NPV or Net Present Value if the method to calculate the profitability of a project-based of tax-free future cash flows. The higher
the NPV, the greater is the profitability.
- IRR or Internal Rate of Return is the rate at which NPV =0. The higher the IRR, the greater is the profitability.
- From the above two statements, we can say that among the two projects the one with higher IRR and higher NPV should be chosen. When both IRR and NPV vary together in the same direction, it is easy to choose the best investment, but there are scenarios where this fails.
Illustration 1: Given Below are two Investment Projects, Find out the profitable One.
- Investment 1: Initial cash Flow = Rs. 10000, Interest Rate = 10%, the tax-free cash flows are as given below:
| Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
| 2000 |
1000 |
5000 |
1000 |
4000 |
2000 |
900 |
- Investment 2: Initial Cash Flow = Rs. 12000, Interest Rate = 10%, the tax-free cash flows are as follows:
| Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
| 5000 |
2000 |
5000 |
1900 |
200 |
3000 |
100 |
Let us Calculate the IRR and NPV of both Projects to determine the Profitable one:
|
Investment 1 |
Investment 2 |
| Year 1 |
2000 |
5000 |
| Year 2 |
1000 |
2000 |
| Year 3 |
5000 |
5000 |
| Year 4 |
1000 |
1900 |
| Year 5 |
4000 |
200 |
| Year 6 |
2000 |
3000 |
| Year 7 |
900 |
100 |
| IRR |
13% |
14% |
| NPV |
1053.36 |
1019.61 |
- We can clearly see that, NPV is higher for investment 1 and IRR is higher for Investment 2, this situation is a conflict between NPV and IRR, if we choose Investment on the basis of IRR then NPV will not support it and vice versa. This is known as Ranking Conflict Between NPV and IRR.
In such cases, the Investment with higher NPV should be chosen.
- This is since NPV considers the market rate of interest on investment which is realistic, and IRR assumes the IRR rate of return on the investment. Market Rate is real where IRR is expected and may or may not be real, this makes NPV more realistic than IRR.
