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Net present value and internal rate of return are measures used to evaluate a potential investment or capital project. Both measures involve using a stream of expected cash inflows and outflows to determine whether an investment is acceptable. Net present value (NPV) indicates what the income potential of a project is worth at the start, while the internal rate of return (IRR) yields a growth percentage.
While the calculations for both net present value and internal rate of return begin with the same data, the IRR shows how profitable a project will be when the NPV equals zero. The internal rate of return is also referred to as the discount rate. When comparing potential projects, a higher internal rate of return is often assumed to indicate the better choice.
Another way to evaluate the internal rate of return is to interpret it as the minimum rate of return that is acceptable. Since the calculation assumes that net present value is zero, the IRR is the least amount of return an investor could expect to receive. This is based on the principle that the investment's future discounted income minus the project's initial cash outflow would not carry any present day value.
The internal rate of return could be viewed as an investment's break even point. The calculation's major weakness is that it assumes that the investment will not generate a cash profit or loss. The IRR is also calculated under the assumption that future income will occur at certain milestones and monetary values throughout the project's lifetime. If any of those factors change, it can alter the actual discount rate.
The NPV calculation is used to discount all future income payments based on a predetermined return rate. For example, if an investor requires a minimum return of 5%, each of the future income payments would be discounted using this percentage to arrive at present day value. All of the discounted future income payments are then added and subtracted from the project's initial cash outflow to arrive at net present value.
When evaluating a group of potential capital projects or investments, a higher net present value is assumed to be favorable. The principle behind this assumption is that a project that is worth more today will yield higher financial benefits than a project with a lower present day value. Since it already assumes a certain rate of return, the NPV method indicates the monetary value of an investment's expected income payment. The predetermined rate of return might not be a project's actual rate of return, however, as this could fluctuate over the project's lifespan.
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