Discover why NPV and IRR can give you conflicting results when evaluating your investments

Have you ever found yourself in a situation where two financial analysis tools give completely different conclusions about whether to invest or not? This is a common reality when investors apply both Net Present Value (NPV) and Internal Rate of Return (IRR) simultaneously to validate a project’s viability. A project may look excellent according to NPV but less attractive according to IRR, leading to confusion in decision-making. The good news is that understanding the strengths and limitations of each metric will allow you to make more accurate assessments.

Net Present Value: more than just a simple sum of numbers

Net Present Value essentially represents the actual economic benefit you will obtain from an investment in terms of today’s money. Imagine investing $10,000 in a project that will return money over the next few years. You can’t simply sum those future cash flows as they are because money tomorrow is worth less than money today due to inflation and opportunity cost.

This is where the NPV formula comes in. This calculation takes each future cash flow and “discounts” it to its present value using an appropriate discount rate. Then, you subtract the initial cost of your investment from the total of these present values. If the result is positive, it means your investment will generate more money than you initially invested.

For example, if you invest $10,000 in a project that generates $4,000 annually for five years with a discount rate of 10%, the calculation would be:

• Year 1: $4,000 ÷ (1.10)¹ = $3,636.36
• Year 2: $4,000 ÷ (1.10)² = $3,305.79
• Year 3: $4,000 ÷ (1.10)³ = $3,005.26
• Year 4: $4,000 ÷ (1.10)⁴ = $2,732.06
• Year 5: $4,000 ÷ (1.10)⁵ = $2,483.02

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

A positive NPV of $2,162.49 indicates that this is a profitable project. But what happens when the result is negative? Consider a certificate of deposit where you invest $5,000 expecting to receive $6,000 in three years at an 8% annual rate:

Present value = $6,000 ÷ (1.08)³ = $4,774.84
NPV = $4,774.84 - $5,000 = -$225.16

A negative NPV suggests that the investment will not adequately recover your initial capital in terms of present value.

The pitfalls of relying solely on Net Present Value

Although NPV is widely used, it has significant limitations that you cannot ignore. The discount rate is fundamentally subjective: different investors may choose different rates based on their personal risk assessment, resulting in inconsistent outcomes for the same project.

Additionally, NPV assumes perfect projections of future cash flows, which is practically impossible. It does not account for flexibility to change course as the project progresses, nor does it properly adjust for inflation in long-term projections. It also tends to favor large projects over small ones simply because they generate higher absolute dollar amounts, even though a small project might be more efficient proportionally.

The Internal Rate of Return: the percentage most investors seek

While NPV tells you how much money you will earn in absolute terms, IRR answers a different question: what percentage return does this investment correspond to? IRR is the discount rate that makes the NPV exactly zero. If the IRR exceeds your reference discount rate, the project is considered profitable.

IRR is particularly useful because it is a single, comparable number. It allows for the evaluation of investments of different sizes on an equal footing, something NPV fails at. A project with an IRR of 15% looks better than one with 8%, regardless of whether you invest $1,000 or $1,000,000.

The inherent complications of Internal Rate of Return

However, IRR also has its own problems. First, a project may not have a unique IRR. Some projects with unconventional cash flow patterns (where there are multiple changes from positive to negative) can have multiple IRRs, making clear evaluation impossible.

IRR also does not work well when cash flows do not follow the typical pattern of an initial outflow followed by inflows. If the project incurs losses or has large fluctuations, IRR can be misleading. Moreover, IRR implicitly assumes that all positive cash flows are reinvested at the same IRR, which rarely happens in reality. This assumption leads to an overestimation of the project’s true profitability.

When NPV and IRR disagree

Conflicts between NPV and IRR typically arise when projects have different scales or cash flow patterns. A large project with moderate flows may have a higher NPV but a lower IRR than a smaller project with concentrated flows at the end of the period.

In such cases, the professional recommendation is to prioritize NPV, as it measures the absolute value added to your wealth. However, this advice comes with the warning that you should carefully review your assumptions about the discount rate and cash flow projections. If cash flows are highly volatile and you applied a very conservative discount rate, you might be underestimating projects that are actually profitable.

How to select the correct discount rate for your NPV formula

The accuracy of your NPV analysis critically depends on the discount rate you choose. Several approaches exist to determine it. Opportunity cost is perhaps the most intuitive: what return could you get from another similar risk investment? If your project is riskier, increase the rate to compensate.

The risk-free rate (typically based on government bonds) provides a minimum floor. Industry or sector-specific discount rates offer a reference point. Finally, your personal experience and intuition as an investor are also valid, but should be grounded in rigorous analysis.

Beyond NPV and IRR: other tools you need

Although NPV and IRR are powerful, they should not be your only metrics. ROI (Return on Investment) offers a different perspective. The payback period (payback period) tells you when you will recover your initial investment. The Profitability Index relates the present value of cash flows to the initial investment, allowing proportional comparisons. The Weighted Average Cost of Capital provides a more sophisticated discount rate based on the financing structure.

A comprehensive assessment involves calculating multiple metrics and then considering qualitative factors: your personal risk tolerance, your specific financial goals, portfolio diversification, and your overall financial situation. Investment decisions should never rely solely on numbers.

Frequently asked questions investors always have

What if a project has a positive NPV but a low IRR? This can happen with large projects that generate significant absolute value but moderate return margins. It depends on your goal: if you seek total value, proceed; if you seek capital efficiency, reject.

Can I ignore IRR if I have a positive NPV? No. IRR provides information about capital efficiency that NPV does not. Use them together.

Is inflation included in these calculations? Not automatically. You should use discount rates that reflect expected inflation and project cash flows realistically, considering price changes.

How do small changes in the discount rate affect my conclusions? Dramatically. A rate of 8% versus 12% can turn a positive NPV into a negative one. Always perform sensitivity analysis testing different rates.