The key differences between NPV and IRR :
Net Present Value Internal Rate of Return
1. Discount Rate that makes the Net Present
1. Calculated as the present value of cash inflow minus
Value (NPV) of all cash flows from a particular
the present value of cash outflow.
project equal to zero.
2. Expressed in the form of currency return expected 2. Expressed in the form of percentage returns
from a project. expected from a project.
3. Absolute Measure: Currency value gained or lost on a 3. Relative Measure: Rate of return of a project
project. over it’s lifespan.
The calculations of both NPV and IRR are given here:
NPV Calculation:
Present Value = Cash Inflow or Future Value x (1 + rate)^-(time)
NPV = sum of all PV – Cash Outflow
If NPV > 0 accept
IRR Calculation:
Set NPV to zero
0 = [Cash Inflow x (1 + IRR)^-(time)] – Cash Outflow
When IRR > rate accept
The discount rate is a critical part of calculating the NPV. Higher the discount rate, lower is the
NPV.
So, let’s take a hypothetical example:
Say our solar system:
* costs Rs. 100
* returns Rs. 25 per year for 5 years
* discount rate of 5%
Therefore NPV
= 25*(1.05)^-1 + 25*(1.05)^-2 + 25*(1.05)^-3 + 25/(1.05)^-4 + 25/(1.05)^-5 – 100
= Rs. 8.236
And therefore, for IRR for 5 years
0 = 25*(1/(1+IRR)) + 25*(1/(1+IRR)^2) + 25*(1/(1+IRR)^3) + 25*(1/(1+IRR)^4) +
25*(1/(1+IRR)^5) – 100
IRR = 7.9%
So, for our example payback period is 4 years.
So, in both cases we should go ahead with the transaction.
Both NPV and IRR are criterion that could be used to evaluate how profitable a project is.
