IRR vs. NPV: What's the Difference?
Edited by Aimie Carlson || By Harlon Moss || Updated on October 20, 2023
IRR is the discount rate making NPV zero; NPV is the present value of future cash flows minus initial investment.
Key Differences
IRR stands for Internal Rate of Return, while NPV stands for Net Present Value. Both are financial metrics used in the analysis of investments, but they approach the evaluation from different perspectives.
IRR represents the discount rate where the NPV of a series of cash flows equals zero. In contrast, NPV calculates the present value of future cash flows, subtracting the initial investment.
When considering IRR, it's about finding a break-even rate of return; whereas with NPV, you're determining the monetary value an investment could generate or lose over time.
One major difference is that IRR provides a percentage indicating an expected return, while NPV provides a dollar amount, showing the anticipated net gain or loss from an investment.
While both IRR and NPV are valuable tools, they have distinct applications. IRR is often used to compare multiple projects, while NPV helps understand an investment's absolute value.
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Comparison Chart
Definition
Rate at which NPV is zero.
Present value of cash flows minus initial investment.
Measure
Percentage (%)
Dollar amount ($)
Key Focus
Break-even rate of return.
Net gain or loss of an investment.
Decision Rule
If IRR > required return, invest.
If NPV > 0, invest.
Dependency
Can be multiple or none in non-conventional cash flows.
Always provides a unique value for a given discount rate.
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IRR and NPV Definitions
IRR
IRR represents an investment's break-even rate of return.
If we achieve more than the IRR, we're making a profit.
NPV
NPV is the difference between the present value of cash inflows and outflows.
The NPV for this project is $20,000 positive.
IRR
IRR can be seen as the growth a project is expected to generate.
This project's IRR suggests it can grow our investment by 15% annually.
NPV
NPV is the present value of future cash flows minus the initial investment.
After factoring in our initial cost, the NPV is still favorable.
IRR
IRR is the rate where inflows match outflows in present value terms.
With an IRR of 8%, our inflows and outflows balance out.
NPV
NPV helps assess the expected monetary returns of a project.
An NPV of $0 means we'll just break even on this project.
IRR
IRR helps compare the profitability of different projects.
Between two projects, the one with the higher IRR is generally more attractive.
NPV
NPV can vary based on the discount rate used.
If we change our discount rate, the NPV will adjust accordingly.
IRR
IRR is the discount rate that equates an investment's NPV to zero.
For this project, the IRR is 10%.
NPV
NPV determines an investment's profitability in dollar terms.
A positive NPV indicates a potentially good investment.
FAQs
What does IRR stand for in finance?
IRR stands for Internal Rate of Return.
How does NPV relate to cash flows?
NPV represents the present value of future cash flows minus the initial investment.
What does a positive NPV suggest?
A positive NPV suggests that the investment would add value to the firm and is potentially profitable.
Is a higher NPV always better?
Generally, a higher NPV indicates a more favorable investment, but context and other factors should also be considered.
Can there be multiple IRRs for a project?
Yes, for projects with non-conventional cash flows, there can be multiple IRRs.
What is the relationship between IRR and NPV?
IRR is the discount rate that results in an NPV of zero.
Can IRR be negative?
Yes, IRR can be negative if the sum of the discounted cash flows is less than the initial investment.
How is NPV different from present value?
NPV accounts for the initial investment, whereas present value only considers the discounted future cash flows.
Which is more sensitive to cash flow timings, IRR or NPV?
IRR is generally more sensitive to cash flow timings than NPV.
Why is IRR called the break-even rate of return?
Because it's the rate at which NPV becomes zero, meaning inflows match outflows in present value terms.
What does IRR reveal about an investment?
IRR reveals the expected growth rate or return of the investment.
Can a project be accepted with a negative IRR?
Theoretically, if IRR is less than the required return, the project isn't advised. But, decisions may vary based on other factors.
What's a common benchmark for NPV decisions?
If NPV is greater than 0, the investment is often considered favorable.
Are IRR and NPV always consistent in their recommendations?
Not always. They might occasionally give conflicting recommendations, especially with differing project scales or cash flow patterns.
How is NPV useful for investment decisions?
NPV provides a tangible dollar amount indicating the net value or loss an investment might generate.
Can NPV ever be zero?
Yes, when the present value of cash flows equals the initial investment, NPV is zero.
Do IRR and NPV require the same cash flow inputs?
Yes, both IRR and NPV are based on the same series of cash flows from an investment or project.
How does changing the discount rate affect IRR?
It doesn't. IRR is the rate that makes NPV zero and is independent of the chosen discount rate.
What happens to NPV if the discount rate increases?
The NPV will decrease as future cash flows are discounted more heavily.
Why might companies prefer IRR over NPV or vice versa?
IRR offers a percentage rate of return, aiding comparisons. NPV provides a dollar value, helping understand absolute profitability.
About Author
Written by
Harlon MossHarlon is a seasoned quality moderator and accomplished content writer for Difference Wiki. An alumnus of the prestigious University of California, he earned his degree in Computer Science. Leveraging his academic background, Harlon brings a meticulous and informed perspective to his work, ensuring content accuracy and excellence.
Edited by
Aimie CarlsonAimie Carlson, holding a master's degree in English literature, is a fervent English language enthusiast. She lends her writing talents to Difference Wiki, a prominent website that specializes in comparisons, offering readers insightful analyses that both captivate and inform.
