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Difference Between NPV and IRR

October 9, 2015 By Surbhi S — Leave a Comment

In the lifespan of every company, there comes a situation of a dilemma, where

it has to make a choice between different projects. Net Present Value (NPV)
and Internal Rate of Return (IRR) are the two most common parameters
used by the companies to decide, which investment proposal is best. However,
in a certain project, both the two criterion give contradictory results, i.e. one
project is acceptable if we consider the NPV method, but at the same time IRR
method favors another project. The reasons of conflict amidst the two are due
to the variance in the inflows, outflows, and life of the project. Go through this
article to understand the differences between NPV and IRR.
Content: NPV Vs IRR
1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

BASIS FOR
NPV IRR
COMPARISON

Meaning The total of all the present IRR is described as a rate

values of cash flows (both at which the sum of
positive and negative) of a discounted cash inflows
project is known as Net Present equates discounted cash
Value or NPV. outflows.

Expressed in Absolute terms Percentage terms

What it Surplus from the project Point of no profit no loss

represents? (Break even point)

Decision It makes decision making easy. It does not help in

Making decision making

Rate for Cost of capital rate Internal rate of return

reinvestment
of
intermediate
cash flows
 Variation in Will not affect NPV Will show negative or
the cash multiple IRR
outflow timing

Definition of NPV
When the present value of the all the future cash flows generated from a
project is added together (whether they are positive or negative) the result
obtained will be the Net Present Value or NPV. The concept is having great
importance in the field of finance and investment for taking important
decisions relating to cash flows generating over multiple years. NPV
constitutes shareholder’s wealth maximization which is the main purpose of
the Financial Management.

NPV shows the actual benefit received over and above from the investment
made in the particular project for the time and risk. Here, one rule of thumb is
followed, accept the project with positive NPV and reject the project with
negative NPV. However, if the NPV is zero, then that will be a situation of
indifference i.e. the total cost and profits of either option will be equal. The
calculation of NPV can be done in the following way:

NPV = Discounted Cash Inflows – Discounted Cash Outflows

Definition of IRR
IRR for a project is the discount rate at which the present value of expected net
cash inflows equates the cash outlays. To put simply, discounted cash inflows
are equal to discounted cash outflows. It can be explained with the following
ratio, (Cash inflows / Cash outflows) = 1.

At IRR, NPV = 0 and PI (Profitability Index) = 1

In this method, the cash inflows and outflows are given. The calculation of the
discount rate, i.e. IRR, is to be made by trial and error method.

The decision rule related to the IRR criterion is: Accept the project in which the
IRR is greater than the required rate of return (cut off rate) because in that
case, the project will reap the surplus over and above the cut-off rate will be
obtained. Reject the project in which the cut-off rate is greater than IRR, as the
project, will incur losses. Moreover, if the IRR and Cut off rate are equal, then
this will be a point of indifference for the company. So, it is at the discretion of
the company, to accept or reject the investment proposal.

Key Differences Between NPV and IRR

The basic differences between NPV and IRR are presented below:

1. The aggregate of all present value of the cash flows of an asset,

immaterial of positive or negative is known as Net Present Value.
Internal Rate of Return is the discount rate at which NPV = 0.

2. The calculation of NPV is made in absolute terms as compared to

IRR which is computed in percentage terms.

3. The purpose of calculation of NPV is to determine the surplus from

the project, whereas IRR represents the state of no profit no loss.

4. Decision making is easy in NPV but not in the IRR. An example can
explain this, In the case of positive NPV, the project is
recommended. However, IRR = 15%, Cost of Capital < 15%, the
project can be accepted, but if the Cost of Capital is equal to 19%,
which is higher than 15%, the project will be subject to rejection.

5. Intermediate cash flows are reinvested at cut off rate in NPV

whereas in IRR such an investment is made at the rate of IRR.

6. When the timing of cash flows differs, the IRR will be negative, or
it will show multiple IRR which will cause confusion. This is not in
the case of NPV.
 7. When the amount of initial investment is high, the NPV will always
show large cash inflows while IRR will represent the profitability
of the project irrespective of the initial invest. So, the IRR will show
better results.

Conclusion
Net Present Value and Internal Rate of Return both are the methods of
discounted cash flows, in this way we can say that both considers the time
value of money. Similarly, the two methods, considers all cash flows over the
life of the project.

During the computation of Net Present Value, the discount rate is assumed to
be known, and it remains constant. But, while calculating IRR, the NPV  fixed
at ‘0’ and the rate which fulfills such a condition is known as IRR.

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