IRR vs NPV When the exercise of capital budgeting is undertaken to calculate the cost of a project and its estimated

returns, two tool are most commonly used. These are Net Present Value (NPV) and Internal Rate of Return (IRR). When evaluating a project, it is generally assumed that higher the value of these two parameters, the more profitable the investment is going to be. Both the instruments are made use of to indicate whether it is a good idea to invest in a particular project or series of projects over a period of time which is normally more than a year. Net present value goes down well with those who are laymen as it is expressed in units of currency and as such preferred method for such purposes. There are however many differences between both parameters which are discussed below. IRR To know whether a project is feasible in terms of returns on investment, a firm needs to evaluate it with a process called capital budgeting and the tool which is commonly used for the purpose is called IRR. This method tells the company whether making investments on a project will generate the expected profits or not. As it is a rate that is in terms of percentage, unless its value is positive any company should not proceed ahead with a project. The higher the IRR, the more desirable a project becomes. This means that IRR is a parameter that can be used to rank several projects that a company is envisaging. IRR can be taken as the rate of growth of a project. While it is only estimation, and the real rates of return might be different, in general if a project has a higher IRR, it presents a chance of higher growth for a company. NPV This is another tool to calculate to find out the profitability of a project. It is the difference between the values of cash inflow and cash outflow of any company at present. For a layman, NPV tells the value of any project today and the estimated value of the same project after a few years taking into account inflation and some other factors. If this value is positive, the project can be undertaken, but if it is negative, it is better to discard the project. This tool is extremely helpful for a company when it is considering to buy or takeover any other company. For the same reason, NPV is the preferred choice to real estate dealers and also for brokers in a stock market.

Difference between IRR and NPV While both the IRR and NPV try to do the same thing for a company, there are subtle differences between the two that are as follows. While NPV is expressed in terms of a value in units of a currency, IRR is a rate that is expressed in percentage which tells how much a company can expect to get in percentage terms from a project down the years. NPV takes into account additional wealth while IRR does not calculate additional wealth If cash flows are changing, IRR method cannot be used while NPV can be used and hence it is preferred in such cases While IRR gives same predictions, NPV method generates different results in cases where different discount rates are applicable. Business managers are more comfortable with the concept of IRR whereas for general public, NPV is better for grasping. Example: Suppose JKL Media wants to buy a small publishing company. JKL determines that the future cash flows generated by the publisher, when discounted at a 12% annual rate, yield a present value of $23.5 million. If the publishing 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 dollar NPV represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition. So, JKL Media's project 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, JKL Media, given its projected cash flows, has a project with a 17.15% return. If there were a project that JKL 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.