What are the differences between IRR and NPV?

Solution(By Examveda Team)

NPV = Net Present value and IRR = Internal rate of return.

Both of these measurements are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

To do this, the firm estimates the future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the Net Present Value (NPV) of the investment.

You can understand it through and example: Suppose Examveda.com wants to buy another company. Examveda determines that the future cash flows generated by the other company, when discounted 12% annual rate, yields a present value of $23.5 million. If the other company’s owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million (23.5 – 20 = $3.5) = The $3.5 million NPV represents the intrinsic value that will be added to Examveda if it undertakes the acquisition.

So, Examveda.com has a positive NPV, but from a business perspective, the firm should also know what rate of return will be generated by this investment. To do this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR).

For this example, the project's IRR could, depending on the timing and proportions of cash flow distributions, be equal to 17.15%. Thus, Examveda, given its projected cash flows, has a project with a 17.15% return. If there were a project that Examveda could undertake with a higher IRR, it would probably pursue the higher-yielding project instead. Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's return and to compare it with other possible investments.

NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.