I usually tend to stay away from technical posts because, quite frankly, there is nothing I can write about that hasn’t already been covered ad nauseam. However, in searching NPV vs. IRR, there was little information on the difference between the two and when to use each.
The net present value (NPV) and internal rate of return (IRR) are the two most commonly used methods to examine a proposed investment. Until recently, I really couldn’t tell you anything but the major differences between the two. All investors have their personal preference, so I wanted to lay out the facts, using examples, so you could decided which you prefer.
Net Present Value: To calculate the NPV of an investment, you choose a discount rate that you believe is appropriate given the inherent risk of the investment and you discount back all of the after-tax cash flows at that rate (less your equity). This will allow you to see the amount of profit you might expect to earn above your cost of capital, and to determine whether or not the profit is great enough to warrant the risk and work involved with the investment.
The purchase price is not included in these cash flows because we are calculating how much the investor is willing to pay. The NPV of the cash flows above, when discounted at 14 percent, is $118,565.
IRR: Alternatively, the internal rate of return shows you what the actual rate of return on your investment is, considering all of the cash inflows and outflows as well as assuming that interim cash flows can be reinvested at the same rate. Like NPV, we use bottom of the line items.
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This is the rate that makes the present value of the projected cash flows equal to the initial investment or the return on the entire property. As you can see from this example the IRR can remain constant although the initial investment, holding period, and payback period may vary greatly.
The Difference between NPV and IRR: Both NPV and IRR take into account when your money is invested and for how long it is invested. However, in deciding which to use, I suggest run both calculations. Sometimes the IRR can be really high, but if the payback period is very short, the money you will make may not be worth the effort. Also, it’s very difficult to compare alternative investments if you only have the NPV in dollar terms.
Whichever you use, the critical thing to understand is what exactly drives the returns. It could be from the cash flow of the property over time, or value-add by raising rents, reducing vacancy, or lowering expenses. Or it could be the future benefits that will result from selling or refinancing the property. Maybe you’re anticipating a change in cap rate at the time of the sale. When using IRR I recommend analyzing both the IRR from the cash flow and the IRR from the reversion. No matter what, it’s important not to get tangled up in the numbers. Look beyond the spreadsheets, in the end, it’s a real property designed for use by real people.
Which do you prefer in your financial analysis, NPV or IRR?