TIR vs VAN: Key Metrics to Assess the Feasibility of Your Investments

When it comes to analyzing investment projects, two financial indicators dominate the decisions of entrepreneurs and investors: the Internal Rate of Return (IRR) and the Net Present Value (NPV). Although both aim to answer whether an investment is profitable, they use different approaches and can lead to contradictory conclusions. Which one to choose? How to interpret their results? In this guide, we will delve into their mechanisms, practical applications, and limitations so you can make clear decisions in your next investment.

Fundamental Differences: NPV vs IRR

NPV answers the question: how much net money will I earn in terms of present value? Conversely, IRR answers: what percentage of annual return does my investment correspond to?

IRR expresses results as a percentage rate of return, making it easier to compare projects of different sizes. NPV, on the other hand, provides an absolute value in currency, reflecting the actual net gain you will obtain.

Another critical difference: NPV requires the investor to set a subjective discount rate (subjetiva), while IRR internally calculates what the equilibrium rate is where income and expenses balance.

Understanding Net Present Value (NPV)

NPV represents the sum of all future cash flows discounted to the present, minus the initial investment. In other words, it brings to “now” the money you will receive “later,” considering the time value of money.

How is it calculated? The formula is:

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

Where the discount rate represents your opportunity cost: what return do you expect from alternative investments.

( Practical example: positive NPV in a productive project

Imagine investing $10,000 in a project that will generate $4,000 annually for 5 years. If your discount rate is 10%:

• Year 1: 4,000 / 1.10¹ = $3,636.36
• Year 2: 4,000 / 1.10² = $3,305.79
• Year 3: 4,000 / 1.10³ = $3,005.26
• Year 4: 4,000 / 1.10⁴ = $2,732.06
• Year 5: 4,000 / 1.10⁵ = $2,483.02

NPV = $15,162.49 - $10,000 = $5,162.49

A positive NPV means your project generates value above your return expectations. It is a viable investment.

) When NPV is negative

Consider a certificate of deposit: invest $5,000 and receive $6,000 in 3 years, with an 8% discount rate.

Present value of $6,000 = $6,000 / 1.08³ = $4,774.84
NPV = $4,774.84 - $5,000 = -$225.16

A negative NPV indicates that future cash flows do not compensate for your initial investment considering opportunity cost. You should reject it.

Deepening into the Internal Rate of Return )IRR###

IRR is the discount rate that makes NPV equal to zero. It is the percentage of annual return your investment automatically generates.

If IRR exceeds your set benchmark rate ###for example, 10%(, the project is profitable. If it is lower, it is not.

IRR is especially useful for comparing projects of different scales, as it normalizes results into a percentage.

When contradictions appear

It is common for NPV and IRR to send opposite signals. This happens when:

• Cash flows are unconventional )multiple sign changes(
• Projects have very different durations
• Discount rates vary significantly

Example of contradiction: Project A may have an NPV of $5,000 with an IRR of 12%, while Project B has an NPV of $3,000 but an IRR of 25%.

Which to choose? If your cost of capital is 15%, Project A is better )its IRR is below, but its NPV is positive and higher(. Conversely, if your cost is 10%, Project B could be superior despite its lower NPV because its IRR is much more attractive.

Limitations of NPV you should know

1. Subjectivity in the discount rate: Two investors may use different rates and reach opposite conclusions about the same project.

2. Assumes certainty in projections: NPV treats future flows as facts, ignoring real market volatility and uncertainty.

3. Ignores operational flexibility: It does not consider the possibility of pivoting, expanding, or canceling the project as it unfolds.

4. Does not properly compare projects of unequal sizes: A large project may have a higher NPV solely due to scale, not efficiency.

5. Disregards inflation: If you do not adjust future flows for inflation, results can be misleading.

Despite these limitations, NPV remains preferred in business analysis because it offers a concrete monetary value that is easy to understand and allows for absolute comparison of investments.

Limitations of IRR you should consider

1. Multiple solutions possible: Projects with non-conventional cash flows can have several IRRs, complicating interpretation.

2. Assumes reinvestment at IRR: IRR presumes you will reinvest all intermediate flows at the same rate, which rarely happens in practice.

3. Problems with non-conventional flows: If there are repeated sign changes )negative-positive-negative(, IRR may be uncomputable or misleading.

4. Dependence on the discount rate: Although IRR is calculated internally, its usefulness depends on what reference rate you compare it to.

5. Does not adequately consider the future time value of money: Future inflation can erode real returns.

IRR shines in projects with uniform cash flows and minimal changes over time, especially for comparing investments of different sizes.

How to select the correct discount rate

The discount rate is the core of NPV calculation. Several approaches can guide you:

• Opportunity cost: What return would I get if I invested in a similar alternative? Use that as a baseline.
• Risk-free rate: Government bonds offer a minimum floor. Add a risk premium based on the project.
• Sector benchmarking: Research what discount rates other investors in your industry use.
• Risk analysis: More volatile projects justify higher rates.

Investor experience and judgment are additional factors. There is no universal “correct” answer; it depends on context.

What to do when NPV and IRR contradict

When indicators send conflicting signals:

1. Review your assumptions: Does the discount rate reflect actual risk? Are your cash flow projections realistic?

2. Adjust the discount rate: If flows are volatile and you used a very high rate, try lowering it slightly to test sensitivity.

3. Prioritize NPV if capital is limited: It provides absolute value, ideal for constrained budgets.

4. Prioritize IRR when comparing small vs large projects: It normalizes by size, facilitating comparison.

5. Use sensitivity analysis: Vary key assumptions and observe how results change.

FAQ: Answers to key questions

What other indicators complement NPV and IRR?

ROI )Return on Investment(, payback period )payback period(, profitability index )discounted cash flows / initial investment(, and Weighted Average Cost of Capital )WACC( are valuable metrics for a more comprehensive analysis.

Why use NPV and IRR together instead of one alone?

NPV tells you how much value you create; IRR indicates the efficiency rate. Combined, they provide a 360° view of profitability.

How does a higher discount rate affect the analysis?

A higher rate reduces both NPV and IRR, as it values future money less. This reflects greater distrust in projected flows.

How to choose among multiple projects with NPV and IRR?

Select the project with the highest NPV if capital is limited. If you can finance multiple projects, choose those with positive NPV and IRR above your cost of capital, prioritizing higher NPV.

Final conclusions

NPV and IRR are complementary tools, not competitors. NPV measures absolute value generated; IRR measures relative profitability. Both depend on future projections subject to uncertainty.

Before investing, conduct thorough analysis: review cash flow assumptions, verify the reasonableness of your discount rate, consider other financial indicators, evaluate your risk tolerance, and align the decision with personal or corporate objectives.

In investing, metrics are compasses, not destinations. Combining NPV, IRR, and critical judgment will lead to more solid decisions.