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Comparing investments with NPV and IRR, like a pro!
There is a lot of media buzz in Luxembourg around entrepreneurs and start-ups. Have you ever imagined what it would be like to be your own boss? It’s a fascinating adventure – and a risky one. Or maybe you have a friend or family member looking for investors in a new project?
In order to decide whether a business idea – or any other kind of investment you are facing, in your private or professional life – is worthwhile or not, you can use one of two very helpful measurements: Net Present Value (NPV) and Internal Rate of Return (IRR).
Both measure the anticipated performance of an investment opportunity, but with a slight different purpose.
NPV: the monetary value of your investment
When you’re looking at a business project that requires an investment (I) and that will produce a series of positive cashflows (C) during several years (n), at some point we will earn back out initial investment (I). At the same time, if instead of investing in our project we had invested our capital (I) in a financial product it would have yield a return. So we need to discount our cashflows into present value at a discount rate (r) that represents the business’ project cost of capital and its risk. If we subtract this value from our initial investment (I), we get the Net Present Value (NPV) of our project.
Whenever the NPV is greater than zero you know that after the time you have used in your calculation you will earn back your initial investment and even make a profit.
IRR: the return on your capital, in percentage
Again, looking at a business project that requires an investment (I) you might want to know the rate of return that said investment will generate before you decide whether to go ahead or not. To do so, you simply recalculate the NPV equation, this time using zero as your NPV value and solving for the discount rate (r). The solution of the formula is the project’s Internal Rate of Return (IRR).
If the IRR is high, the business project you’re looking appears to be highly profitable, comparable to an investment at high interest rates, which you probably won’t find in the market. However, if the IRR is low, it could be an indication that you might be better off investing elsewhere. Whatever the result, don’t be hasty in your decision and consider all factors of the investment proposal (risk, timing, volumes, etc).
Different measurement for different purposes
As we said at the beginning, both NPV and IRR are used when deciding whether to go ahead or not with an investment. So, why the two measures? The NPV is useful when convincing investors or the general public of the monetary value of an investment. It is especially useful when calculating long term projects, whereas the IRR is more accurate in short term calculations with steady in- and out flows. Finally, the IRR is a percentage that allows easy comparison with alternative investment scenarios when making a strategic decision.
There are many factors to take into account when deciding whether or not to invest in a large business, real estate or other type of project, but both NPV and IRR offer a good starting point!
11/2021
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