WHAT IS NET PRESENT VALUE (NPV) ?
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. Present value of a cash flow means the amount of cash due to be received or paid at a future point of time, discounted using an appropriate discount factor which in most cases is the company’s cost of capital.
Project with positive cash flow are considered favourable since they indicate a positive cash outflow.
On the other hand, Project with negative cash flow are unfavourable as they indicate a negative or poor cash outflow from the project.
FORMULA FOR NPV :
NPV = Total cash inflows – Total cash outflows
WHAT IS INTERNAL RATE OF RETURN (IRR) ?
The internal rate of return (IRR) calculates the percentage rate of return at which the cash flows associated with a project will result in a net present value of zero. It is used to evaluate a proposed capital expenditure.
The projects whose IRR is greater than the company’s cost of capital are considered desirable and are accepted .
On the other hand, projects whose IRR is less than company’s cost of capital are considered undesirable and are therefore rejected.
COMPARISON BETWEEN IRR & NPV –
The following points highlight the main differences between the two –
- OUTCOME – The NPV method results in a dollar value that a project will produce, while IRR generates the percentage return that the project is expected to create.
- MEASURES – NPV is an absolute measure while IRR is a relative measure.
- CASH FLOW CHANGES – NPV method can be used to evaluate projects or investments where the cash flows have changes. On the other hand, IRR cannot be used to evaluate projects where there are changing cash flows.
- DISCOUNT RATE – In the NPV method, it is required to calculate the discount rate which is very difficult to derive while in the IRR method discount rate is not required.
- REINVESTMENT RATE – NPV’s presumption is that intermediate cash flow is reinvested at cutoff rate while under the IRR approach, an intermediate cash flow is invested at the prevailing internal rate of return.
Thus, both NPV and IRR are considered to be sound analytical tools. Out of these two, the NPV method is generally preferred by managers because it is considered more suitable and accurate when mutually exclusive projects are to be ranked.