what is difference between npv and irr in excel?

Difference Between NPV and IRR

Last Updated : 28 Mar, 2024

In finance, there are two important ways to check if an investment is a good idea: Net Present Value (NPV) and Internal Rate of Return (IRR). NPV looks at
the money you’ll get back from an investment compared to what you put in, while IRR figures out the percentage return you’ll get. NPV tells you how much
money you’ll make or lose, while IRR tells you the percentage of profit. Both NPV and IRR help people decide if an investment is worth it or not. They’re like
tools to see if an investment will make money or not.

What is an NPV?

Net Present Value (NPV) is a financial measure used to determine if an investment will be profitable. It compares the current value of expected cash inflows
with the initial investment. NPV takes into account the fact that money received in the future is worth less than money received today due to factors
like inflation and the potential to earn interest. By discounting future cash flows back to their present value using a specified discount rate, NPV provides a
clear indication of whether an investment will generate a positive or negative return. The NPV formula is

Net Present Value = Cash flow / (1 + i) ^ t – Initial Investment

here, ‘i’ will represent the discount rate, and t will represent the number of periods.

Key Features of NPV:

 Time Value of Money Consideration: NPV acknowledges that money received in the future is worth less than money received today due to the
potential to earn returns on current funds.

 Absolute Dollar Value Assessment: The NPV provides a clear indication of the dollar value added by an investment project.

 Decision-Making Tool: NPV serves as a decision-making tool for evaluating the profitability and feasibility of investment projects.

What is an IRR?

The Internal Rate of Return (IRR) is a financial concept used to figure out how profitable an investment could be. It tells us the annual percentage rate at
which the investment’s value becomes zero. In simple terms, IRR helps us understand the percentage return we can expect from an investment. It considers
both the timing and size of cash flows, giving us insights into whether an investment is worth it or not. To calculate IRR, we find the discount rate that
makes the present value of cash inflows equal to the initial investment. If the calculated IRR is higher than the cost of capital, the investment is usually seen
as a good choice. IRR is handy for comparing different investment options and making smart decisions about where to put our money. The IRR formula is

Internal Rate of Return = ((Future Value / Present Value) ^ (1 / No. of Periods)) – 1

Key Features of IRR:

 Percentage Return Calculation: IRR calculates the yearly percentage return of an investment, showing how profitable it could be over time.

 Timing of Cash Flows Consideration: IRR looks at when cash comes in and goes out, helping assess how well an investment uses money over its
lifespan.

 Zero Net Present Value (NPV) Point: IRR gives the discount rate where the NPV of cash flows equals zero, indicating when the investment breaks
even. This helps decide if the investment is worth it or not.
What is NPV vs IRR?

When analyzing a typical project, it is important to distinguish between the figures returned by NPV vs IRR, as conflicting results arise when comparing two
different projects using the two indicators.

Typically, one project may provide a larger IRR, while a rival project may show a higher NPV. The resulting difference may be due to a difference in cash flow
between the two projects. Let’s have a look first at what each of the two discounting rates stands for.

What is NPV?

NPV stands for Net Present Value, and it represents the positive and negative future cash flows throughout a project’s life cycle discounted today. NPV
represents an intrinsic appraisal, and it’s applicable in accounting and finance where it is used to determine investment security, assess new ventures, value
a business, or find ways to effect a cost reduction.

What is IRR?
IRR or Internal Rate of Return is a form of metric applicable in capital budgeting. It is used to estimate the profitability of a probable business venture. The
metric works as a discounting rate that equates NPV of cash flows to zero.

Differences Between NPV vs IRR

Under the NPV approach, the present value can be calculated by discounting a project’s future cash flow at predefined rates known as cut off rates.
However, under the IRR approach, cash flow is discounted at suitable rates using a trial and error method that equates to a present value. The present
value is calculated to an amount equal to the investment made. If IRR is the preferred method, the discount rate is often not predetermined, as would be
the case with NPV.

NPV takes cognizance of the value of capital cost or the market rate of interest. It obtains the amount that should be invested in a project in order to
recover projected earnings at current market rates from the amount invested.

On the other hand, the IRR approach doesn’t look at the prevailing rate of interest on the market, and its purpose is to find the maximum rates of interest
that will encourage earnings to be made from the invested amount.

NPV’s presumption is that intermediate cash flow is reinvested at cutoff rate, while under the IRR approach, an intermediate cash flow is invested at the
prevailing internal rate of return. The results from NPV show some similarities to the figures obtained from IRR under a similar set of conditions. At the
same time, both methods offer contradicting results in cases where the circumstances are different.

NPV’s predefined cutoff rates are quite reliable compared to IRR when it comes to ranking more than two project proposals.

Similarities of Outcomes under NPV vs IRR

Both methods show comparable results regarding “accept or reject” decisions where independent investment project proposals are concerned. In this case,
the two proposals don’t compete, and they are accepted or rejected based on the minimum rate of return on the market.

Conventional proposals often involve a cash outflow during the initial stage and are usually followed by a number of cash inflows. Such similarities arise
during the process of decision-making. With NPV, proposals are usually accepted if they have a net positive value. In contrast, IRR is often accepted if the
resulting IRR has a higher value compared to the existing cutoff rate. Projects with a positive net present value also show a higher internal rate of return
greater than the base value.

Conflicts Between NPV vs IRR

In the case of mutually exclusive projects that are competing such that acceptance of either blocks acceptance of the remaining one, NPV and IRR often give
contradicting results. NPV may lead the project manager or the engineer to accept one project proposal, while the internal rate of return may show the
other as the most favorable. Such a kind of conflict arises due to a number of problems.

For one, conflicting results arise because of substantial differences in the amount of capital outlay of the project proposals under evaluation. Sometimes,
the conflict arises due to issues of differences in cash flow timing and patterns of the project proposals or differences in the expected service period of the
proposed projects.

When faced with difficult situations and a choice must be made between two competing projects, it is best to choose a project with a larger positive net
value by using cutoff rate or a fitting cost of capital.

The reason the two abovementioned options works is because a company’s objective is maximizing its shareholder’s wealth, and the best way to do that is
choosing a project that comes with the highest net present value. Such a project exerts a positive effect on the price of shares and the wealth of
shareholders.

So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is
considered the best criterion when ranking investments.

Final Word

Both NPV and IRR are sound analytical tools. However, they don’t always agree and tell us what we want to know, especially when there are two competing
projects with equally favorable alternatives. That said, most project managers prefer to use NPV because it is considered the best when ranking mutually
exclusive projects.

NPV (Net Present Value) and IRR (Internal Rate of Return) are two important financial metrics used in capital budgeting to evaluate the profitability of
potential investments. Both NPV and IRR are available as built-in functions in Excel, and they can be used to compare different investment opportunities.

NPV is the present value of all future cash inflows minus the present value of all future cash outflows associated with an investment. In other words, NPV
calculates the difference between the present value of the expected cash inflows and the initial investment. If the NPV is positive, the investment is
considered profitable, and if it is negative, the investment is not profitable.

For example, let's say a company is considering investing in a new project that requires an initial investment of $100,000 and is expected to generate cash
inflows of $25,000 per year for the next five years. Using a discount rate of 8%, the NPV of the project would be calculated as follows:

NPV = -$100,000 + ($25,000 / (1+0.08)^1) + ($25,000 / (1+0.08)^2) + ($25,000 / (1+0.08)^3) + ($25,000 / (1+0.08)^4) + ($25,000 / (1+0.08)^5) = $12,821
Since the NPV is positive, the investment is considered profitable.

IRR, on the other hand, is the discount rate at which the NPV of an investment becomes zero. In other words, IRR is the rate at which the present value of
the expected cash inflows equals the initial investment. If the IRR is greater than the cost of capital, the investment is considered profitable, and if it is less
than the cost of capital, the investment is not profitable.

Using the same example as above, the IRR of the project would be calculated as follows:

IRR = the discount rate at which NPV = 0

IRR = 16.2% (using Excel's IRR function)

Since the IRR is greater than the cost of capital (assumed to be 8%), the investment is considered profitable.

Advantages of NPV:

* NPV takes into account the time value of money, which is an important factor in evaluating long-term investments.

* NPV provides a clear and objective measure of the profitability of an investment.

* NPV can be used to compare different investment opportunities of different sizes and durations.

Disadvantages of NPV:

* NPV assumes that the cash flows are known with certainty, which may not always be the case.

* NPV is sensitive to the discount rate used, which can be subjective.

* NPV does not take into account the timing of cash flows, which can be important in some cases.

Advantages of IRR:

* IRR provides a clear and objective measure of the profitability of an investment.

* IRR can be used to compare different investment opportunities of different sizes and durations.

* IRR takes into account the timing of cash flows, which can be important in some cases.

Disadvantages of IRR:

* IRR assumes that the cash flows are reinvested at the IRR, which may not always be possible.

* IRR may not provide a reliable measure of profitability for investments with unconventional cash flow patterns.

* IRR may not provide a unique solution for investments with multiple IRRs.

Limitations of NPV and IRR:

* Both NPV and IRR assume that the cash flows are known with certainty, which may not always be the case.

* Both NPV and IRR are sensitive to the discount rate used, which can be subjective.

* Both NPV and IRR may not provide a reliable measure of profitability for investments with unconventional cash flow patterns.

According to a survey by the Association for Financial Professionals, NPV is the most commonly used method for evaluating capital investments, followed by
IRR.
"NPV is the gold standard for capital budgeting. It's the most accurate and reliable way to evaluate the profitability of an investment." - Aswath Damodaran,
Professor of Finance at NYU Stern School of Business.

In conclusion, NPV and IRR are two important financial metrics used in capital budgeting to evaluate the profitability of potential investments. While both
NPV and IRR have their advantages, disadvantages, and limitations, they can be used together to provide a more comprehensive evaluation of investment
opportunities.