LESSON 4 – THE NET PRESENT VALUE (NPV) AND THE INTERNAL RATE OF

RETURN (IRR)

1. INTRODUCTION

Investment decisions are among the most important decisions companies make and
these usually imply many opportunities and investment projects, as for example:
opening a new factory, launching a new production line, buying another company, etc.
For this reason, the analysis of the investment project is fundamental, it helps determine
which projects are to be considered “good” and which “bad”, that is, which will lead to
maximising the company’s value and, therefore, the stockholders’ wealth, and which
not. We, then, need to obtain answers to two fundamental questions:

− What projects are to be chosen among the different alternatives presented? 

− How many projects are to be accepted?

As investment projects can be valued in different ways, and these not always produce
coinciding results, it is necessary to establish certain rules. The rule, on which optimal
decisions should be made, has four characteristics:

− It will consider the investment’s cash flow.

− It will discount the cash flow from the opportunity cost of the capital, which will
be set by the market.
− It will select among the projects, mutually exclusive, the one which maximises
the company’s wealth and, therefore, that of stockholders.
− It will allow us to consider each project independently. This means that it is not
necessary to study the combination of projects that maximise the value of the
company, but rather knowing what each one will contribute with to the
company’s value, so as to understand which one is the best.

The criterion of the net present value is the only one that fulfils these characteristics,
reason for which we are going to study it first. Later, we will study other criteria that

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also present advantages, such as the internal rate of return. Furthermore, together with
the internal rate of return, the criterion of the net present value is one of the most used
methods by large companies. That is the reason why we are going to start studying the
net present value and, after that, we are going to study other valuation methods and
their problems dealing with investment decisions.

2. THE CONCEPT OF THE NET PRESENT VALUE

The net present value (NPV) of an investment is equal to the difference between the
discounted value of the expected future cash flows and the value, also discounted, of
the expected future payments. Therefore, it is convenient to carry out only those
investments whose NPV results positive, because these are the ones which will
contribute to a value increase. When there are various investments with a positive net
present value, we are to give priority to those whose net present value is higher.

Let us give an example: Suppose we have today 100 euros and we deposit them in a
bank for a period of three years at an interest rate of the 10%. Then, at the end of the
three-year period, we will have:

𝐹𝑉 = 100(1 + 0.10) = 133.1€

Now, let us imagine that two further investment opportunities appear for our 100 euros:

− The first opportunity will give us a return of 30 euros at the end of the first year,
40 at the end of the second, and 50 at the end of the third.
− The second opportunity offers a return of 50 euros at the end of the first year,
40 at the end of the second and 30 at the end of the third.

Considering this, and if we did not have any other opportunity of investment, the two
alternatives would seem satisfactory for our money, as we would be turning 100 euros
into 120.

However, the existence of the initial opportunity allows us to suppose we can invest our
money and obtain a return of 10%, which is what we would obtain by depositing the
money in the bank. This is our opportunity cost of capital and would imply for the two

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further offers a higher value than the previous 120 euros, otherwise we will choose the
bank account.

We can make an approximate calculation of the final value, comparing the initial offer
whose details we already know to the other two offers:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑜𝑓𝑓𝑒𝑟 → 𝐹𝑉 = 100(1 + 0.10) = 133.1€

𝑂𝑓𝑓𝑒𝑟 1 → 𝐹𝑉 = 30(1 + 0.10) + 40(1 + 0.10) + 100(1 + 0.10) = 130.3€

𝑂𝑓𝑓𝑒𝑟 2 → 𝐹𝑉 = 50(1 + 0.10) + 40(1 + 0.10) + 30(1 + 0.10) = 134.5€

We observe that the second offer (offer 2) is better than our initial investment, as the
final value is higher than 133,1 euros. For the same reason, the first offer (offer 1) is
worse than the initial one. So, under these circumstances, if we could choose between
these two possible alternatives, we would opt for offer 2, whose income of return,
invested at a 10%, will turn into a higher quantity in three years’ time.

We are now going to carry out our analysis by applying the rule of the present value and
bearing in mind that the initial investment interest rate is that of the 10%. Under those
circumstances, we would obtain the following:

133.1
𝐼𝑛𝑖𝑡𝑎𝑙 𝑂𝑓𝑓𝑒𝑟 → 𝑃𝑉 = 100 =
(1 + 0.10)

30 40 50
𝑂𝑓𝑓𝑒𝑟 1 → 𝑃𝑉 = 97.9 = + +
(1 + 0.10) (1 + 0.10) (1 + 0.10)

50 40 30
𝑂𝑓𝑓𝑒𝑟 2 → 𝑃𝑉 = 101.05 = + +
(1 + 0.10) (1 + 0.10) (1 + 0.10)

Thus, we will get to the same conclusion that we have would obtain by calculating the
future value, that is, offer two is better than the initial offer and offer one is worse. We

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will choose the offer two because it is the one with the highest present value, 101.05,
which is higher than all the rest. This means that offer two produces more money than
our initial investment, in fact 1.05 euros more when talking about present value.

However, the easiest way to compare different investment possibilities is by using the
net present value (NPV), that is, as we mentioned at the beginning, no more than the
difference between the money invested and the money that will be gain in the future in
terms of present value or, it is, discounted at the rate available in our investment
market.

In our case, the NPV of the two offers, in comparison to the initial one, would be the
following:

133.1
𝑁𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝐼𝑛𝑖𝑡𝑎𝑙 𝑂𝑓𝑓𝑒𝑟 → 𝑁𝑃𝑉 = 0 = −100 + 100 = −100 +
(1 + 0.10)

𝑁𝑃𝑉 𝑜𝑓 𝑂𝑓𝑓𝑒𝑟 1 → 𝑁𝑃𝑉 = −2.1 = −100 + 97.9

30 40 50
= −100 + + +
(1 + 0.10) (1 + 0.10) (1 + 0.10)

𝑁𝑃𝑉 𝑜𝑓 𝑂𝑓𝑓𝑒𝑟 2 → 𝑁𝑃𝑉 = 1.05 = −100 + 101.5

50 40 30
= −100 + + +
(1 + 0.10) (1 + 0.10) (1 + 0.10)

So, the money produced by the initial investment has, by definition, a present value of
100 euros. Therefore, its NPV, that is, the amount of money we recuperate in terms of
present value minus what we invest would be equal to zero. This is obvious due to the
fact that the initial investment compared to itself must be equal, it is the same thing,
there cannot be any difference. This investment does not reflect anything else than what
we can obtain in our reduced investment market. It also facilitates us the discount rate
to calculate de NPV of the two possible offers and see which one will contribute with a
higher value, that is, which one will have a higher NPV.

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If we analyse offer one, we observe it has a negative NPV of 2.1 euros, which means that
we will not be earning that amount, compared to what we can easily obtain in the
market, that is what our initial investment shows. Consequently, the negative NPV
quantifies the money that we will not be earning in the future, in a specific investment,
with respect to another one used as reference.

If we now concentrate on offer two, we see it has a positive NPV of 1.05 euros that
comes from discounting the existing difference between the future value of the cash
flows we expect to earn and the value of the initial investment. Therefore, a positive
NPV quantifies the present value we would be additionally earning in the future in a
specific investment, with respect to another one used as reference.

As a result, we can consider that the NPV is a useful discriminator for investments as it
distinguishes between those in which we can earn more money with respect to another
pre-existing one, and how much more, compared to those in which we can earn less,
and how much less. The general expression of the NPV is the following:

𝑵𝑷𝑽 = −𝑰𝒏𝒊𝒕𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 + 𝑻𝒉𝒆 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝑭𝒖𝒕𝒖𝒓𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔

Therefore, the NPV measures if a project creates or destroys wealth. Hence, according
to this criterion, an investment is more feasible when the NPV is higher than zero and,
among different investment alternatives, those whose NPV is higher would be
preferable as those projects will be the ones contributing with a higher value to the
company. If the NPV is equal to zero, it would mean that the project will generate
enough cash flow (money) so as to pay the interest rate of the external financing we
asked for and the expected investment return of our internal financing.

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Then, the decision criteria base on the NPV will be as follows:

Results Economic Interpretation Decision to be made

NPV > 0 Net profit Accept the project

NPV = 0 No profit, no loss We can accept or not

NPV < 0 Net loss Reject the project

NPV advantages

This criterion presents two main advantages:

− The first one is the simplicity of its calculations, as it only requires carrying out
elementary mathematical operations.
− The second, bearing in mind the different value of money throughout time, as,
obviously, the quantity of money available today has more value than the same
quantity of money available in a near future. In terms of Brealey y Myers (1998),
“the NPV recognises that a dollar today is worth more than a dollar tomorrow,
due to the fact that a dollar today can be invested so as to begin to generate
interests immediately. Any reinvestment rule that does not recognise the value
of money throughout time cannot be considered intelligent”.

NPV Drawbacks

The main drawbacks are also two:

− The first is the difficulty of specifying the discount rate. The interest rate that is
used in the calculation of the net present value, is the interest that governs the
financial market, that is, the opportunity cost of capital. But here is where the
hypothesis of the financial market perfection is based, that is, in the fact that
such a rate will exist as such and that any person or company can turn to the

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 market and find that return or profitability without limits. However, the financial
market is imperfect, fact which makes more difficult determining such a rate.
− The second one is that the NPV considers that the intermediate cash flows the
project generates are reinvested at the same rate till the end of the project, it is,
the cost of capital. When we calculate the NPV, we are implicitly assuming that
the rate of reinvestment is the same as the one used as discount rate. Therefore,
this criterion presupposes that the net cash flows provides a profitability or
return equal to the discount rate used and that the negative cash flows will be
equally financed by the mentioned rate. Hence, if once we have started the
project, the cash flows are reinvested at a different rate to the discount rate used
to calculate the NPV, the result will differ from that obtained with this criterion.

3. THE CONCEPT OF THE INTERNAL RATE OF RETURN

The internal rate of return (IRR) of an investment is the discount rate that makes the net
present value (NPV) equal zero.

As we have seen, any investment whose final value is higher than the present value
implies, by definition, the existence of an interest rate. Nevertheless, there may be
several investment alternatives in which the interest rate is not implicit and, thus, it is
necessary to calculate it. Let us suppose, for instance, that we have the two following
investment alternatives:

− Offer 1:We invest 10.000 euros and obtain 13.310 in three years’ time.
− Offer 2: We invest 10.000 euros and obtain 3.000 in a year, 4.000 in two years
and 5.000 in three years.

If we now try to calculate the present value of these investments, supposing that the
interest rate is unknown, we will obtain the following mathematical expression:

13,310
𝑃𝑉 =
(1 + 𝑖 )

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 3,000 4,000 5,000
𝑃𝑉 = + +
(1 + 𝑖 ) (1 + 𝑖 ) (1 + 𝑖 )

So, now, each equation has two unknown data, the one corresponding to the present
value and the other to the interest rate. Therefore, being able to determine one is
conditioned to specifying the other. For instance, in offer 1, with an interest rate equal
to 0% we would obtain a present value of 13,310 and, with an interest rate of the 10%,
a present value of 10,000. Hence, we conclude that higher discount rates lead to
decreasing present values which would tend to zero when the rate tends to infinite.
Graphically expressed, it would be:
Present Value

13.310

10.000

0 10% Discount rate

Thus, we can say that infinite combinations exist, even though this information might
not seem very useful at first. However, this could provide useful information by applying
the NPV, let us see how:

13,310
𝑁𝑃𝑉 = −10,000 +
(1 + 𝑖 )

3,000 4,000 5,000

𝑁𝑃𝑉 = −10,000 + + +
1+𝑖 1+𝑖 (1 + 𝑖 )

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In this case, also infinite combinations exist for the IRR and the interest rate, but there
is only one interest rate that would make the IRR become zero:

13,310
𝑁𝑃𝑉 = 0 = −10,000 + → 𝑖 = 10% 𝑠𝑖𝑛𝑐𝑒
1+𝑖
13,310
→ −10,000 + =0
(1 + 0,10)

3,000 4,000 5,000

𝑁𝑃𝑉 = 0 = −10,000 + + + →𝑖
1+𝑖 1+𝑖 1+𝑖
= 8.896% 𝑠𝑖𝑛𝑐𝑒
3,000 4,000 5,000
→ −10,000 + + + =0
(1 + 0.08896) (1 + 0.08896) (1 + 0.08896)

As we can see, there is only one rate for each of the possible alternatives that would
make the present value of the future cash flows equal to the initial investment. This rate
is what is called the Internal Rate of Return and (IRR) and we obtain it by solving the
equation that makes the NPV equal to zero.

Different investments have different IRRs and that will help us to see which investments
are profitable and which are not. In our example we have seen that if we choose the
first offer, we earn a 10% and if we choose the second offer, we earn an 8.896%. This is
because the IRR represent the profitability of the investment itself, so the higher, the
better. Then, the IRR rule is to accept an investment project if the opportunity cost of
capital, which is the profitability that we can obtain easily in the market in similar
investments, is less that the internal rate of return. Be aware of not confuse the internal
rate of return with the cost of capital, even when both appear as discount rates in the
NPV formula. The internal rate of return is a profitability measure that depends solely
on the amount and timing of the project cash flows. The opportunity cost of capital is a
standard profitability which we use to calculate how much the project is worth and is

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established in capital markets. It is the expected rate of return offered by other
(investments) with the same risks as the project being evaluated.

Then, the decision criteria base on the IRR will be as follows:

Results Economic Interpretation Decision to be made

IRR > Cost of capital Net profit Accept the project

IRR = Cost of capital No profit, no loss We can accept or not

IRR < Cost of capital Net loss Reject the project

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