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Last updated on 2024年9月17日

How do you use the net present value and the internal rate of return to rank and select projects?

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If you are a business owner or manager, you probably have to make decisions about which projects to invest in and which ones to reject. How do you compare different projects that have different costs, durations, and cash flows? Two of the most common methods are the net present value (NPV) and the internal rate of return (IRR). In this article, you will learn how to use these tools to rank and select projects based on their profitability and efficiency.

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Lanre Robert Johnson FCCA

Experienced UK Accountant| Statutory Reporting Expert for Audited & Unaudited Firms| VAT, Self Assessments, &…
Ashis Basak, FCMA

Sr. Finance Manager at TotalEnergies | Month end closing | Controlling & Reporting | Budgeting & Planning | Credit…
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??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant…

1 What is NPV?

NPV is the difference between the present value of the cash inflows and the present value of the cash outflows of a project. It measures how much value a project adds to the business over its lifetime. A positive NPV means that the project is profitable and worth investing in. A negative NPV means that the project is unprofitable and should be rejected. A zero NPV means that the project is indifferent and does not affect the value of the business.

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Ashis Basak, FCMA

Sr. Finance Manager at TotalEnergies | Month end closing | Controlling & Reporting | Budgeting & Planning | Credit Control | Fixed & Leased Asset | Power BI | SAP | Oracle | Hyperion Essbase | CMA
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NPV is crucial for any investment decision. Without a positive NPV project is not viable. In the phase of cash flow projection, accurate forecasting is very important. Sometimes project can be rejected even though the positive NPV. For example, if the project could be negatively affected due to any regulatory decision.

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??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant | ??Certified Concurrent Auditor | ??Virtual CFO | ??Researcher | ??16K+ Family | ??800K+ Impressions
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Understanding how to effectively utilize net present value (NPV) and internal rate of return (IRR) is pivotal in strategic project selection. By employing NPV, we're able to gauge the present value of future cash flows, factoring in the time value of money. Meanwhile, IRR enables us to determine the project's inherent rate of return, offering insights into its profitability and potential for generating value over time. Integrating both metrics allows for a comprehensive evaluation, facilitating informed decision-making in project prioritization and resource allocation. It's about optimizing returns while mitigating risks, ultimately driving sustainable growth and maximizing shareholder value.

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2 What is IRR?

IRR is the discount rate that makes the NPV of a project equal to zero. It represents the annualized return that the project generates for the business. A higher IRR means that the project is more efficient and attractive. However, IRR is not always reliable because it may not exist, be unique, or reflect the true cost of capital. Therefore, it should be used with caution and in conjunction with NPV.

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Reghu Achikulathu MSc, MCIOB, MIIQS , NCMA, MRICS-APC Candidate

Manager Quantity Surveyor/Commercial Manager @ Shapoorji Pallonji Group | MSc, Quantity Surveying, Commercial Management
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Combining NPV and IRR offers a comprehensive view of a project's potential. NPV helps in understanding the absolute value of returns, while IRR provides a relative rate of return. For instance, while a project with a high IRR might seem attractive, I also consider NPV to ensure that it delivers substantial value in absolute terms. Balancing these metrics helps in selecting projects that are both profitable and align with our financial objectives.

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3 How to calculate NPV and IRR?

To calculate NPV and IRR, you need to estimate the cash flows of the project over its duration. You can use a spreadsheet software or a financial calculator to perform the calculations. The formula for NPV is:

NPV = C0 + C1/(1+r) + C2/(1+r)^2 + ... + Cn/(1+r)^n

Where C0 is the initial investment, C1, C2, ..., Cn are the cash flows in each period, r is the discount rate, and n is the number of periods.

The formula for IRR is:

NPV = 0 = C0 + C1/(1+IRR) + C2/(1+IRR)^2 + ... + Cn/(1+IRR)^n

Where IRR is the unknown variable that you have to solve for using trial and error or a built-in function.

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4 How to rank and select projects using NPV and IRR?

When ranking and selecting projects using NPV and IRR, you need to compare them based on certain criteria. The accept-reject rule states that a project should be accepted if it has a positive NPV and an IRR higher than the discount rate, or rejected if it has a negative NPV and an IRR lower than the discount rate. If the NPV is zero and the IRR is equal to the discount rate, it can be accepted or rejected depending on other factors. The profitability index compares the present value of cash inflows to outflows to measure how much value a project creates per unit of investment. A higher index indicates a more profitable project, with an index greater than 1 indicating a positive NPV and acceptable project. However, ranking conflicts can arise between NPV and IRR when the projects have different sizes, durations, or cash flow patterns. To avoid this, you should always prefer NPV over IRR due to its consistency and accuracy in reflecting the true value of projects.

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5 How to apply NPV and IRR in practice?

When applying NPV and IRR in practice, you need to consider a few practical issues that may affect your calculations and decisions. The discount rate should reflect the opportunity cost of capital and should be realistic and consistent for all projects. Additionally, cash flows should include all relevant revenues and expenses, as well as taxes and working capital changes. Furthermore, you should account for inflation, depreciation, and salvage value in your cash flow estimation. Lastly, sensitivity analysis is a technique that tests how sensitive your NPV and IRR are to changes in key variables. It helps you assess the risk and uncertainty of the project while identifying the most critical factors that affect its profitability and efficiency.

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Richard Avison

Experienced finance leader with a passion for understanding, and improving, businesses through cross-functional collaboration
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IRR and NPV can be used to evaluate completed projects but it's also important to remember that when using them to review current choices sunk costs should be ignored.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Lanre Robert Johnson FCCA

Experienced UK Accountant| Statutory Reporting Expert for Audited & Unaudited Firms| VAT, Self Assessments, & Corporation Tax Specialist
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In my experience, NPV and IRR are valuable financial techniques, but they should be used with economic indicators, stress testing and an understanding that projects operate in real world complexities. Economic indicators assess external factors impacting projects, while stress testing evaluated resilience and identifies risks. Projects should be evaluated in practical contexts, considering stakeholder dynamics and resource constraints. Integrating these factors with NPV and IRR leads to informed decisions, accounting for uncertainties and complexities, resulting in successful project selections.

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David T.

Financial Planning & Analysis, Financial Reporting, Finance Business Partner, Treasury Management.
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For informational purposes only, several other metrics to consider are, the profitability index measures the ratio of present value of cash inflows to the initial investment. It's advantageous as it accounts for the time value of money, aiding in comparing projects based on returns per unit of investment. On the other hand, the payback period estimates the time needed to recover the initial investment, giving a quick assessment of liquidity and risk. Lastly, the benefit-cost ratio considers the total benefits divided by the total costs, providing a holistic view of project feasibility. These metrics should be used in combination to gain a comprehensive understanding of potential investments

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How do you use the net present value and the internal rate of return to rank and select projects?

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1 What is NPV?

2 What is IRR?

3 How to calculate NPV and IRR?

4 How to rank and select projects using NPV and IRR?

5 How to apply NPV and IRR in practice?

6 Here’s what else to consider

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