VAN and IRR: Key tools to assess the viability of your investments

What is the actual NPV? Why do some projects with higher NPV have lower IRR? Investment opportunity assessment requires understanding specific financial metrics that enable informed decision-making. Two indicators stand out above the rest: Net Present Value (NPV) and Internal Rate of Return (IRR). Although both measure profitability, they do so in different ways that can produce contradictory results.

What is the fundamental difference between NPV and IRR?

The profitability of a project can be evaluated from two complementary perspectives. NPV answers the question: “How much money will we earn in present terms?” while IRR answers: “At what annual percentage will our money grow?”

Although these questions seem similar, the answers can differ significantly depending on the project’s characteristics. A project may offer a more attractive NPV in absolute money, but a lower IRR in percentage terms. That’s why it is essential to analyze both indicators together rather than choosing only one.

Understanding what NPV is and how it is calculated

Net Present Value is a fundamental finance concept that translates the future benefits of an investment into their equivalent value today. Essentially, NPV answers how much tomorrow’s income would be worth today, subtracting the initial investment.

The calculation process involves three key steps:

1. Project future cash flows during the project’s lifespan, including revenues, operational expenses, taxes, and other relevant costs

2. Determine the appropriate discount rate, reflecting the opportunity cost of capital: what you could earn investing in a similar alternative

3. Calculate the present value of each future cash flow and sum all the values, then subtract the initial outlay

The NPV formula is expressed as:

NPV = (Cash Flow 1 / ((1 + Discount Rate))^1) + (Cash Flow 2 / ((1 + Discount Rate))^2) + … + (Cash Flow N / ((1 + Discount Rate))^N) - Initial Investment

Interpretation of results:

• Positive NPV: the investment generates gains and is viable
• Negative NPV: expected revenues do not cover the investment, indicating losses
• Zero NPV: the project just recovers the investment without generating additional profit

Practical examples to understand NPV in action

Case 1: A profitable prospects project

A company evaluates investing $10,000 in a project that will generate $4,000 annually for five years. Using a discount rate of 10%:

The present values for each year would be:

• Year 1: $3,636.36
• Year 2: $3,305.79
• Year 3: $3,005.26
• Year 4: $2,732.06
• Year 5: $2,483.02

Adding these values and subtracting the initial investment: NPV = $2,162.49

With a positive NPV of this magnitude, the project is attractive because it will generate real gains in present terms.

Case 2: An unattractive investment

Consider a certificate of deposit requiring an investment of $5,000 today to receive $6,000 at the end of year three, with an interest rate of 8%:

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

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

The negative NPV indicates that the investment is not profitable; the present value of what we will receive does not justify what we invested today.

How to select the correct discount rate

Choosing the discount rate is crucial because it directly affects the NPV result. This rate is not a fixed number but a subjective estimate by the investor.

Criteria for choosing the discount rate:

• Opportunity cost: What return could you obtain from an alternative investment with similar risk? If the current project is riskier, increase the rate.

• Risk-free rate: Use as a minimum reference the rate offered by safe instruments like treasury bonds, adding a risk premium.

• Industry analysis: Research what discount rates other companies in your industry use to maintain consistency.

• Experience and intuition: Your knowledge of the market and the specific project adds value to this decision.

Important limitations of NPV

Despite its usefulness, NPV has restrictions that investors should consider:

Despite these limitations, NPV is widely used because it is relatively simple to understand and apply. It provides concrete monetary answers that facilitate comparison between options.

Understanding IRR and its relevance

The Internal Rate of Return is the annual percentage return a project would generate over its lifespan. It is the rate at which the net present value would be exactly zero, meaning the discounted inflows exactly equal the initial investment.

Expressed as a percentage, IRR allows comparison of projects regardless of their size. If IRR exceeds a reference rate (such as the bank interest rate), the project is recommended.

Main advantages:

• Provides a relative measure of profitability easy to compare
• Especially useful for projects with regular, predictable cash flows
• Facilitates comparison of investments of very different magnitudes

Significant limitations of IRR

Although useful, IRR has restrictions that make it insufficient as a sole metric:

What to do when NPV and IRR give contradictory results?

Conflicts between both indicators occur frequently, especially when:

• Cash flows are volatile
• There are significant differences in payment timing
• The discount rate used in NPV is very high or very low

Strategy to resolve conflicts:

First, review your assumptions: verify that the discount rate adequately reflects the project’s risk. A project with erratic cash flows may require a higher rate than initially used. Second, perform sensitivity analyses adjusting key variables to see how results change. Third, consider the context: if you aim to maximize absolute value, emphasize NPV; if you seek efficiency relative to capital, emphasize IRR.

In cases of clear divergence, NPV is often the more reliable indicator because its result depends less on reinvestment assumptions.

Complementary tools for more robust decisions

NPV and IRR should not be the only decision criteria. Complement your analysis with:

• ROI (Return on Investment): Measures return as a percentage of the initial investment
• Payback Period: Calculates how long it takes to recover the initial investment
• Profitability Index: Divides the present value of future flows by the initial investment
• Weighted Average Cost of Capital: Reflects the average cost of financing the project

How to choose the best project among several options

When evaluating multiple opportunities:

1. Calculate NPV and IRR for each option, ensuring the same discount rate is used across all
2. Select the one with the highest NPV if capital is limited
3. Consider IRR to evaluate the relative efficiency of capital
4. Verify alignment with strategic objectives and risk tolerance
5. Analyze the time horizon: some projects may not align with your timelines

Final considerations for investors

Investment evaluation goes beyond numbers. Besides NPV and IRR, consider:

• Your personal short- and long-term financial goals
• Available budget and alternative options
• Your risk tolerance and volatility
• The need to diversify your portfolio
• Your overall financial situation and capacity to withstand losses

Both indicators are powerful tools but imperfect. True analytical power arises from using them together, complemented by other metrics and your professional judgment about each specific investment context.