Key Points
Both NPV and IRR consider the time value of money for investment decisions.
NPV shows the dollar value a project adds; IRR shows the project’s annual return rate.
NPV handles complex cashflows and multiple project stages more effectively.
IRR is easier to communicate since percentages are familiar, but can be confusing with irregular cashflows.
NPV’s focus on discount rates encourages more rigorous risk assessment than IRR.
Both Net Present Value (NPV) and Internal Rate of Return (IRR) are powerful tools in the arsenal of financial analysts and investors, as they recognise the time value of money. This makes them effective methods for project and investment evaluation.
But which one should you be using? Before we jump into answering this question, let’s first cover a brief explanation.
What do Net Present Value and Internal Rate of Return mean?
When your business needs to decide whether to move forward with a new project or investment, one of the primary challenges is to establish whether the future returns will be worth the upfront costs. Enter financial tools like NPV and IRR, which are used by financial analysts, investors and business owners to assess a project’s financial viability.
Both methods are grounded in the principle that money spent today is worth more than money tomorrow. (Otherwise known as the time value of money). But while NPV and IRR are both used to evaluate profitability, they approach this by asking two different questions:
Where NPV asks ‘How much value (in today’s dollars) will this project add?’, IRR asks ‘What annual return will this project generate?’ Which translates to:
- NPV gives you a dollar amount by calculating the net benefit or cost of a project after accounting for the time value of money.
- IRR calculates a percentage. AKA the project’s expected rate of return (ROR).
When it comes to selecting the appropriate one for your use case, the answer depends on a). What you’re evaluating, b). Who you’re presenting the findings to, and c). How much complexity you are comfortable with.
NPV vs. IRR – A Side-by-Side Comparison
Now let’s consider the strengths and weaknesses of both financial methods.
Advantages of NPV
- One of the biggest advantages of NPV is the fact that any project with a positive NPV should, in theory, be approved. NPV enables non-conventional cashflows to be allocated a precise individual value amongst the overall result, and even copes with multiple negative cashflow outcomes during the project life. It also provides outcomes in dollar terms, which comes in handy if you need to compare different projects and their ability to generate net wealth.
- Finally, NPV allows for a decision tree approach, so the component parts of the decision-making can be disaggregated. Meaning, if a project has various stages or options to pursue, each decision tree can be separately assessed.
Disadvantages of NPV
- NPV can require a more detailed explanation than an IRR. Although naturally, this depends on your audience.
Advantages of IRR
- The benefit of IRR mostly boils down to the fact that people are already familiar with percentage rates of return (ROR), which makes it easier to present the results.
Disadvantages of IRR
- It requires a negative cash flow in the first period to start the calculation (otherwise, an IRR cannot be determined). If there are negative cash flows in a period during the project, it’s also possible to generate two IRR results, which leads to confusion as to which IRR is the ‘correct’ one.
- Further, while you can compare ROR, you can’t compare the overall dollar value of any increase in wealth, which means you can’t clearly see which IRR choice ultimately generates more wealth.
Why We Prefer NPV over IRR
Both methods have merit, however, a key element for any NPV calculation is establishing an appropriate discount rate. This forces you to consider (and make a judgement about) the level of risk that the project entails before the analysis. Whereas with an IRR, you get the ROR and then assess whether it is sufficient to justify the risk, which is, in our experience, a less rigorous approach.
If you need assistance with either using these methods or fine-tuning a presentation for a Board or other group, please drop us a line.
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