FM (MID-TERM TEST)

Assignment

Submitted by: Ankita Singh

Roll Number: 19186
Section:HA
 Difference Between

NPV
IRR

Introduction
Net present value (NPV) and internal rate of return (IRR) are
extensively used measures to appraise investment projects.
Unlike simple payback method and accounting rate of return
method, NPV and IRR both take into account the time value of
money which make them more reliable and practical
investment appraisal techniques for companies.

NPV is calculated as present value of cash inflow less present

value of cash outflow.

IRR is known as discount rate that makes NPV of all cash

inflows of a project equal to zero.

Definitions and meaning

NPV (Net Present Value)
When the present value of the all the future cash flows
generated from a project is added together, the result
obtained will be the Net Present Value or NPV.
NPV = Discounted Cash Inflows – Discounted Cash Outflows
The concept is having great importance in the field of finance
and investment for taking important decisions relating to cash
flows generating over multiple years.
NPV shows the actual benefit received over and above from the
investment made in the particular project for the time and risk.
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Advantages of NPV
 Time Value of Money is given more importance i.e. the
value of money today is more than the value of money
received a year from now.
 Project profitability & risk factors are given high priority.
 It helps you to maximize your wealth as it will show are
your returns greater than its cost of capital or not.

NPV formula calculation

NPV = CF/ (1+r)t – Cash Outflow

Where:
 CF = cash inflow
 r = discount rate
 t = time
 Cash outflow = total project cost

IRR (Internal Rate of return)

IRR for a project is the discount rate at which the present value
of expected net cash inflows equates the cash outlays. To put
simply, discounted cash inflows are equal to discounted cash
outflows.

(Cash inflows / Cash outflows) = 1

The decision rule related to the IRR criterion is:
Accept the project in which the IRR is greater than the required
rate of return (cut off rate) because in that case, the project will
reap the surplus over and above the cut-off rate will be
obtained.

Advantages
If you use this of IRR to make a decision between two projects,
method
accept the project if the IRR is greater than the required rate of return.
 This approach is mostly used by financial managers as it is
expressed in percentage form so it is easy for them to
compare to the required cost of capital.
 It will provide you excellent guidance on a project’s value
and associated risk.
 IRR method gives you the advantage of knowing the actual
returns of the money which you invested today.

IRR Formula Calculation

Cash Outflow = CF /(1+IRR)t
Where:
 CF = cash inflow
  t = time

BSIS FOR
NPV IRR
COMPARISON

Meaning The total of all the IRR is described as a

present values of rate at which the
cash flows (both sum of discounted
positive and cash inflows
negative) of a equates discounted
project is known as cash outflows.
Net Present Value or
NPV.

Expressed in Absolute terms Percentage terms

What it Surplus from the Point of no profit no

represents? project loss (Break- even
point)

Decision Making It makes decision It does not help in

making easy. decision making

Rate for Cost of capital rate Internal rate of

reinvestment of return
intermediate
 BSIS FOR
NPV IRR
COMPARISON

cash flows

The basic differences between NPV and IRR are

presented below:
The main difference between NPV and IRR is given below:

1. Outcome value:
The net present value (NPV) technique of investment appraisal
shows the estimated net value of return in monetary terms that
the project would generate. It considers the discounted value
of all the possible cash outflows and inflows regarding a specific
project and then compares the two to get a net positive or
negative cash flow known as net present value.

The internal rate of return (IRR) method shows the value of

return for a project in percentage terms. If IRR is applied to the
cash flows of a project instead of cost of capital, the NPV of the
project would be zero.

2. Basis of decision:
Generally, a project is accepted if its NPV is positive or it shows
surplus funds at the end of the project. However, it is possible
that a project generates positive cash flows but the business is
still not ready to accept it because the positive NPV does not
match the NPV set by the management of the business.
IRR is used to appraise the sensitivity of cost of capital which is
used to appraise a project. IRR effectively shows a percentage
below which NPV would start to fall negative. Therefore if IRR is
greater than the cost of capital, the project is accepted and
otherwise rejected.

3. Assumptions:
The NPV technique assumes that the cash inflows generated by
the project are reinvested at the cost of capital of the business.
This assumption is somehow realistic because the cost of
capital of a business indicates the risk that a business is already
facing in its investments.

The IRR method assumes that the cash inflows are reinvested
at IRR or internal rate of return.

4. Cash flow variations:

The NPV calculation accommodates any cash outflows after the
initial outflow of cash. If a later cash outflow occurs after the
initial cash outflow, it can be discounted at applicable discount
factor or cost of capital and included in the calculation easily.

The IRR calculation is disturbed by the cash outflows that occur

after the initial cash outflow because in such a situation its
calculations could produce more than one IRR’s which would be
unrealistic. An alternative method of calculation available to
overcome this problem is known as the modified internal rate
of return (MIRR) method which is beyond the scope of this
discussion.

5. Applications:
NPV enables a business to make constructive investment
decisions because not only it accounts for whole project life but
also takes into account the discounting factor which indicates
the minimum amount of return the investors of business would
agree upon or the level of return the business is already earning
on its other investments.

IRR is used to indicate the risks attached to the project for

which NPV is calculated. As the cash flows increase/decrease by
an increase/decrease in the cost of capital of the company, IRR
shows the percentage at which the project will be neither
positive nor negative, which would indicate the sensitivity level
of the cost of capital of that project.

Results of Comparison
 The aggregate of all present value of the cash flows of an
asset, immaterial of positive or negative is known as Net
Present Value. Internal Rate of Return is the discount rate at
which NPV = 0.
 The calculation of NPV is made in absolute terms as
compared to IRR which is computed in percentage terms.
 The purpose of calculation of NPV is to determine the surplus
from the project, whereas IRR represents the state of no
profit no loss.
 Decision making is easy in NPV but not in the IRR. An
example can explain this, In the case of positive NPV, the
project is recommended. However, IRR = 15%, Cost of Capital
< 15%, the project can be accepted, but if the Cost of Capital
is equal to 19%, which is higher than 15%, the project will be
subject to rejection.
 Intermediate cash flows are reinvested at cut off rate in NPV
whereas in IRR such an investment is made at the rate of IRR.
 When the timing of cash flows differs, the IRR will be
negative, or it will show multiple IRR which will cause
confusion. This is not in the case of NPV.
 When the amount of initial investment is high, the NPV will
always show large cash inflows while IRR will represent the
profitability of the project irrespective of the initial invest. So,
the IRR will show better results.
Example of NPV and IRR
XYZ Company planning to invest in a plant, it generates the
following cash flows.

Step 1: Project the Cash Flows, Expected discount Rate and

apply the NPV formula in Excel
Step 2: Add the Cash Outflow to the NPV Formula

Step 3: Sum total to find the Net Present Value

Step 3: Sum total to find the Net Present Value

Calculate IRR
Step 1: Populate the Cash Flows
Step 2: Apply the IRR formula

Step 3: Compare the IRR with the Discount Rate

From the above calculation, we can see that the NPV generated
by the plant is positive and IRR is 14% which is more than the
required rate of return
This implies when the discounting rate will be 14% NPV will
become zero.
Hence, XYZ company can invest in this plant.

Conclusion
As I can conclude that if you are evaluating two or more
mutually exclusive projects so better go for the NPV method
instead of the IRR method. It is safe to depend on the NPV
method for selecting the best investment plan due to its
realistic assumptions & better measure of profitability. Even
you can make use of the IRR method it is a great complement
to NPV and will provide you accurate analysis for investment
decisions.