Difference Between NPV and IRR

NPV or otherwise known as Net Present Value method, reckons the present value of the flow of
cash, of an investment project, that uses the cost of capital as a discounting rate. On the other hand,
IRR, i.e. internal rate of return is a rate of interest which matches present value of future cash flows
with the initial capital outflow.

In the lifespan of every company, there comes a situation of a dilemma, where it has to make a
choice between different projects. NPV and IRR are the two most common parameters used by the
companies to decide, which investment proposal is best. However, in a certain project, both the two
criterion give contradictory results, i.e. one project is acceptable if we consider the NPV method, but
at the same time, IRR method favors another project.

The reasons of conflict amidst the two are due to the variance in the inflows, outflows, and life of
the project. Go through this article to understand the differences between NPV and IRR.

Content: NPV Vs IRR

1. Comparison Chart

2. Definition

3. Key Differences

4. Similarities

5. Conclusion

Comparison Chart
Basis for Comparison NPV IRR

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

Expressed in Absolute terms Percentage terms

What it represents? Surplus from the project Point of no profit no loss (Break
even point)

Decision Making It makes decision making easy. It does not help in decision making

Rate for reinvestment Cost of capital rate Internal rate of return

of intermediate cash
flows

Variation in the cash Will not affect NPV Will show negative or multiple IRR
outflow timing

Definition of NPV

When the present value of the all the future cash flows generated from a project is added together
(whether they are positive or negative) the result obtained will be the Net Present Value or NPV. 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 constitutes shareholder’s wealth
maximization which is the main purpose of the Financial Management.

NPV shows the actual benefit received over and above from the investment made in the particular
project for the time and risk. Here, one rule of thumb is followed, accept the project with positive
NPV and reject the project with negative NPV. However, if the NPV is zero, then that will be
a situation of indifference i.e. the total cost and profits of either option will be equal. The calculation
of NPV can be done in the following way:

NPV = Discounted Cash Inflows – Discounted Cash Outflows

Definition of IRR
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. It
can be explained with the following ratio, (Cash inflows / Cash outflows) = 1.

At IRR, NPV = 0 and PI (Profitability Index) = 1

In this method, the cash inflows and outflows are given. The calculation of the discount rate, i.e. IRR,
is to be made by trial and error method.

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. Reject the project in which the cut-off rate is greater
than IRR, as the project, will incur losses. Moreover, if the IRR and Cut off rate are equal, then this
will be a point of indifference for the company. So, it is at the discretion of the company, to accept
or reject the investment proposal.

Key Differences Between NPV and IRR

The basic differences between NPV and IRR are presented below:

1. 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.

2. The calculation of NPV is made in absolute terms as compared to IRR which is computed in
percentage terms.

3. The purpose of calculation of NPV is to determine the surplus from the project, whereas IRR
represents the state of no profit no loss.

4. 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.

5. Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR such an
investment is made at the rate of IRR.

6. 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.

7. 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.

Similarities

 Both uses Discounted Cash Flow Method.

 Both takes into consideration the cash flow throughout the life of the project.
  Both recognize time value of money.

Conclusion

Net Present Value and Internal Rate of Return both are the methods of discounted cash flows, in this
way we can say that both considers the time value of money. Similarly, the two methods, considers
all cash flows over the life of the project.

During the computation of Net Present Value, the discount rate is assumed to be known, and it
remains constant. But, while calculating IRR, the NPV fixed at ‘0’ and the rate which fulfills such a
condition is known as IRR.

RELEVANCE OF DIVIDEND
According to this concept, dividend policy is considered to affect the value of the firm.
Dividend relevance implies that shareholders prefer current dividend and there is no direct
relationship between dividend policy and value of the firm. Relevance of dividend concept
is supported by two eminent persons like Walter and Gordon.
Walter’s Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of
the firm.
Walter model is based in the relationship between the following important factors:
• Rate of return I
• Cost of capital (k)
According to the Walter’s model, if r > k, the firm is able to earn more than what the
shareholders could by reinvesting, if the earnings are paid to them. The implication of
r > k is that the shareholders can earn a higher return by investing elsewhere.
If the firm has r = k, it is a matter of indifferent whether earnings are retained or
distributed.
Assumptions
Walters model is based on the following important assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.
_
_ mathematical formula for determining the value of market share.
_
_
Where,
P = Market price of an equity share
D = Dividend per share
r = Internal rate of return
E = Earning per share
Ke = Cost of equity capital

 Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:
Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation. Hence, it is applicable.
According to Walter model, it is based on constant cost of capital. But it is not applicable
in the real life of the busine

Gordon’s Model
Myron Gorden suggest one of the popular model which assume that dividend policy of a
firm affects its value, and it is based on the following important assumptions:
1. The firm is an all equity firm.
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpectual life.
5. There are no taxes.
6. Constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (Ke>br).

Gordon’s model can be proved with the help of the following formula:
P=
_
______1
__1
Where,
P = Price of a share
E = Earnings per share
1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate
br = Growth rate = rate of return on investment of an all equity firm.

Criticism of Gordon’s Model

Gordon’s model consists of the following important criticisms:
Gordon model assumes that there is no debt and equity finance used by the firm. It is
not applicable to present day business.
Ke and r cannot be constant in the real practice.
According to Gordon’s model, there are no tax paid by the firm. It is not practically applicable.