NPV is the Net Present Value . It is the summation of
present values of future cash flows less the present value
of cash outflow. This method takes into accoutn the time
value of money. Generally present value of cash outflow is
determined by multiplying with the discounting factor which
is the cost of capital of the company.
IRR is the Internal rate of return . It is the rate at
which the PV of Inflow is equal to the PV of outflow.
If IRR is positive then we can go with the project else
For capital budgeting decisions a mix of techniques is
used. No single method is accurate enough.
Key differences between the most popular methods, the NPV
(Net Present Value) Method and IRR (Internal Rate of Return)
• NPV is calculated in terms of currency while IRR is
expressed in terms of the percentage return a firm expects
the capital project to return;
• Academic evidence suggests that the NPV Method is
preferred over other methods since it calculates additional
wealth and the IRR Method does not;
• The IRR Method cannot be used to evaluate projects where
there are changing cash flows (e.g., an initial outflow
followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);
• However, the IRR Method does have one significant
advantage -- managers tend to better understand the concept
of returns stated in percentages and find it easy to compare
to the required cost of capital; and, finally,
• While both the NPV Method and the IRR Method are both DCF
models and can even reach similar conclusions about a single
project, the use of the IRR Method can lead to the belief
that a smaller project with a shorter life and earlier cash
inflows, is preferable to a larger project that will
generate more cash.