NPV vs IRR: What Is the Difference and Which One Should You Trust?
NPV and IRR both use time value of money, but one measures dollar value created and the other measures an implied percentage return.
Net present value
NPV compares the present value of future cash inflows with the present value of cash outflows. A positive NPV generally indicates value creation relative to the required return assumption.
Internal rate of return
IRR is the discount rate that makes NPV equal zero. For a conventional independent project, IRR above the required return generally supports acceptance.
Why they often agree
For conventional independent projects, positive NPV and IRR above the hurdle rate often point in the same direction.
When rankings can conflict
Mutually exclusive projects can conflict because project size, timing, and cash-flow patterns differ. One project can have a higher percentage return while another creates more total dollar value.
Do not forget terminal cash flows
Working-capital recovery, salvage value, disposal effects, and taxes can affect final-period cash flows when included in the fact pattern.
Payback is different
Traditional payback focuses on how quickly the initial investment is recovered and does not fully incorporate time value of money or all later cash flows.
The takeaway
NPV tells you dollar value created. IRR tells you the project's implied percentage return.
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FAQ
What does NPV of zero mean?
The project is expected to earn exactly the required return under the assumptions.
What does IRR calculate?
The discount rate that sets NPV equal to zero.
Does traditional payback consider time value of money?
No. Discounted payback is a separate measure.