Difference Between NPV and IRR
Venturing into a new opportunity can be stressful. It involves heavy decision making and many things can go wrong. Even if you have a background in finance or accounting, these areas involve a lot of terms. Sometimes the terms are so similar that they get confused. If you can’t distinguish one term from another, how can you choose the best option? NPV and IRR are examples of this.
What is the difference between NPV and IRR? Are they the same? How do you compare NPV and IRR? When comparing NPV and IRR, what should be our key indicator of their distinction? This article will, therefore, discuss the difference between NPV and IRR, lay down the difference between IRR and NPV and provides a comparison using a tabular method, and hopefully provides a better understanding of these two complex concepts.
Definition of NPV
NPV stands for Net Present Value. Also known as net present work, this term refers to a series of cash flows that occur at various intervals. The definition of NPV can be best deduced by first explaining the concept of the time value of money. This term implies that the value of money can vary depending on when it was acquired.
What 50 dollars can buy today will be different from what it will be able to buy ten years from now because of inflation. However, the money you invest now may also be worth more in the future. NPV takes this time difference into account and allows managers to make informed decisions when considering good investment opportunities. NPV is calculated as the value of current cash flows (or the value of returns) minus the value of current investments.
NPV is easily calculated using spreadsheets and other calculation software. When you get a positive result, it means that you have probably chosen a good investment and that it will bring you significant positive gains. On the other hand, if you get a negative result, it means that the investment may not be a good platform and you may lose money along the way. If the resulting NPV is 0, then the investment will not gain or lose a significant amount and may not be a good investment platform.
In other words, the NPV calculation gives a better picture of what your money will be invested in the future.
Definition of IRR
IRR is also a technique for assessing the performance of an investment. IRR is the abbreviation for “internal rate of return”. It is often compared to return on investment (ROI) and is considered its most complex counterpart. It is also called the discounted cash flow rate of return. The definition of IRR can be further explained by the time preference of funds and forms of investment. Time preference means that a good (or service) is valued at an earlier date, even if it is received at a later date.
As a measure of profitability, IRR takes into account time preference and recognizes the annual growth rate of an investment. It also calculates when the discounted cash outflows and inflows will equal and when the NPV will be zero. Therefore, the calculated IRR yields a percentage. This figure can then be used to assess whether a business is feasible. If the calculated IRR is greater than the target rate of return for the business, it may be a viable business. If not, it may not be worth pursuing.
NPV vs IRR Comparison Table
In order to better identify deviations from the IRR and NPV, a table of key differences is presented below:
|Basis of Comparison||NPV||IRR|
|Definition||Calculated as the value of current cash flows (or the value of returns) minus the value of current investments||Calculates at what threshold the discounted cash outflows and inflows will equal and when the NPV will be zero|
|What it confirms||Confirms profitability or non-profitability||Provides the break-even threshold|
|Acronym for||Net Present Value||Internal Rate of Return|
Conclusion of the Main Difference Between NPV vs IRR
Investing can be either harmful or rewarding. If you own a business, it can make your business grow or fall by investing. Therefore, before confirming investment verdicts, you need to make an informed decision. Between NPV vs IRR, the former is the best way to do this. However, if you want to know how to break even, you can calculate IRR instead. It is, therefore, best to consult with financial professionals before you start capitalizing on a business.