5/19/2015

UnderstandingtheDifferenceBetweenNPVvsIRR

UnderstandingtheDifferenceBetweenNPVvsIRR
JUNE28,2013BYROBERTSCHMIDT

14
COMMENTS

Understandingthedifferencebetweenthenetpresentvalue(NPV)versustheinternalrateofreturn(IRR)iscriticalforanyone
makinginvestmentdecisionsusingadiscountedcashflowanalysis.Yet,thisisoneofthemostcommonlymisunderstood
conceptsinfinanceandrealestate.ThispostwillhelpyouunderstandthedifferencebetweenNPVvsIRR,andclearupsome
commonmisconceptions.
First,letsgooversomedefinitionsofNPVandIRR,thenwellwalkthroughanexampleandsomecommonpitfalls.

NetPresentValue(NPV)Definition
Netpresentvalue(NPV)isaninvestmentmeasurethattellsaninvestorwhethertheinvestmentisachievingatargetyieldata
giveninitialinvestment.NPValsoquantifiestheadjustmenttotheinitialinvestmentneededtoachievethetargetyield
assumingeverythingelseremainsthesame.Formally,thenetpresentvalueissimplythesummationofcashflows(C)foreach
period(n)intheholdingperiod(N),discountedattheinvestorsrequiredrateofreturn(r):

InternalRateofReturn(IRR)Definition
Internalrateofreturn(IRR)foraninvestmentisthepercentagerateearnedoneachdollarinvestedforeachperioditis
invested.IRRisalsoanothertermpeopleuseforinterest.Ultimately,IRRgivesaninvestorthemeanstocomparealternative
investmentsbasedontheiryield.Mathematically,theIRRcanbefoundbysettingtheaboveNPVequationequaltozero(0)
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UnderstandingtheDifferenceBetweenNPVvsIRR

andsolvingfortherateofreturn(IRR).

DistinctionBetweenNPVvsIRR
So,whatsthedifferencebetweenNPVandIRR?Asshownintheformulasabove,theNPVformulasolvesforthepresent
valueofastreamofcashflows,givenadiscountrate.TheIRRontheotherhand,solvesforarateofreturnwhensettingthe
NPVequaltozero(0).
Inotherwords,theIRRanswersthequestionwhatrateofreturnwillIachieve,giventhefollowingstreamofcashflows?,
whiletheNPVanswersthequestionwhatisthefollowingstreamofcashflowsworthataparticulardiscountrate,intodays
dollars?TodivedeeperintoamoreintuitiveexplanationofIRRandNPV,checkouttheIntuitionBehindtheNPVandIRR.

QuantitativeExampleofNPVvsIRR
Considerapropertywithexpectedfuturenetcashflowsof$30,000peryearforthenextfiveyears(startingoneyearfrom
now).Ifyouexpecttoselltheproperty5yearsfromnowforaprice10timesthenetcashflowatthattime,whatisthevalueof
thepropertyiftherequiredreturnis12%?
Plugginginthe$30,000netcashflowsforfiveyearsintotheNPVequationabovealongwiththe12%discountrate,youllfind
thatthenetpresentvalueis$278,371.Youcanalsofindalloftheformulasandanswerstothesequestionsinthisspreadsheet
weputtogether:

DownloadNPVvsIRRExcelSolutions
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UnderstandingtheDifferenceBetweenNPVvsIRR

WhereshouldwesendyourNPVvsIRRsolutionsfile?

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