VAN vs TIR: Practical Guide to Evaluating Investment Decisions

2025-12-24 21:05:31

Introduction: Two Perspectives to Measure Profitability

When an investor or company evaluates whether it is worth dedicating resources to a project, they need tools that allow them to measure the potential gains. The Net Present Value (NPV) and the Internal Rate of Return (IRR) are the two most used indicators in financial analysis for this task. However, both measure profitability from different angles, and sometimes they can offer contradictory recommendations.

Understanding what NPV and IRR are, as well as their strengths and weaknesses, is essential for making informed investment decisions. This article will guide you through both metrics, explain how they work, when to use them, and what to do when they give conflicting signals.

Net Present Value (NPV): Measuring the Absolute Value Generated

What is the essence of NPV?

Net Present Value is a measure that answers a fundamental question: how much additional money will my investment generate in today’s terms? Essentially, NPV brings all expected future revenues to the present, subtracts the initial cost, and shows whether that project will leave you with money in hand.

The logic is simple: money available today is worth more than the same money received in the future. Therefore, future cash flows are discounted using a rate that reflects the opportunity cost of invested capital.

How is the NPV calculation structured?

To obtain the NPV, the process follows these steps:

Project the future cash flows that the investment will generate (revenues, operating expenses, taxes, other costs)
Select an appropriate discount rate that represents the minimum acceptable return for the investor
Calculate the present value of each future flow by dividing it by (1 + discount rate) raised to the corresponding period
Sum all present values and subtract the initial investment

The general formula is expressed as:

NPV = (FC1 / ((1 + r)¹) + )FC2 / ((1 + r)²( + … + )FCn / )(1 + r)ⁿ( - Initial Investment

Where FC represents the cash flows of each period and r is the discount rate.

Interpretation of results:

Positive NPV: The investment will generate more value than the cost of capital, meaning it is financially viable
Negative NPV: The project will destroy value; losses will outweigh benefits
Zero NPV: The investment just covers the cost of capital, with no net gain or loss

( Practical cases of NPV in real scenarios

Scenario 1: Favorable NPV project

A company considers investing $10,000 to modernize its production line. Projections show that over 5 years, it will receive $4,000 annually, with a discount rate of 10%.

Calculating the present value of each year:

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

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

With a positive NPV of $2,162.49, the project is recommended.

Scenario 2: Investment with negative result

An investor considers placing $5,000 in a certificate of deposit that promises to pay $6,000 after 3 years, with an annual interest rate of 8%.

Present value of the future payment: 6,000 / ###1.08(³ = $4,774.84

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

The negative NPV indicates that this instrument does not generate a real return after considering the opportunity cost of capital.

) Choosing the correct discount rate

The discount rate is the core of the NPV calculation but also its biggest source of subjectivity. Investors can approach it in different ways:

Opportunity cost: What return could be obtained in an alternative investment with similar risk? That is your minimum reference. If the investment is riskier, the rate increases.
Risk-free return: Treasury bonds provide a safe baseline. Then, a risk premium is added based on the project’s nature.
Sector benchmarking: Analyzing what discount rates the industry uses for similar projects offers useful context.
Criteria and experience: The investor’s intuition, supported by historical analysis, also has validity.

( Limitations of relying solely on NPV

Despite its usefulness, NPV has important restrictions:

Limitation	Implication
Subjectivity of the discount rate	Small changes in the rate produce large changes in the result. Two investors may evaluate the same project differently.
Assumptions about the future	Assumes that cash flow projections are accurate, without considering volatility or unexpected changes.
Inflexibility of the model	Does not capture strategic options )to stop, expand, or wait for more information### that may arise during execution.
Project size ignored	A small project with an NPV of $100 and another of $10 million could seem comparable if only looking at NPV.
Inflation effect not incorporated	Calculations may not adequately reflect how inflation erodes future flows.

Nevertheless, NPV remains the most used tool in financial evaluation because it is relatively easy to understand, provides a concrete monetary result, and allows direct comparisons between options.

Internal Rate of Return ###IRR(: Measuring the Percentage of Return

) What does IRR represent?

The Internal Rate of Return is the percentage of return that an investment will generate over its useful life. Technically, it is the discount rate that makes the NPV exactly zero.

In other words, it is the implied interest rate in a project’s cash flows. If you invest $1,000 and receive returns that, when discounted at a certain rate, total exactly $1,000, that rate is your IRR.

( Why compare IRR with a reference rate?

An IRR in isolation doesn’t say much. Its real value emerges when compared to a benchmark:

If IRR > reference rate )example: bank deposit rate###, the project exceeds that alternative
If IRR < reference rate, better options are available
If IRR = reference rate, it is indifferent between this project and the alternative

This relative comparison is what makes IRR useful for ranking projects by efficiency.

Weaknesses of IRR as a sole metric

IRR has significant limitations that make it insufficient as the only decision criterion:

Problem	Description
Multiple solutions possible	With certain cash flow patterns (frequent sign changes), there can be several rates that set the NPV to zero, leaving ambiguity about which to use.
Limited applicability	Works best with conventional flows ###initial outlay, subsequent inflows(. Erratic or negative flows later generate misleading results.
Questionable reinvestment assumption	IRR assumes positive flows are reinvested at the same IRR, which rarely happens in reality. This tends to overestimate returns.
Scale distortion	A small project may have a very high IRR, while a large one has a moderate IRR, but the large project generates more absolute value.
Context sensitivity	IRR does not consider that money in the future is worth less than today due to inflation, nor adapts well to environments with changing interest rates.

Despite this, IRR is particularly useful for comparing projects of different sizes because it expresses profitability in relative terms )percentage( rather than absolute.

When NPV and IRR give conflicting signals

It is perfectly possible for a project to have a higher NPV but a lower IRR than an alternative. How does this happen?

Example of conflict:

Project A: Investment of $100, immediate return of $110. NPV = $10 )assuming a 5% discount rate(, IRR = 10%
Project B: Investment of $100, return of $150 in 10 years. NPV = $92 )with the same rate(, IRR = 4.1%

B has a higher NPV but a lower IRR. Which one to choose?

Expert recommendation: When there is a conflict, prioritize NPV. NPV measures the absolute value created; IRR only shows efficiency relative to the investment size. If your goal is wealth maximization, NPV is the more reliable guide.

Practical actions in case of discrepancy:

Review your cash flow projections
Verify the discount rate used; does it truly reflect the risk?
Analyze the nature of the flows: are they conventional or erratic?
Consider adjusting the discount rate if you believe it underestimates or overestimates the project’s risk
Use both metrics along with other indicators )ROI(, payback period, profitability index) for a comprehensive view

Comparative Table: NPV vs IRR

Aspect	NPV	IRR
Base measure	Absolute value in dollars	Return percentage
Interpretation	Net gain generated	Project’s rate of return
Main utility	Assessing profitability in terms of value	Comparing efficiency between options
Strength	Clear measure of economic viability	Facilitates project ranking by efficiency
Key weakness	Does not compare well across different sizes	Can be misleading with unconventional flows
Best application	Choosing between projects when NPV aligns with value priorities	Projects with uniform flows and similar sizes
Recommendation	Use as the main criterion	Use as a complement, not the sole factor

Final considerations for investors

Both NPV and IRR are powerful tools, but neither is perfect nor sufficient on its own. Prudent investors:

Calculate both metrics for each project under consideration
Recognize that their results depend on future estimates and chosen discount rates, factors that entail uncertainty
Complement these analyses with other indicators: ROI (Return on Investment), payback period, profitability index, and weighted average cost of capital
Consider qualitative factors: alignment with strategic objectives, personal risk tolerance, portfolio diversification, overall financial situation
Periodically review their assumptions as new information emerges during project execution

Rigorous financial analysis reduces risks but does not eliminate them. Experience, good judgment, and a clear understanding of your own financial goals remain indispensable.

Frequently Asked Questions

What other indicators should I consider alongside NPV and IRR?
ROI (Return on Investment), payback period (recovery period), profitability index, and WACC (Weighted Average Cost of Capital) complement the analysis and offer additional perspectives.

Why use NPV and IRR together instead of just one?
Because they measure different aspects. NPV tells you how much value you add; IRR shows efficiency. Together, they provide a more complete picture and reduce the risk of biased decisions.

How does the chosen discount rate impact?
Directly. A higher rate reduces both NPV and IRR; a lower rate increases them. Small variations in the rate can produce large changes in results, so choosing it carefully is critical.

How to choose among multiple projects using these metrics?
Compare the NPVs and IRRs of all. Generally, select the project with the highest NPV if capital is limited, or all projects with positive NPV and IRR above your minimum required rate if capital is sufficient.

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