NPV and IRR are both used in the evaluation process for capital expenditures. Net present value (NPV) discounts the stream of expected Cash flows associated with a proposed project to their current value, which presents a cash surplus or loss for the project. The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero.
The two capital budgeting methods have the following differences:
• Outcome. The NPV method results in a money value that a project will produce, while IRR generates the percentage return that the project is expected to create.
• Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project.
• Decision support. The NPV method presents an outcome that forms the foundation for an investment decision, since it presents a pound return. The IRR method does not help in making this decision, since its percentage return does not tell the Investor how much money will be made.
• Reinvestment rate. The presumed rate of return for the reinvestment of intermediate cash flows is the firm’s cost of capital when NPV is used, while it is the internal rate of return under the IRR method.
• Discount rate issues. The NPV method requires the use of a discount rate, which can be difficult to derive, since management might want to adjust it based on perceived risk levels. The IRR method does not have this difficulty, since the rate of return is simply derived from the underlying cash flows.
Generally, NPV is the more utilized method, while IRR tends to be calculated as part of the capital budgeting process and supplied as additional information.