VAN and IRR: Essential tools to evaluate your investments

Have you ever wondered if that investment project is truly worth it? Two key financial metrics can help you answer this question: Net Present Value (NPV) and Internal Rate of Return (IRR). While both assess profitability, they work in very different ways. This in-depth analysis will show you how to master both tools and apply them correctly in your financial decisions.

The challenge of choosing between NPV and IRR

Professional investors constantly face a dilemma: when comparing two projects using NPV and IRR, they often get results that seem contradictory. One project might have a higher NPV but a lower IRR than its competitor. This apparent conflict is precisely why it’s crucial to understand in depth how both indicators work and when to trust each one.

Understanding Net Present Value (NPV)

###What is NPV really?

Net Present Value fundamentally answers a simple question: how much extra money will this investment generate after recovering your initial capital?

To calculate it, you take all the expected future cash flows, adjust them to their present value (considering the passage of time and opportunity cost), and subtract the initial investment.

The logic is straightforward:

• Positive NPV = your investment will generate more money than it costs
• Negative NPV = you will probably lose money
• Zero NPV = neither gain nor loss in real terms

How to calculate NPV: beyond the formula

The mathematical expression of NPV 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

Let’s break this down practically:

Discount Rate: This is the percentage you use to “bring future flows to present.” It represents how much you could earn if you invested that money elsewhere with similar risk. If you expect a 10% return on Treasury bonds, that would be your discount rate benchmark.

Cash Flows: These are your estimated amounts of money you expect to receive each year from the project. These are not exact numbers but projections based on market analysis.

Time Period: Determines how many years your analysis covers. Distant cash flows have less weight in the decision because present money is always worth more than future money.

( Example 1: A profitable project with positive NPV

Imagine a company evaluates a project requiring an initial investment of $10,000. It expects to generate $4,000 at the end of each year for five years. The discount rate is 10%.

The present value calculation for each year would be:

• Year 1: 4,000 / 1.10 = $3,636.36
• Year 2: 4,000 / 1.21 = $3,305.79
• Year 3: 4,000 / 1.331 = $3,005.26
• Year 4: 4,000 / 1.464 = $2,732.06
• Year 5: 4,000 / 1.611 = $2,483.02

Total present flows: $15,162.49
NPV = $15,162.49 - $10,000 = $5,162.49 positive

This result indicates the project is attractive, as it will generate nearly $5,162 more than the invested capital.

) Example 2: An investment that doesn’t close

Suppose a certificate of deposit costs $5,000 and promises to pay $6,000 in three years with an 8% annual interest rate.

The present value of the future $6,000 is:
6,000 / )(1.08)³### = 6,000 / 1.2597 ≈ $4,774.84

NPV = $4,774.84 - $5,000 = -$225.16 negative

This suggests rejecting the investment, as the future cash flows do not compensate for the initial outlay today.

Limitations every investor should know about NPV

Although NPV is widely used, it has several important weaknesses:

Subjectivity of the discount rate: NPV calculation depends entirely on the discount rate you choose. Two investors analyzing the same project with different discount rates can reach opposite conclusions. There is no “correct” universal discount rate; it’s an estimate reflecting your risk perception.

Assumes certainty where there is uncertainty: NPV treats your cash flow projections as guaranteed. In reality, they are estimates subject to market risks, competition, and economic changes that are not adequately reflected in the model.

Ignores project flexibility: NPV presumes all major decisions are made at the start. It does not consider that during project execution, you might change strategies, pause operations, or pivot to new opportunities.

Does not compare projects of different scales equitably: A small project might have a lower NPV than a large one simply due to differences in initial investment, even if the small project is proportionally more profitable.

Overlooks inflation: If future inflation is significant, NPV can overestimate the real value of future cash flows, especially in long-term projects.

Despite these limitations, NPV remains a fundamental tool because it is relatively easy to understand and provides a concrete monetary figure that facilitates comparisons.

Discovering the Internal Rate of Return ###IRR(

)What makes IRR different from NPV?

While NPV answers “how much extra money will I generate?”, IRR answers “at what speed will my money grow?”. Technically, IRR is the discount rate that makes NPV exactly zero.

In practical terms: it’s the annual return percentage you would earn from your investment over its lifespan, expressed as a percentage.

To evaluate if it’s attractive, compare IRR with a reference rate (such as the yield on Treasury bonds or your cost of capital). If IRR exceeds that benchmark, the project is profitable. If it’s below, reject it.

How to calculate IRR: the core concept

Unlike NPV, which requires an external discount rate, IRR is calculated internally. It’s the rate that automatically equates the initial outflow with all future inflows.

Finding IRR is typically done through iterative methods (trial and error or computational algorithms) until the exact rate where:

Initial Investment = ###Cash Flow Year 1 / (1 + IRR)¹( + )Cash Flow Year 2 / (1 + IRR)²( + … + (Cash Flow Year N / (1 + IRR)ⁿ)

Critical limitations of IRR you should know

Multiple solutions: In projects with non-conventional cash flows )where there are outflows in intermediate years(, there can be more than one IRR or none at all. This makes it difficult to identify the “correct” rate.

Assumes perfect reinvestment: IRR presumes all intermediate positive cash flows are reinvested at the same IRR. In reality, this rarely happens, which can lead to overestimating actual returns.

Does not work well with irregular flows: If cash flows vary significantly year to year or change direction (positive to negative), IRR’s reliability diminishes or it may not exist.

Context-dependent: IRR of a project is not independent of other factors. Changes in market rates do not affect the IRR value itself but do affect its relevance as a decision tool.

Does not consider investment size: An IRR of 50% on a small project generates less absolute money than a 20% IRR on a large project. IRR does not capture this scale difference.

How to choose the right discount rate

This decision is crucial because it directly determines your results. Consider these approaches:

Opportunity cost: How much could you earn by investing that money in the best available alternative with similar risk? That return is your starting point.

Risk-free rate: Begin with the return on safe assets like Treasury bonds. It’s your baseline.

Risk premium: Add an additional percentage depending on how risky the project is compared to your reference investment.

Sector analysis: Research what discount rates other investors in your industry use for consistency.

Your experience and intuition: After analyzing all the above, your market knowledge and specific project insights should inform the final decision.

What to do when NPV and IRR conflict?

When these indicators give contradictory signals, the typical reason lies in how the discount rates interact with the timing of cash flows.

Common scenario: A project has a positive IRR but a negative NPV. This occurs when the discount rate used is high, heavily penalizing distant cash flows. In this case, it’s wise to review whether your discount rate is realistic or overly conservative.

Recommended action: Re-examine your assumptions. Are your cash flow projections realistic? Does the discount rate adequately reflect the project’s risk? Sensitize your model: test different discount rates and see how your conclusions change.

Fundamental differences between NPV and IRR

How to choose your indicator: a practical guide

Use NPV mainly when:

• You need a concrete monetary figure for budgeting
• Comparing projects of similar scale
• Cash flows are relatively conventional
• You want an absolute measure of value added to your company

Trust IRR more when:

• You need to compare the relative efficiency of investments of different sizes
• Flows are predictable and uniform
• You want to communicate returns in percentage terms
• Conducting multiple project analyses simultaneously

In practice: Most sophisticated investors use both indicators simultaneously. NPV provides the absolute value perspective, while IRR offers the profitability efficiency view.

Complementary indicators for more robust analysis

Beyond NPV and IRR, professionals use:

• ROI )Return on Investment(: Similar to IRR but simpler, shows net gain as a percentage of initial investment
• Payback Period: How many years it takes to recover the original investment
• Profitability Index: Divides the present value of future flows by the initial investment; greater than 1 is good
• Weighted Average Cost of Capital )WACC(: Reflects the average cost of financing your project, essential for setting the discount rate

Frequently asked questions about investment evaluation

What does it mean when NPV is zero?
It means the project generates exactly the return you expected )the discount rate used(. Financially, it’s indifferent, though you might consider it marginally acceptable if other factors favor it.

Why do two analysts get different NPVs for the same project?
Almost always because they use different discount rates, reflecting different risk perceptions or cost of capital.

Can I use IRR without knowing the discount rate?
Yes, that’s its advantage. IRR is self-computed. But to interpret it, you need to compare it against an appropriate reference rate.

Which project should I choose if they have positive NPVs but different IRRs?
If both NPVs are positive, both add value. Choose based on the absolute NPV if sizes are similar; if sizes differ, also consider IRR as a measure of efficiency.

How does inflation affect these metrics?
Both are affected if the discount rate does not properly incorporate expected inflation. High future inflation should increase your discount rate.

Conclusions for your investment strategy

NPV and IRR are not opposing tools but complementary. Each answers a different question: NPV tells you how much extra money you will get; IRR tells you how fast your capital will grow.

Both depend critically on future cash flow estimates and discount rates, introducing inherent uncertainty in any financial analysis. Neither guarantees real-world results.

To make sound investment decisions, consider both NPV and IRR together, supplemented with other indicators. Always review your underlying assumptions, test your models with different scenarios, and evaluate qualitative factors such as strategic alignment, execution capacity, and risk tolerance.

Remember, these are tools to inform your decision, not to replace your judgment. Projects with excellent financial metrics can fail due to poor execution, and mediocre opportunities might be worth pursuing for strategic reasons.