Complete Comparison: Net Present Value vs Internal Rate of Return

When investors need to assess whether an investment project is worthwhile, two financial metrics dominate the analysis: Net Present Value (NPV) and Internal Rate of Return (IRR). Although both tools aim for the same goal—determining the viability of an investment—they use different approaches that can produce contradictory recommendations. Understanding what NPV is, how IRR works, and when to trust each is essential for making sound financial decisions.

Understanding Net Present Value (NPV)

Net Present Value represents profitability expressed in monetary terms. Essentially, it identifies how much money an investment will actually earn after accounting for all future cash flows discounted to the present.

The basic concept is simple: take the expected revenues, subtract the initial and present costs, and see if the remaining amount is positive (profit) or negative (loss).

How NPV is calculated

The calculation follows this formulation:

NPV = (Cash Flow Year 1 / ((1 + Discount Rate) ^ 1) + )Cash Flow Year 2 / ((1 + Discount Rate) ^ 2( + … + )Cash Flow Year N / )(1 + Discount Rate) ^ N( - Initial Cost

Key components:

• Initial Cost: upfront investment made at the start
• Cash Flows: expected income year by year
• Discount Rate: the percentage reflecting the opportunity cost of capital

( Practical cases: positive vs negative NPV

Scenario 1: Profitable project

A company invests $10,000 in a project that generates $4,000 annually for 5 years, with a discount rate of 10%.

The present values per year are:

• Year 1: $3,636.36
• Year 2: $3,305.79
• Year 3: $3,005.26
• Year 4: $2,732.06
• Year 5: $2,483.02

Total: -$10,000 + $15,162.49 = $2,162.49 of positive NPV

Conclusion: The project creates real value beyond the initial investment.

Scenario 2: Non-profitable project

An investor places $5,000 in a certificate of deposit that pays $6,000 in 3 years, with an interest rate of 8%.

Present value of the future payment: $6,000 / )1.08)³ = $4,774.84

NPV = $4,774.84 - $5,000 = -$225.16

Conclusion: The investment does not compensate for the initial capital invested.

Exploring the Internal Rate of Return ###IRR(

IRR answers a different question: at what percentage would my money grow if I invest in this project? It is the annualized return you expect to obtain.

Unlike NPV )which tells you how much money you will earn in absolute terms(, IRR shows the percentage of return. It is compared with a reference rate—such as the yield on treasury bonds—to decide if it’s worthwhile.

Simple rule: If IRR > reference rate, the project is profitable.

Limitations you should know

) The problem with NPV

The reliability of NPV depends entirely on your estimates. Its main limitations include:

• Subjectivity of the discount rate: Different investors may use different rates, leading to opposite results for the same project
• Ignores actual risk: Assumes projections are accurate, without considering volatility or unexpected events
• Does not capture flexibility: Does not value the ability to change strategy during project execution
• Scale problem: Two projects with very different NPVs could have similar risks if one is larger than the other
• Inflation effect not considered: Future cash flows may be distorted by inflation

Despite this, NPV remains the most used tool because it is relatively accessible and provides a concrete monetary result.

( Challenges of IRR

IRR also faces significant limitations:

• Multiple solutions: Sometimes multiple IRRs exist for the same project, causing confusion
• Non-conventional cash flows: Unexpected changes in future flows or expenses can make IRR misleading
• Assumes perfect reinvestment: Presumes intermediate gains can be reinvested at the same IRR, which rarely happens in practice
• Sensitivity to discount rate: Small changes in reference rates affect comparability between investments
• Does not consider inflation: Overestimates profitability in inflationary contexts

When NPV and IRR contradict each other

It often happens: a project has a high NPV but a low IRR, or vice versa. This typically occurs when:

• Cash flows are highly volatile
• The discount rate used is excessively high or low
• Projects differ greatly in scale or duration

Recommendation: When there is conflict, review the underlying assumptions. Adjust the discount rate to better reflect the project’s actual risk. In these cases, NPV is usually more reliable because it provides an absolute monetary value that reflects real monetary terms.

Choosing the correct discount rate

This is perhaps the most critical decision. Practical considerations:

• Opportunity cost: What return would you get on an alternative investment with similar risk?
• Risk-free rate: Start with treasury bonds as a base, then add a risk premium
• Sector analysis: Examine what rates experienced investors in your industry use
• Your experience: Your history and knowledge also inform the appropriate rate

Complementary tools

NPV and IRR should not be the only indicators in your analysis. Also consider:

• ROI )Return on Investment###: Simple percentage profitability
• Payback Period: How long it takes to recover the initial investment
• Profitability Index: Ratio of present value of future flows to initial investment
• Weighted Average Cost of Capital ###WACC(: Average cost of all your sources of financing

Key points to remember

Net Present Value and Internal Rate of Return approach profitability from complementary angles. NPV tells you how much money a project will generate in present terms, while IRR tells you at what percentage your investment will grow.

Both tools are based on future projections, which involve uncertainty. For this reason, investors should conduct thorough evaluations considering:

• Their personal objectives and time horizon
• Available budget and risk tolerance
• Portfolio diversification
• Current financial situation and future outlook
• Other financial indicators beyond NPV and IRR

Using both metrics together, adjusted for context and complemented with other analyses, allows for more secure and well-founded investment decisions.