How To Choose Between NPV And IRR For Smart Investment Decisions
Making informed investment and financial decisions is not all about picking the asset with the most returns, it also includes understanding the value created by investment, for which having knowledge of different financial metrics is crucial.
IRR, or Internal Rate of Return and NPV or Net Present Value, are two such financial metrics that all investors should know for informed financial decision-making. The similarities between NPV and IRR are that both these metrics are methods used in discounted cash flows, yet they provide important insights about a project profitability metrics.
NPV helps in finding out whether an investment is profitable, and the Internal Rate of Return (IRR) calculates the projected rate of return for an investment.
In this blog, we will take a look at the difference between NPV and IRR so that you can use these concepts for comparing and evaluating different investment opportunities.
What Is NPV Or Net Present Value?
NPV or Net present value is an investment decision making tool that finds the value of an investment in today’s terms. It gives you the discounted present value of the cash flows expected in the future for an investment.
Similarly, this discounting process is repeated for all future cash flows. Therefore, the formula for NPV is,
Here
CF - Cash flow
r - Discount rate (expected rate from a similar investment)
N - Period.
For example, an investment will be worth INR 110 after a year at a 10% discount rate, so its discounted value is INR 100.
Now, if you invested INR 100 to purchase the investment, your NPV will be 0, but if you can get it for below INR 100, you will have a positive NPV.
When the NPV is positive, it makes sense to invest since you are paying less for the investment as compared to its discounted value. When it is negative, it does not make sense to invest as you are paying more for an investment as compared to its discounted value.
Example Of NPV
Suppose you purchase a bond for INR 1,00,000, and receive INR 12,000 per year as coupon payments. In the fourth year, you will receive interest plus the initial investment back. Similar investments have a rate of return of 10%, which we will use as a discount rate.
So, the NPV for the investments will be –
NPV = Sum of all discounted cash flows - Initial Investment
Particulars | Year 1 | Year 2 | Year 3 | Year 4 |
| Expected cash flow (INR) | 12,000 | 12,000 | 12,000 | 1,12,000 |
Discounting factor, (1+ r) ^ n | 1.1 | 1.21 | 1.331 | 1.4641 |
Discounted Value (INR); (CF / Discounting factor) | 10,909 | 9,917 | 9,015 | 76,497 |
NPV = INR 10,909 + INR 9,917 + INR 9,015 + INR 76,497 - INR 1,00,000
NPV = INR 6,338
This means the investment has a positive NPV. NPV can be a helpful tool in bond investment analysis.
What Is The IRR Or Internal Rate Of Return?
IRR is a discount rate at which the NPV of an investment is equal to zero. In simple words, in the NPV formula above, you need to find a value of discount rate, such that the NPV = 0.
The IRR is the rate of return (annualised) that is expected from an investment based on the given initial investment and expected future cash flows. IRR is also considered a break-even rate of returns, and above that the investment becomes profitable.
The formula for IRR is –
CF - Cash flow
N - Period
IRR - Internal rate of return
Finding the value of IRR uses a hit-and-trial method, where different values of IRR are used in the formula until the NPV is 0, but this can be done by calculators or through Excel (manual calculations are not required).
For example, a INR 1,00,000 bond will yield cash flows of INR 12,000 as coupon payments over 4 years. In the fourth year, the principal will be returned, and then the IRR will be –
| Initial Investment | INR 1,00,000 |
| Year 1 | INR 12,000 |
| Year 2 | INR 12,000 |
| Year 3 | INR 12,000 |
| Year 4 | INR 1,12,000 |
| IRR | 12% |
It means the investment is expected to generate 12% per annum. If your return rate (or required rate of return) is below the IRR, the investment becomes attractive for the investor. If the required rate of return is higher than the IRR, then the investment is not attractive for the investor.
Remember, bond yield and IRR of a bond can be different because yield to maturity refers to current yield based on market price, while IRR is the actual return based on all future cash flows, including reinvestment of cash flows.
NPV vs IRR: Key Differences In Investment Analysis
Both NPV and IRR comes under the umbrella of discounted cash flows, but it is crucial to understand the difference between NPV and IRR –
Criteria | NPV | IRR |
| Output | NPV gives the present value (discounted) of all the cash flows expected in future. | IRR gives the expected annualised percentage return of an investment. |
| Uses | Used for evaluating the total value created | Used for comparing the returns of various projects. |
| Favourable value | Investors invest if NPV is negative | Invest if the required rate of return is less than IRR. |
| Unfavourable value | No investment if NPV is negative. | No investment if the required rate of return is higher than IRR. |
| Drawback | Requires an exact discount rate, slight change in discount rate can give wrong results. | Can be misleading, as it gives percentage value not an absolute value. |
When To Use NPV vs IRR: A Practical Guide
Let us look at when you should use NPV and IRR while making an investment analysis.
1. Net Present Value:
It is better to use NPV when:
- Different Project Sizes: Using NPV can be practical when you are comparing projects with different sizes. It helps you find the absolute value created (or lost) by various projects.
For example, you want to compare projects where one has an initial investment of INR 10 lakhs and another worth INR 1 crore.
- Unequal Cash Flows: NPV is also a great tool to find the value of projects when the cash flows are unequal. Net Present Value allows you to discount each cash flow accurately and evaluate the investment.
For example, a project provides INR 20,000 in year 1, INR 35,000 in Year 2, and so on.
2. Internal Rate of Return;
It can be beneficial to use IRR when:
- Comparing Returns of Similar Investments: IRR can be helpful when comparing returns of similar investments. Suppose two bond investments have the same credit risk, same maturity, and same initial investment. Then, IRR can help us determine the better investment option.
- Stable Cash Flow: Internal Rate of Return (IRR) proves valuable when assessing projects with consistent and stable cash flows like fixed income investment returns. This includes ventures like rental income properties or structured debt instruments giving predetermined payouts.
Conclusion
IRR and NPV can be very useful tools when comparing and evaluating different investment opportunities. These tools are used for evaluating financial securities as well as business projects. Investors can incorporate these tools in long-term investment planning and implementing portfolio diversification strategies.
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FAQs On NPV vs IRR
1. Which is better for bonds: NPV or IRR?
Both IRR and NPV are relevant for bonds. IRR helps you understand the percentage return you can expect if the bond is held until maturity and the interest is reinvested. NPV, on the other hand, is used for calculating the absolute monetary value created or value lost from a particular bond investment.
2. Is NPV/IRR relevant for retail investors?
The concepts of NPV and IRR can be useful for investors in evaluating and comparing various investment opportunities. These tools support long-term investment planning and provide a structured approach to understanding risks and returns. NPV can help retail investors find undervalued opportunities.
3. What are the limitations of using IRR over NPV?
A major issue with using IRR is that it assumes that all the cash flows of an investment are being reinvested at the IRR itself.
That might not always be the case. IRR also ignores the scale of the investment, meaning a small project with a high IRR may appear better than a large project with a lower IRR, even if the larger one adds more absolute value.
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