NPV) is the difference between the present value of cash inflows and the present

value of cash outflows. NPV compares the value of a dollar today to the value of that
same dollar in the future, taking inflation and returns into account. NPV analysis is
sensitive to the reliability of future cash inflows that an investment or project will yield
and is used in capital budgeting to assess the profitability of an investment or project.

NPV is calculated using the following formula:

If the NPV of a prospective project is positive, the project should be accepted.

However, if NPV is negative, the project should probably be rejected because cash
flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it

would first estimate the future cash flows that store would generate, then discount
those cash flows into one lump-sum present value amount, say $565,000. If the
owner of the store was willing to sell his business for less than $565,000, the
purchasing company would likely accept the offer as it presents a positive NPV
investment. Conversely, if the owner would not sell for less than $565,000, the
purchaser would not buy the store, as the investment would present a negative NPV.
(Sometimes losing investments aren't what they seem. Learn more in How To Profit
From Investment "Losers".)

Internal rate of return (IRR) is the discount rate often used in capital budgeting that
makes the net present value of all cash flows from a particular project equal to zero.
Generally speaking, the higher a project's internal rate of return, the more desirable it
is to undertake the project. As such, IRR can be used to rank several prospective
projects a firm is considering. Assuming all other factors are equal among the
various projects, the project with the highest IRR would probably be considered the
best and undertaken first.

You can think of IRR as the rate of growth a project is expected to generate. While
the actual rate of return that a given project ends up generating will often differ from
its estimated IRR rate, a project with a substantially higher IRR value than other
available options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities
market. If a firm can't find any projects with IRRs greater than the returns that can be
generated in the financial markets, it may simply choose to invest its retained
earnings into the market. (For related reading, see The Top New Investment: Doing
Nothing.)

Differences between NPV and IRR and Their Uses

Both NPV and IRR are primarily used in capital budgeting, the process by which
companies determine whether a new investment or expansion opportunity is
worthwhile. Given an investment opportunity, a firm needs to decide whether
undertaking the investment will generate net economic profits or losses for the
company.

To do this, the firm estimates the future cash flows of the project and discounts them
into present value amounts using a discount rate that represents the project's cost of
capital and its risk. Next, all of the investment's future positive cash flows are
reduced into one present value number. Subtracting this number from the initial cash
outlay required for the investment provides the net present value (NPV) of the
investment.

Let's illustrate with an 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. (Learn about industry-specific investment options in Fine Art
Funds: A Beautiful Investment, The Perfect Investment For Chocolate-
Lovers and The Shoe-Lover's Investment Portfolio.)
DCF

What is a 'Discounted Cash Flow (DCF)'

Discounted cash flow (DCF) is a valuation method used to estimate the
attractiveness of an investment opportunity. DCF analyses use future free cash flow
projections and discounts them, using a required annual rate, to arrive at present
value estimates. A present value estimate is then used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the current
cost of the investment, the opportunity may be a good one.

Calculated as:

DCF = [CF1/(1+r)1] + [CF2/(1+r)2] + ... + [CFn/(1+r)n]

CF = Cash Flow

r= discount rate (WACC)

DCF is also known as the Discounted Cash Flows Model

For a hypothetical Company X, we would apply DCF analysis by first estimating the
firm's future cash flow growth. We would start by determining the company's trailing
twelve month (TTM) free cash flow (FCF), equal to that period's operating cash
flow minus capital expenditures.

Say that Company X's TTM FCF is $50m. We would compare this figure to previous
years' cash flows in order to estimate a rate of growth. It is also important to consider
the source of this growth. Are sales increasing? Are costs declining? These factors
will inform assessments of the growth rate's sustainability.

Say that you estimate that Company X's cash flow will grow by 10% in the first two
years, then 5% in the following three. After a few years, you may apply a long-term
cash flow growth rate, representing an assumption of annual growth from that point
on. This value should probably not exceed the long-term growth prospects of the
overall economy by too much; we will say that Company X's is 3%. You will then
calculate a WACC; say it comes out to 8%.

The terminal value, or long-term valuation the company's growth approaches, is

calculated using the Gordon Growth Model: Terminal value = projected cash flow for
final year (1 + long-term growth rate) / (discount rate - long-term growth rate).

Limitations of Discounted Cash Flow Model

Discounted cash flow models are powerful, but they are only as good as their inputs.
As the axiom goes, "garbage in, garbage out". Small changes in inputs can result in
large changes in the estimated value of a company, and every assumption has the
potential to erode the estimate's
NPV and IRR adv and disa

Advantages:

 With the NPV method, the advantage is that it is a direct measure of the dollar
contribution to the stockholders.
 With the IRR method, the advantage is that it shows the return on the original money
invested.

Disadvantages:

 With the NPV method, the disadvantage is that the project size is not measured.
 With the IRR method, the disadvantage is that, at times, it can give you conflicting
answers when compared to NPV for mutually exclusive projects. The 'multiple IRR
problem' can also be an issue, as discussed below.