Net Present Value (NPV) and Internal Rate of Return (IRR)

What is NPV and what are its shortcomings?

The net present value (NPV) is the difference between the initial cost of the investment and the present value of those future returns discounted at a minimum required rate of return. If the investment has a 0 or positive NPV, it’s worth considering. If the NPV is 0, investors are earning their required rate of return. What NPV doesn’t quantify is what that means in terms of a divergence from a required rate of return. It effectively gives a yes or no answer, accept or reject. This is where the Internal Rate of Return (IRR) is useful.

One of the issues with NPV is that it doesn’t rank the desirability of investments; the results are not ordinal. A higher NPV does not necessarily mean one investment is superior to another. The higher number could be the result of the size of the cash flows associated with it. It might have the higher NPV but a lower IRR than a smaller investment.

What is IRR?

The Internal Rate of Return is another way of assessing the profitability of an investment. It is referred to as the break-even rate i.e. the discount rate that produces an NPV of 0. It reflects the difference between the actual rate of return of the cash flows against the required rate.

It is sometimes possible to derive more than one IRR depending on the pattern of the cash flows. It also assumes that when returns are received they can be re-invested at that same rate, which might not be possible. The advantage IRR has over NPV is that it ranks investments in terms of return. Presumably, given the same risk and limited funds investors would prefer to invest in the opportunity with the higher IRR.