IRR VS NPV

By Ahmad Syuaib Bin Ahmad Razali

MTE 1
Meaning of NPV

 The difference between the present value of cash inflows and the present
value of cash outflows. NPV is used in capital budgeting to analyze the
profitability of an investment or project. Present value of the expected cash
flows is computed by discounting them at the required rate of return.

 Where, N=total number of periods T= the time of the cash flow i= the discount
rate (the rate of return that could be earned on an investment) Rt = the net
cash flow i.e. cash inflow – cash outflow at time t (R0: it is subtracted from
the whole as any initial investments during first year is not discounted for NPV
purpose
NPV Decision Rules

If NPV >0, accept the Project

If NPV =0, accept or reject the

Project

If NPV <0, reject the Project

Advantages of NPV

 NPV method, is a direct measure of the contribution.

 It increases the wealth of the share holders as it gives you money.
 The investment will increase the firm's value
 Considers all the cash flows
 Considers the time value of money
 Considers the risk of future cash flows
 Provides better forecast
Three properties of NPV

 Higher income amounts make the net present value higher

 If profits come sooner, the net present value is higher.
 Changing the discount rate changes the net present value.
IRR- Internal rate of return

 IRR on an investment or project is the annualized effective

compounded return rate or rate of return that makes the NPV
of all cash flow from a particular investment equal to zero.

 – CF: Cash Flow

 – r: Internal Rate of Return
Internal Rate of Return Rules

 In IRR decisions, if we have only one project, most of the time

we need the basic rule «independent project»:
 IRR > Cost of capital (should be accepted)
 IRR = Cost of capital (provides the minimum return)
 IRR < Cost of capital (shouldn’t be accepted)
 In addition, we need to take other situations into account too.
Especially, eventhough NPV and IRR will generally give us the
same decision, there are some exceptions:
 Nonconventional cash flows – cash flow signs change more than
once
 Mutually exclusive projects
Advantages of IRR

 IRR is indicating a rate of return of a project.

 IRR is sometimes referred to as "economic rate of return (ERR)".
 IRR method, it shows the return on the original money invested.
 No need to calculate the cost of capital.
 Tell weather an investment increase the firm value
 It calculates Break-even.
 IRR calculates an alternative cost of capital including an appropriate risk
premium
Which is better NPV or IRR?

 NPV calculated in terms of currency while IRR is

expressed in terms of the percentage
 The IRR Method cannot be used to evaluate projects
where there are changing in cash flows
 NPV calculate additional wealth
 IRR calculation is ineffective if a project with a mixture of
multiple positive and negative cash flow
 Flexibility
Conclusion

 NPV is better than IRR because a positive NPV

indicates addition to shareholder's wealth and
negative NPV indicates vie versa. This thumb rule
cannot be applied to IRR.
 INVESTMENT PROJECT

MC COMPANY’ PROJECTS
GOLD FISH SILVER FISH
• Capital RM 15000 • Capital RM 5000
 Projects’ Properties
 Invest in farming of gold fish and silver fish.
 The capital of gold fish is RM 15000, the capital of
silver fish is RM 5000.
 The discount interest rate of the Gold Fish
investment is 7 % anually, while the discount
interest rate of the Silver Fish investment is 10
%anually.
 This project run for 4 years.
 PROJECTION IN 4 YEARS

INVESTMENT GOLD FISH SILVER FISH

YEAR COST INTEREST COST INTEREST

1 10000 15000 1500 3000

2 10000 15000 2000 4000

3 5000 15000 1000 3500

4 - 5000 1200 3000

NET PRESENT VALUE ANALYSIS
  
NPV(G) gold fish =
= RM 1935

NPV(S) silver fish =

= RM 1124
 Conclusion.
 NPV for both projects is more than zero >0, NPV
(G)= RM 1935,NPV (S)= RM 1124. In this case both
of the project can be run but the gold fish
investment project is much more relevant than
the silver fish investment project.
 But this is not the end, let’s find the IRR first.
 INTERNAL RATE OF RETURN
GOLD FISH
YEAR CASH FLOW DISCOUNT OF DISCOUNT OF
CASH FLOW 7% CASH FLOW 20%
0 -15000 -15000 -15000

1 5000 4673 4167

2 5000 4367 3472

3 5000 4081 2893

4 5000 3814 2411

NPV 5000 1935 -2057

 CALCULATION OF INTERNAL RATE OF
RETURN GOLD FISH.
 
IRR (G) =


= 13.3 %
 INTERNAL RATE OF RETURN
SILVER FISH
YEAR CASH FLOW DISCOUNT OF DISCOUNT OF
CASH FLOW 10% CASH FLOW 20%

0 -5000 -5000 -5000

1 1500 1363 1250

2 2000 1652 1389

3 2500 1878 1445

4 1800 1124 868

NPV 2800 1124 -48

 CALCULATION OF INTERNAL RATE OF
RETURN GOLD FISH.
 
IRR (S) =


= 19.6 %
 CONCLUSION
 Based on IRR, IRR (S) is greater than IRR (G), IRR(S) > IRR(G),
which IRR (G) is 13.3 % while IRR (S) is 19.6 %.
 This shown that Silver Fish investment project is much more
relevant.
 Although it seems that both of NPV and IRR are contradictory
because of matter of duration of cash flow and the size of the
project deals. I prefer to choose the Gold Fish investment
project because due to short duration which is 4 years it is
better to choose which NPV is greater so that tbe profit (return)
will be much more worth it for the investor.
 REFERENCE
John Richard Kopp. (2009). Towards a Multi-Dimensional Framework
for Assessing the Value of Software Projects. Seidenberg
School of Computer Science and Information Systems Pace University.

Michael James Osborne. (2010). THE USE AND MEANING OF ALL SOLUTIONS
(INTEREST RATES) TO THE TIME VALUE OF MONEY EQUATION.
Middlesex University Business School.

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