years taking into account inflation and some other factors. If this value is positive, the project can be undertaken, but if it is negative, it is better to discard the project. This tool is extremely helpful for a company when it is considering to buy or takeover any other company. For the same reason, NPV is the preferred choice to real estate dealers and also for brokers in a stock market. Difference between IRR and NPV While both the IRR and NPV try to do the same thing for a company, there are subtle differences between the two that are as follows. While NPV is expressed in terms of a value in units of a currency, IRR is a rate that is expressed in percentage which tells how much a company can expect to get in percentage terms from a project down the years. NPV takes into account additional wealth while IRR does not calculate additional wealth If cash flows are changing, IRR method cannot be used while NPV can be used and hence it is preferred in such cases While IRR gives same predictions, NPV method generates different results in cases where different discount rates are applicable. Business managers are more comfortable with the concept of IRR whereas for general public, NPV is better for grasping.

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NPV vs IRR The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two faces of the same coin as both reflect on the anticipated performance of a firm or business over a particular period of time. The main difference however should be more evident in the method or should I say the units used. While NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project. Due to the fact that NPV is calculated in currency, it always seems to resonate more easily with the general public as the general public comprehends monetary value better as compared to other values. This does not necessarily mean that the NPV is automatically the best option when evaluating a firms progress. The best option would depend on the perception of the individual doing the calculation, as well as, his objective in the whole exercise. It is evident that managers and administrators would prefer the IRR as a method, as percentages give a better outlook that can be used to make strategic decisions over the firm. Another major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus. Evaluating the viability of a project using the IRR method could cloud the true picture if the figures on the inflow and outflow remain to fluctuate persistently. It may even give the false impression that a short term venture with high return in a short time is more viable as compared to a bigger long-term venture that would otherwise make more profits. In order to make a decision between any of the two methods, it is important to take note of the following significant differences. Summary: 1. While the NPV will work better in helping other people such as investors in understanding the actual figures in so far as the evaluation of a project is concerned, the IRR will give percentages which can be better understood by managers 2. As much as discrepancies in discounts will most likely lead to similar recommendations from both methods, it is important to note that the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures.

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