NPV vs IRR

NPV Vs. IRR

• NPV and IRR will generally give us the
same decision
• Exceptions
– Non-conventional cash flows – cash flow
signs change more than once
– Mutually exclusive projects
• Initial investments are substantially different(scale
of project)
• Timing of cash flows is substantially different
• The projects may have different expected lives
 Multiple IRRs
NPV ($)

NPV>0
IRR

NPV>0
Discount
NPV<0 NPV<0
rate

IRR

When project cash flows have multiple sign changes,

there can be multiple IRR
 Another Example – Non-
conventional Cash Flows
• Suppose an investment will cost $90,000
initially and will generate the following
cash flows:
– Year 1: 132,000
– Year 2: 100,000
– Year 3: -150,000
• The required return is 15%.
• Should we accept or reject the project?
Excel Output—Example #2
Year 0 -$90,000
Year 1 $1,32,000
Year 2 $1,00,000
Year 3 -$1,50,000

IRR 10.11% reject

NPV fx 15% $91,769.54

Less inv. -$90,000.00
NPV at 15% $1,769.54 accept

IRR says to reject, but NPV says to

accept. Go with NPV.
 Summary of Decision Rules
• The NPV is positive at a required return of
15%, so you should Accept
• IRR of 10.11% which would tell you to
Reject
• When there are non-conventional cash
flows ,look at the NPV profile
 NPV Profile
• A project’s NPV profile is a graph of its
NPV vs. the cost of capital
• It crosses the horizontal axis at the IRR
Figure 9.1: NPV Profile
 NPV Profile and IRR

A B C D E F G H
1 NPV Profile
Discount
2 Cash Flow rate NPV
3 -20000 0% 12,580
IRR
4 5430 5% 7,561 IRR
5 5430 10% 3,649
6 5430 15% 550
7 5430 16% 0
8 5430 20% (1,942)
9 5430 25% (3,974)
Figure 8.1 NPV Profile
 NPV Profiles
These show the affect on NPV of change in a variable
In this illustration, the variable chosen is the discount rate
Discount
$60.00
Rate NPVL NPVS
0.00% 50.00 40.00 $50.00 Which Project is more
6.00% 30.00 27.33 $40.00 sensitive toPoint
discount rate?
Of Indifference
10.00% 18.78 19.98 Why?
14.00% 8.94 13.38 NPV $30.00
18.126% 0.00 7.23 $20.00
22.00% -3.70 4.63 IRRS
$10.00
23.564% -10.20 0.00
26.00% -14.28 -2.95 $0.00
0 0.05 0.1 0.15 0.2 0.25 0.3
($10.00)
IRRL
($20.00)

Discount Rate
 Timing of Cash Flows  

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%
 Scale of Investment  

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
 Project Life Span  

Cash Flows (Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

X – 10,000 12,000 – – – – 908 20%

Y – 10,000 0 0 0 0 20,120 2,495 15%
 How to calculate SIP returns-
ET wealth Dec. 27
• Investments in mutual funds through systematic investment plans
(SIPs) have become a favoured route for most investors.
• But one question dogs every investor’s mind: How are SIP returns
calculated? It is very easy to calculate a fund’s return when the
investments are made through the non-SIP (lump sum) route. This is
because the entry date and exit date are known. However, in case of
an SIP, although the exit date and the exit value is known, there are
series of dates on which the investments are made, implying multiple
entry dates.
• Moreover, there are possibilities of variations in the amount of
investments made at different time intervals. For example, one may
be investing Rs 2,500 every month that could be increased to Rs
4,500 per month or reduced to Rs 1,500 per month. How to estimate
returns from such investments?
 contd..
• IRR is useful not only for SIP returns but also for estimating returns
from money back insurance policies and bond yields. This
calculation method equates the discounted value of the stream of
investments (also known as cash outflows) to the discounted exit
value of the investment (cash inflows). The discount rate that
equates the present value of cash outflows and the present value of
cash inflows is the rate of return earned by an SIP.

• Let us understand this with an example: Assume you were

investing Rs 2,500 per month in HDFC Equity fund (growth option)
from October 2009 onwards. The investment was made on the 1st
of every month and the tenure of the SIP was October 2009 to
December 2010. This means a stream of 15 payments of Rs 2,500.
 Contd...
• The last SIP was made on 1 December 2010
and all the units (accumulated over the tenure
of the SIP) were redeemed on the same day.
The exit value of the investment is Rs 46,004.
Now, we need to look for a discount rate that
will equate the present value of Rs 46,004
(cash inflow) and the present value of stream of
SIPs, that is Rs 2,500 (cash outflows). Using
IRR, we get the return as 2.85% per month or
34.25% annualised return.