Net Present Value (NPV) and Internal Rate of Return (IRR) are crucial tools for evaluating investment opportunities. NPV calculates the present value of future cash flows, while IRR determines the rate that makes NPV zero. Both help assess project profitability.
These methods have strengths and limitations. NPV is generally more reliable, measuring absolute value in dollars. IRR provides a percentage return but can be misleading for comparing projects. Understanding both helps make informed investment decisions.
Net Present Value (NPV)
Net present value calculation
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NPV sums all future cash flows discounted to present value
Discounting accounts for time value of money (a dollar today is worth more than a dollar in the future)
Discount rate represents required rate of return or cost of capital (hurdle rate )
NPV formula : N P V = ∑ t = 0 n C F t ( 1 + r ) t NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t} NP V = ∑ t = 0 n ( 1 + r ) t C F t
C F t CF_t C F t cash flow at time t t t
r r r discount rate
n n n number of periods
Calculating NPV involves:
Determine expected cash flows for each period (inflows and outflows)
Choose appropriate discount rate (based on risk and opportunity cost )
Discount each cash flow to present using discount rate
Sum all discounted cash flows and subtract initial investment
NPV rule for investment decisions
NPV rule: accept project if NPV positive, reject if NPV negative
Positive NPV indicates project generates returns greater than cost of capital (creates value)
Negative NPV suggests insufficient returns to cover cost of capital (destroys value)
When comparing mutually exclusive projects, choose project with highest positive NPV
NPV assumes cash flows reinvested at discount rate, which may not always be realistic (reinvestment rate assumption)
Internal Rate of Return (IRR)
Internal rate of return determination
IRR is discount rate that makes NPV of project equal to zero
Represents expected rate of return generated by project (breakeven rate)
IRR formula: 0 = ∑ t = 0 n C F t ( 1 + I R R ) t 0 = \sum_{t=0}^{n} \frac{CF_t}{(1+IRR)^t} 0 = ∑ t = 0 n ( 1 + I RR ) t C F t
Calculating IRR involves:
Set NPV equation equal to zero
Solve for discount rate (IRR) using trial and error or financial calculator
IRR assumes cash flows reinvested at project's IRR, which may not always be realistic
NPV vs IRR in capital budgeting
Both NPV and IRR evaluate financial viability of investment projects
NPV measures absolute value in monetary terms (dollars), IRR measures rate of return (percentage)
NPV generally considered more reliable because:
Accounts for time value of money
Assumes cash flows reinvested at cost of capital, more realistic
IRR may give inconsistent results when comparing mutually exclusive projects with different:
Cash flow patterns (timing of inflows and outflows)
Project sizes (scale of investment)
When NPV and IRR conflict, prioritize NPV
Use both methods with other factors like strategic fit and risk when making capital budgeting decisions