How to measure the profitability of an investment (IRR and NPV)

Two of the most used tools to obtain this data are the NPV and the IRR. The acronym NPV stands for Net Present Value, while the acronym IRR stands for Internal Rate of Return.

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What is the NPV?

Both the NPV and the IRR are financial tools that allow the evaluation of the expected returns of certain business investments.

NPV is an investment criterion that consists of discounting future cash flows (collections and payments). In other words, bring the expected cash flows to the present, discounting them at a given rate. Thus, the NPV will express a measure of a project’s profitability in absolute terms.

The NPV is calculated according to the following formula

Where:

IO is the original investment;

F1, are the cash flows in each period;

n, is the number of periods; and

k the discount rate.

When the NPV is greater than zero, it can be understood that updating the cash flows will generate profits. If the NPV is equal to zero, the investment will not generate profits or losses. And finally, when the NPV is below zero, the investment project will generate losses.

The main disadvantage that the NPV can present is the determination of the discount rate.  Remember that the discount rate is the rate at which projected future cash flows can be updated. Bring them to the present moment. One of the most widely used methods of calculating this rate is the so-called WAAC (Weighted Average Cost of Capital).

What is the IRR?

Likewise, as we indicated, it is a tool that allows you to evaluate an investment. Unlike NPV, the IRR is expressed as a percentage.

The IRR is calculated from the NPV. Specifically the IRR is the discount rate in the NPV formula that we have expressed above. For your calculation, we take the NPV to zero:

The higher the IRR of an investment in a project, the more desirable the investment is. The most appropiate is to compare the IRR with an opportunity cost (r). Each investor will mark his opportunity cost. When the IRR is higher than this opportunity cost marked by the investor, the investment makes economic sense.

Example of the use of the IRR

Suppose an investor has the opportunity to invest in a new company. At the same time, a financial entity offers you a financial product with a 4% interest.

In order to make the decision to invest in the new company, it will have to calculate its IRR.  For this purpose, it applies the formulas expressed in the previous exhibitions.

Once the calculation is made, the IRR obtained amounts to 6.8%.

Under these results, it seems reasonable to invest in the business project. Given that, the profitability expectations are higher than those offered by the mentioned financial product.

Differences between NPV and IRR

As we said, the NPV and the IRR are tools that allow the investor to make decisions, based on profitability. However, these criteria may not be the same in all cases. Mainly when investments have to be prioritized.

The main difference between the two methods is the result. The NPV gives results in absolute (net) terms, in monetary units. For example, euros. Thus, it indicates the value of the investment at the present time. The IRR gives us a relative measure, expressed as a percentage. The IRR indicates the rate at which the initial investment will be recovered.

Conclusions

Before making any investment, it seems reasonable to analyse the potential future profitability of the investment. Both the NPV and the IRR are tools that allow the calculation of such profitability. Both in absolute terms (NPV) and in terms of the recovery rate (IRR).

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The Incentives of the MiFID Directive