UnderstandingtheDifferenceBetweenNPVvsIRR
UnderstandingtheDifferenceBetweenNPVvsIRR
JUNE28,2013BYROBERTSCHMIDT
14
COMMENTS
Understandingthedifferencebetweenthenetpresentvalue(NPV)versustheinternalrateofreturn(IRR)iscriticalforanyone
makinginvestmentdecisionsusingadiscountedcashflowanalysis.Yet,thisisoneofthemostcommonlymisunderstood
conceptsinfinanceandrealestate.ThispostwillhelpyouunderstandthedifferencebetweenNPVvsIRR,andclearupsome
commonmisconceptions.
First,letsgooversomedefinitionsofNPVandIRR,thenwellwalkthroughanexampleandsomecommonpitfalls.
NetPresentValue(NPV)Definition
Netpresentvalue(NPV)isaninvestmentmeasurethattellsaninvestorwhethertheinvestmentisachievingatargetyieldata
giveninitialinvestment.NPValsoquantifiestheadjustmenttotheinitialinvestmentneededtoachievethetargetyield
assumingeverythingelseremainsthesame.Formally,thenetpresentvalueissimplythesummationofcashflows(C)foreach
period(n)intheholdingperiod(N),discountedattheinvestorsrequiredrateofreturn(r):
InternalRateofReturn(IRR)Definition
Internalrateofreturn(IRR)foraninvestmentisthepercentagerateearnedoneachdollarinvestedforeachperioditis
invested.IRRisalsoanothertermpeopleuseforinterest.Ultimately,IRRgivesaninvestorthemeanstocomparealternative
investmentsbasedontheiryield.Mathematically,theIRRcanbefoundbysettingtheaboveNPVequationequaltozero(0)
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UnderstandingtheDifferenceBetweenNPVvsIRR
andsolvingfortherateofreturn(IRR).
DistinctionBetweenNPVvsIRR
So,whatsthedifferencebetweenNPVandIRR?Asshownintheformulasabove,theNPVformulasolvesforthepresent
valueofastreamofcashflows,givenadiscountrate.TheIRRontheotherhand,solvesforarateofreturnwhensettingthe
NPVequaltozero(0).
Inotherwords,theIRRanswersthequestionwhatrateofreturnwillIachieve,giventhefollowingstreamofcashflows?,
whiletheNPVanswersthequestionwhatisthefollowingstreamofcashflowsworthataparticulardiscountrate,intodays
dollars?TodivedeeperintoamoreintuitiveexplanationofIRRandNPV,checkouttheIntuitionBehindtheNPVandIRR.
QuantitativeExampleofNPVvsIRR
Considerapropertywithexpectedfuturenetcashflowsof$30,000peryearforthenextfiveyears(startingoneyearfrom
now).Ifyouexpecttoselltheproperty5yearsfromnowforaprice10timesthenetcashflowatthattime,whatisthevalueof
thepropertyiftherequiredreturnis12%?
Plugginginthe$30,000netcashflowsforfiveyearsintotheNPVequationabovealongwiththe12%discountrate,youllfind
thatthenetpresentvalueis$278,371.Youcanalsofindalloftheformulasandanswerstothesequestionsinthisspreadsheet
weputtogether:
DownloadNPVvsIRRExcelSolutions
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WhereshouldwesendyourNPVvsIRRsolutionsfile?
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