Dominate VAN and IRR: Essential Metrics to Evaluate Profitability in Your Investments

The proper evaluation of investment opportunities requires robust analytical tools. Net Present Value (NPV) and Internal Rate of Return (IRR) represent two fundamental pillars in financial decision-making. Although both indicators pursue the same goal — determining the viability of a project — they operate under different logics and can lead to contradictory conclusions. Mastering their characteristics, applications, and limitations is essential for any investor seeking to maximize profitability and minimize risks.

What is Net Present Value (NPV) Really?

NPV is a financial measure that translates future cash flows of an investment into their equivalent present value. Simply put: it’s what will remain in your pocket today if you discount the initial investment from the money you expect to receive tomorrow.

The calculation starts with a projection of expected cash flows over the investment horizon. These flows include income, operating expenses, taxes, and associated costs. Subsequently, a discount rate — reflecting the opportunity cost of capital — is selected to convert each future flow to its present value. The sum of these present values, minus the initial investment, yields the NPV.

The meaning is simple:

• Positive NPV = Profitable investment (generates more money than invested)
• Negative NPV = Investment with expected losses (destroys value)
• Zero NPV = Break-even point with no profit or loss

The NPV formula explained

NPV = (Cash Flow 1 / ((1 + Discount Rate))^1) + (Cash Flow 2 / ((1 + Discount Rate))^2) + … + (Cash Flow N / ((1 + Discount Rate))^N) - Initial Cost

Where:

• Initial Cost: initial disbursement of the investment
• Cash Flow: net expected income in each period
• Discount Rate: rate representing the opportunity cost (investor’s estimate)

Practical Applications: Seeing NPV in Action

Case 1: Project with positive NPV

A company evaluates investing $10,000 in an initiative that will generate $4,000 annually for five years, with a discount rate of 10%.

Calculating the present value year by year:

• Year 1: 4,000 / (1.10)^1 = 3,636.36 dollars
• Year 2: 4,000 / (1.10)^2 = 3,305.79 dollars
• Year 3: 4,000 / (1.10)^3 = 3,005.26 dollars
• Year 4: 4,000 / (1.10)^4 = 2,732.06 dollars
• Year 5: 4,000 / (1.10)^5 = 2,483.02 dollars

Total NPV = (3,636.36 + 3,305.79 + 3,005.26 + 2,732.06 + 2,483.02) - 10,000 = 2,162.49 dollars

Conclusion: With an NPV of $2,162.49 positive, the project is viable and should be considered an attractive investment.

Case 2: Financial product with negative NPV

An investor considers placing $5,000 in a certificate of deposit that will pay $6,000 in three years, with an annual rate of 8%.

Present value of the future payment: 6,000 / (1.08)^3 = 4,774.84 dollars

NPV = 4,774.84 - 5,000 = -225.16 dollars

Conclusion: The negative NPV indicates that the investment will not recover its initial cost in terms of present value, so it is not recommended.

Choosing the Correct Discount Rate

Selecting the discount rate is one of the most critical decisions in NPV calculation. Several valid approaches exist:

Opportunity Cost: Compare the expected return with other risk comparable investments. If your project is riskier, increase the discount rate proportionally.

Risk-Free Rate: Use the return on treasury bonds or other safe assets as a base, then add a risk premium.

Sector Analysis: Investigate what discount rates similar companies in your industry use for equivalent projects.

Experience and Judgment: Your accumulated knowledge as an investor also plays a role in calibrating this subjective metric.

Strengths and Weaknesses of NPV

Advantages of Net Present Value:

• Expresses results in absolute monetary terms, facilitating interpretation
• Allows comparison of investments of any size or duration
• Conceptually simple and practically applicable
• Provides a direct measure of value creation

Limitations of NPV:

Despite these limitations, NPV remains a predominant tool in financial practice. For a more robust analysis, it should be complemented with other metrics.

What Does the Internal Rate of Return (IRR) Imply?

IRR represents the annualized rate of return that exactly balances the initial investment with the generated cash flows. Essentially: it is the discount rate that makes the NPV equal to zero.

Unlike NPV, which expresses value in monetary units, IRR is presented as a percentage of relative profitability, making it especially useful for comparing investments of different scales.

Decision criterion with IRR:

• IRR > Reference Rate (e.g.: treasury bond rate) = Attractive project
• IRR < Reference Rate = Rejected project
• IRR = Reference Rate = Indifference (marginal return)

Inherent Limitations of IRR

Technical problems:

IRR is especially useful in projects with uniform and predictable flows. However, it should not be the sole decision criterion.

FAQ - Common Questions about NPV and IRR

What metrics accompany NPV and IRR in a complete analysis?

ROI (Return on Investment), Payback Period (payback), Profitability Index, and Weighted Average Cost of Capital (WACC) are valuable complements that provide different perspectives on the same project.

Why combine NPV and IRR instead of choosing just one?

NPV reveals the absolute value generated; IRR expresses the relative return. Together, they offer a more precise picture: you understand both how much money you will earn and at what speed.

How does the discount rate impact both metrics?

A higher rate reduces both NPV and IRR; a lower rate increases them. This underscores the importance of calibrating this variable accurately.

How to prioritize among multiple projects using NPV and IRR?

Select the project with the highest absolute NPV if you have unlimited budget. If capital is constrained, use the Profitability Index (NPV divided by initial investment) or compare IRR directly.

Conflicts between NPV and IRR: Who is Right?

It’s possible for a project to have a high NPV but a modest IRR, or vice versa. This occurs because they measure different dimensions:

• Scale differences: A large project generates a lot of NPV but low IRR; a small, intensive project may show high IRR with low NPV
• Flow patterns: Projects with revenues concentrated in later years may show low IRR but positive NPV if discounted flows are significant

In these scenarios, review the underlying assumptions: Is your discount rate correct? Are your flow projections realistic? Adjust these parameters and recalculate.

Summary: NPV and IRR, Complementary Metrics

NPV and IRR are analytical pillars with different but aligned purposes. The first translates viability into present monetary value; the second expresses it as a percentage of return. Neither is superior; both are necessary.

Key differences:

Recommendation for investors: Do not rely on a single metric. Evaluate NPV and IRR together, consider your portfolio context, risk tolerance, diversification, and personal financial goals. These indicators are compasses, not complete maps.