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Difference between NPV and IRR

This page compares NPV vs IRR and describes difference between NPV and IRR.

NPV-Net Present Value

NPV is a process of calculating the present value of cash flows of an investment proposal. This is done using cost of capital(k) as appropriate discounting rate and finding out the net present value(NPV) by substracting the present value of cash inflows from the present values of cash outflows.


NPV

Where CI and CO are future cash inflow and cash outflows and k is the cost of capital.

Cost of capital(k) is the rate of return required by the suppliers of the finances such as banks or other financers. It is used as a cutoff rate, hurdle rate or discount rate. Using the NPV method, projects are be ranked in order of highest NPV's. Changing the value of "k" can alter the original NPV ranking of the projects.

NPV method considers all cash flows over the entire project life cycle. This includes operation and maintenance costs also. In practice, to determine the value of "k" in advance for the entire project life cycle is complex, since it can alter due to many uncontrolled external factors.

IRR-Internal Rate of Return

IRR rate(R) is the discount rate (k) which equates the present value of cash inflows with the present values of the cash outflows i.e. when NPV is equal to zero.


IRR

IRR may be interpreted as the highest rate of interest a firm would be ready to pay on the funds borrowed to finance the project, without being financially worse off, by repaying loan - principal and accurued interest - out of cash inflows generated by the project.

IRR may be referred to as break-even rate of borrowing from the bank or lender.

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