Net Present Value VS Rate Of Return: What’s The Difference?

Net Present Value VS Rate Of Return: What's The Difference?
Net Present Value VS Rate Of Return: What’s The Difference?

Define Net Present Value?

Net Present Value or NPV refers to the negative and positive cash flows that will occur in the future throughout the life cycle of the project that is discounted at the moment. The net present value is used in the domain of finance and accounting and the amount determines the value of a business, investment securities, new ventures assessments, and methods to effect cost reductions. The amount indicates a natural appraisal. If you are curious to know what is net present value in a bit more detail you should visit here.

What is IRR?

IRR refers to the Internal Rate of Return. The IRR is used to evaluate the profitability of a potential firm or business. The internal Rate of Return is pertinent in capital budgeting. The IRR associates the Net Present Value of the cash flow to zero by working as a discounting rate. The time value of money is also considered in the Internal Rate of Return. The time value of money indicates that the current monetary value is more than its future sum. To know more about how time affects money click here.

What are the differences between IRR and NPV?

  • In the Net Present Value method, the present value is calculated at predetermined rates that are known as cut off rates, whereas there is a suitable discounted rate at which present value is calculated in the Internal Rate of Return method.
  • Net Present Value considers the market rate of interest. It takes into consideration the amount that needs to be spent for a project as an investment so that the projected earnings can be recovered at the current market rates from the investment whereas, it’s not the case with the Internal Rate of Return. IRR takes into consideration the highest rate of interest so that maximum earnings can be made from the investment.
  • Intermediate cash flow is reinvested at cutoff rates or predetermined rates in the Net Present Value method, whereas in the Internal Rate of Return method, the intermediate cash flow investment is made according to the current rate of return.
  • The predefined or cutoff rates of the Net Present Value are more reliable than the suitable rates of the Internal Rate of Return if there are more than two projects.

Both the analytical tools i.e., NPV and IRR are very useful in nature but do not always give the desired results, especially in the case of two or more than two competing projects. The NPV method is preferred by most project managers.

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