Practical Guide: How to Differentiate Between IRR and NPV for Making Sound Investment Decisions

When investors face multiple investment opportunities, an inevitable question arises: what is the best metric to evaluate a project’s feasibility? Two tools stand out in financial analysis: the Internal Rate of Return (IRR) and the Net Present Value (NPV). Although both serve to measure profitability, they operate in radically different ways. Understanding the differences between IRR and NPV is essential to avoid analytical traps that can lead to costly decisions.

NPV: measures absolute gains in today’s money

Net Present Value (NPV) answers a simple question: how much real money will I earn if I undertake this investment, expressed in current terms? It is a measure that quantifies the net benefit of a project in real monetary values.

To calculate it, all cash flows generated by the investment over its useful life (revenues minus operational costs, taxes, and expenses) are projected, discounted to present value using a rate that reflects opportunity cost, and finally, the initial outlay is subtracted.

The NPV formula is:

NPV = (Cash Flow Year 1 / (1 + Discount Rate)¹) + (Cash Flow Year 2 / (1 + Discount Rate)²) + … - Initial Investment

A positive NPV indicates net gain (the investment is viable), while a negative NPV signals loss (it is advisable to reject the project).

Practical example of positive NPV

A company invests $10,000 in a project expecting to receive $4,000 annually for 5 years, with a discount rate of 10%:

• Year 1: $4,000 ÷ (1.10)¹ = $3,636
• Year 2: $4,000 ÷ (1.10)² = $3,306
• Year 3: $4,000 ÷ (1.10)³ = $3,005
• Year 4: $4,000 ÷ (1.10)⁴ = $2,732
• Year 5: $4,000 ÷ (1.10)⁵ = $2,483

NPV = $15,162 - $10,000 = $5,162

The project generates a real profit of $5,162, so it is profitable.

When NPV is negative

Imagine investing $5,000 in a certificate of deposit that will pay $6,000 in 3 years at an 8% rate:

Present value of $6,000 = $6,000 ÷ (1.08)³ = $4,775

NPV = $4,775 - $5,000 = -$225

The investment is deficit because future flows do not compensate for the initial outlay.

IRR: measures percentage profitability

The Internal Rate of Return (IRR) is the annual return percentage generated by an investment. It is defined as the discount rate that makes the NPV exactly zero. In other words, IRR answers: what percentage return will I get from this project?

IRR is expressed as a percentage and compared with a reference rate (such as the risk-free rate or treasury bond yields) to determine if the project exceeds that minimum profitability threshold.

If IRR > reference rate → project is viable If IRR < reference rate → project is not advisable

NPV vs IRR: key differences

What happens when NPV and IRR give contradictory results?

A project can have a very high NPV but a moderate IRR, or vice versa. This often occurs when projects differ in size or duration.

Example of conflict:

• Project A: NPV = $50,000 with IRR = 12%
• Project B: NPV = $30,000 with IRR = 25%

Which to choose? If the goal is to maximize absolute money, Project A. If maximizing return efficiency, Project B. The answer depends on the investor’s objectives and capital constraints.

When this contradiction arises, the recommendation is to review:

• Assumptions about cash flows
• The discount rate used (if it is very high/low)
• The volatility of flows (if they change significantly year to year)
• The reinvestment capacity of intermediate funds

Limitations of NPV you should know

Although NPV is a valuable tool, it has vulnerabilities:

1. Subjective discount rate: Its accuracy depends entirely on choosing the correct rate. A poor estimate distorts the result.

2. Ignores uncertainty: Assumes cash flow projections are exact, when in reality there is risk and unpredictability.

3. Does not capture flexibility: Does not value the ability to adjust decisions during project execution.

4. Insensitive to scale: A small project with positive NPV appears as attractive as a large one with similar NPV, even if their risk profiles are totally different.

5. Omit inflation: If future inflation is not adjusted in flows, the evaluation will be inaccurate.

Despite these limitations, NPV remains widely used in business practice for its simplicity and clarity: it provides a direct monetary answer that most executives understand immediately.

The weaknesses of IRR you cannot ignore

IRR also presents operational challenges:

1. Multiple IRRs: When cash flows change sign multiple times (non-conventional flows), multiple return rates may exist, creating ambiguity.

2. Inapplicability with non-conventional flows: If there are additional investments mid-project or negative flows later, IRR can mislead about true profitability.

3. False reinvestment assumption: IRR assumes that generated flows are reinvested at the same IRR, which is rarely realistic.

4. Comparison issues: Projects of different durations may have comparable IRRs but radically different risk profiles.

5. Does not consider the time value of money: Although technically it does, it does not adequately capture how inflation erodes future purchasing power.

Despite this, IRR is invaluable for projects with uniform flows and no drastic changes, especially when comparing initiatives of different magnitudes.

Which tool should you use?

The short answer: both. NPV and IRR are complementary, not competing.

Use NPV when:

• You need to know how much absolute money the project will generate
• Comparing projects of similar size
• Want to maximize total value in the portfolio

Use IRR when:

• You want to measure relative return efficiency
• Comparing projects of different scales
• You have limited capital constraints

Best practice: Evaluate both metrics along with additional indicators such as ROI (Return on Investment), payback period (payback period), profitability index (PI), and weighted average cost of capital (WACC). A comprehensive assessment also requires considering your risk tolerance, personal objectives, portfolio diversification, and time horizon.

Frequently asked questions about IRR and NPV

Which is more important, NPV or IRR? Both are equally important but answer different questions. NPV tells you how much you earn, IRR tells you how efficiently you earn it. You need both to make informed decisions.

How does changing the discount rate affect it? Changes in the discount rate significantly alter NPV (higher rates reduce it) but do not directly affect IRR, which is intrinsic to the project. However, a higher discount rate makes IRR less attractive comparatively.

What other indicators should I analyze? Besides NPV and IRR, consider ROI, payback period, profitability index (PI), net margin, weighted average cost of capital, and sensitivity analysis for pessimistic/optimistic scenarios.

How to choose among multiple projects? Select the project with the highest NPV if your goal is to maximize total gains, or the one with the highest IRR if you seek maximum relative efficiency. Ideally, choose the one that offers both at satisfactory levels aligned with your financial strategy.

The key is not to rely on a single metric. A robust analysis combines multiple indicators, stress tests, and expert judgment to navigate the inherent uncertainty of every investment.