NPV Vs IRR

1. NPV AND IRR

2. WHAT IS NPV?
• NET PRESENT VALUE IS A FUNDAMENTAL FINANCIAL METRIC USED
TO EVALUATE THE PROFITABILITY AND FEASIBILITY OF AN
INVESTMENT OR PROJECT. IT REPRESENTS THE DIFFERENCE BETWEEN
THE PRESENT VALUE OF CASH INFLOWS AND THE PRESENT VALUE OF
CASH OUTFLOWS. BY DISCOUNTING EACH CASH FLOW BACK TO ITS
CURRENT VALUE, NPV INDICATES HOW MUCH VALUE AN
INVESTMENT OR PROJECT WILL GENERATE COMPARED TO ITS COSTS
IN TODAY’S MONEY TERMS. A POSITIVE NPV MEANS THAT THE
PROJECTED EARNINGS EXCEED THE ANTICIPATED COSTS, MAKING IT
A VIABLE INVESTMENT, WHILE A NEGATIVE NPV SUGGESTS THE

3. EXAMPLE OF NPV
• CONSIDER A SCENARIO WHERE YOU CONTEMPLATE INVESTING IN A
SMALL BUSINESS IN INDIA. THE COST TO INVEST IN BUSINESS IS
₹20,000. YOU PROJECT THAT THE INVESTMENT WILL GENERATE A NET
CASH FLOW OF ₹5000 PER YEAR FOR THE NEXT 3 YEARS,PLUS RS.12,000
IN THE THIRD YEAR . TO EVALUATE THIS INVESTMENT, YOU CALCULATE
THE NET PRESENT VALUE (NPV) USING A DISCOUNT RATE OF 10% TO
ACCOUNT FOR THE TIME VALUE OF MONEY AND THE RISKS ASSOCIATED
WITH THE INVESTMENT.

4. YEAR CASH FLOW DCF @ 10% PRESENT VALUE
0 (20,000.00) 1.00 (20,000.00)
1 5000 .9091 4545.45
2 5000 .8264 4132.23
3 5000 .7513 3756.57
3 12000 .7513 9015.78
NPV 1450.04
INITIAL INVESTMENT = RS. 20,000, PERIOD = 3
YEARS, DISCOUNT RATE = 10%

5. EXPLANATION
• THE NPV CALCULATION INVOLVES DISCOUNTING
EACH OF THE PROJECTED CASH FLOWS BACK TO
THEIR PRESENT VALUE AND THEN SUBTRACTING
THE INITIAL INVESTMENT AMOUNT. THE DISCOUNT
RATE OF 10% REFLECTS THE TIME VALUE OF MONEY
AND THE RELATIVE RISK OF THE INVESTMENT.

6. CONCLUSION
• THE POSITIVE NPV OF 1450 SUGGESTS THAT, BASED
₹
ON THE GIVEN PROJECTIONS AND DISCOUNT RATE,
THE BUSINESS INVESTMENT IS EXPECTED TO GENERATE
MORE VALUE THAN ITS COST. THEREFORE, INVESTING
IN BUSINESS UNDER THE CURRENT CONDITIONS MAY
BE A FINANCIALLY SOUND DECISION.

7. WHAT IS AN IRR?
• THE INTERNAL RATE OF RETURN (IRR) IS ESSENTIALLY A
FINANCIAL METRIC FOR CALCULATING THE NET RETURN
FROM A GIVEN INVESTMENT. IT IS ALSO THE RATE AT
WHICH THE NPV OF CASH FLOWS IS ZERO. IRR FINDS USE
WHEN POTENTIAL INVESTMENTS, BUSINESS
OPPORTUNITIES, AND PROJECTS ARE COMPARED.

8. STEPS TO CALCULATE IRR
“GUESS AND CHECK” METHOD IS THE COMMON WAY TO FIND IRR
STEP 1: SELECT 2 DISCOUNT RATES FOR THE CALCULATION OF NPVS
YOU CAN START BY SELECTING ANY 2 DISCOUNT RATES ON A RANDOM BASIS THAT WILL BE
USED TO CALCULATE THE NET PRESENT VALUES IN STEP 2.
IT IS IMPORTANT NOT TO SELECT DISCOUNT RATES THAT ARE RIDICULOUSLY DISTANT FROM THE
IRR (E.G. 10% AND 90%) AS IT COULD UNDERMINE ACCURACY.

9. STEP 2: CALCULATE NPVS OF THE INVESTMENT USING THE 2 DISCOUNT RATES
YOU SHALL NOW CALCULATE THE NET PRESENT VALUES OF THE INVESTMENT ON THE BASIS OF
EACH DISCOUNT RATE SELECTED IN STEP 1.
STEP 3: CALCULATE THE IRR
USING THE 2 DISCOUNT RATES FROM STEP 1 AND 2 CALCULATE NET PRESENT VALUES . THEN
YOU SHALL CALCULATE THE IRR

10. STEP 4: INTERPRETATION
THE DECISION RULE FOR IRR IS THAT AN INVESTMENT SHOULD ONLY BE SELECTED WHERE THE
COST OF CAPITAL (WACC) IS LOWER THAN THE IRR.
THE DECISION RULE ABOVE WILL LEAD TO THE SAME CONCLUSION AS THE NPV
ANALYSIS WHERE ONLY ONE INVESTMENT IS BEING CONSIDERED.

11. MR. AMILA IS CONSIDERING TO INVEST RS. 350,000 IN A HARDWARE
BUSINESS. THE CASH INFLOWS DURING THE FIRST, SECOND AND THIRD
YEARS ARE EXPECTED TO BE RS. 125,000, RS. 150,000 AND RS, 170,000
RESPECTIVELY.
CALCULATE THE IRR FOR THE PROPOSED INVESTMENT AND INTERPRET
YOUR ANSWER.
STEP 1: SELECT 2 DISCOUNT RATES
R1= 10% AND R2 = 15%
STEP 1 FIND NPVS OF THE INVESTMENT USING 2 DISCOUNT RATES AT 10%

12. YEAR CASH FLOW DCF@ 10% PRESENT VALUE
0 350000 1.00 350000
1 125000 0.9091 113636.36
2 150000 0.8264 123966.94
3 170000 0.7513 127723.52
NPV1 15326.82

13. YEAR CASH FLOW DCF@15% PRESENT
VALUE
0 (350000) 1.00 (350000)
1 125000 .8696 108695.65
2 150000 .7561 113421.55
3 170000 .6575 111777.76
NVP2 (-16105.04)

14. STEP 3 : CALCULATE THE IRR
INTERNAL RATE OF RETURN = R1% + NPV1*(R2-R1) / (NPV1-NPV2)
= 10% + 15326.82*(15-10) % / (15326.82-(-16105.04))
= 10% + 15326.82* 5% / (15326.82 + 16105.04)
= 10% + 2.44%
= 12.44%

15. DIFFERENCE BETWEEN NPV AND IRR
ASPECT NPV IRR
DEFINITION NPV may be described as the summation of the
present values of cash proceeds (CFAT) in each
year minus the summation of present values of
the net cash outflows in each year. (Khan & jain
Pgno. 5.28)
The internal rate of return is usually the rate of
return that a project earns. It is defined as the
discount rate(r) which equates the aggregate
present value of the net cash inflows (CFAT)
with the aggregate present value of cash
outflows of a project.(Khan & jain pgno. 5.30)
MEASUREMENT In monetary terms ( e.g. $) In percentage terms (%)
PERSPECTIVE Provides a net value of the investment over the
project life
Provides an annual return rate over the project
life.
DECISION CRITERION The decision rule for a project under NPV is to
accept the project if the NPV is positive and
reject if it is negative.
The use of the IRR, as a criterion to accept
capital investment decisions, involves a
comparison of the actual IRR with the required
rate of return also known as the cut-off rate or
hurdle rate.

16. WHICH IS BETTER : NPV OR IRR
IT DEPENDS. IRR IS USUALLY MORE USEFUL WHEN YOU ARE
COMPARING ACROSS MULTIPLE PROJECTS OR INVESTMENTS,
OR IN SITUATIONS WHERE IT IS DIFFICULT TO DETERMINE THE
APPROPRIATE DISCOUNT RATE. NPV TENDS TO BE BETTER
FOR WHEN CASH FLOWS MAY FLIP FROM POSITIVE TO
NEGATIVE (OR BACK AGAIN) OVER TIME, OR WHEN THERE
ARE MULTIPLE DISCOUNT RATES.

17. THE END
THANK YOU