What is the Difference between NPV and IRR?
NPV or Net Present Value is a standard way of appraisal used in finance. It is based on calculating the present values of all the cash inflows and cash outflows related to any asset or for any project and finding their sum. If the net present value of cash flows is negative it indicates that acquiring the asset or taking up the project is not financially viable. On the other hand a positive net present value gives the profit that one can make by taking up the project or acquiring the asset.
IRR or the Internal Rate of Return is the rate at which if the cash inflows and outflows are discounted their net present value is equal to zero. The IRR gives the actual rate at which a project or an asset is going to yield returns. It is used as a tool for decision making when there are a number of options and the best has to be chosen.
These abbreviations refers to the terms Net Present Value (NPV) and Internal Rate of Return (IRR). These two terms are use in connection with the concept and techniques that consider that the money that available at a given time is more valuable than the same amount of money at some later time because the money can earn interest or because the satisfaction that can be derived immediately is more attractive to individuals than the satisfaction some later date.
To compare the values of money available at different times, we use the concept of interest or rate of return on money. There are several different methods used based on this basic principle. In NPV method the present value of any series of given amounts of money at future times is discounted by a standard interest rate so that the amount NPV amount so arrived at will yield a stream of returns represented by the future amounts of money when invested at that standard rate of interest.
The IRR method is used to evaluate the attractiveness of an investment when a sum invested now yields a stream of returns at future dates. This method does on use a standard rate of return. It considers the rate of return as variable which is calculated in such a way that the future stream of returns discounted are the rate will result in the exact sum invested initially. The rate so calculated is called the IRR.
As can be seen from the above discussion, NPV represent the real value of a stream of flow of money, while the IRR represent a rate for discounting the value of a stream of flow of money to ascertain its real value.