2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

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Di erence Between NPV and IRR

October 9, 2015 By Surbhi S — 1 Comment

NPV or otherwise known as Net Present Value method, reckons the present value
of the flow of cash, of an investment project, that uses the cost of capital as a
discounting rate. On the other hand, IRR, i.e. internal rate of return is a rate of
interest which matches present value of future cash flows with the initial capital
outflow.

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2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

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

has to make a choice between different projects. NPV and 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. Similarities
5. Conclusion

Comparison Chart

BASIS FOR
NPV IRR
COMPARISON

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2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

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

Rate for Cost of capital rate Internal rate of return

reinvestment of
intermediate
cash flows

Variation in the Will not affect NPV Will show negative or

cash outflow multiple IRR
timing

De nition of NPV
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2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

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

De nition 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.

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2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

Key Di erences 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.

Similarities
Both uses Discounted Cash Flow Method.
Both takes into consideration the cash flow throughout the life of the project.
Both recognize time value of money.

Conclusion
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2/23/2018 Difference Between NPV and IRR (with Comparison Chart) - Key Differences

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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Filed Under: Finance

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Comments

Dr Kannan says
December 16, 2016 at 7:03 am

Glad at least here is one article that clearly concluded the difference.

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