NPV vs IRR: What’s the Difference and Which One Should You Use?

When evaluating investment opportunities, two of the most commonly used tools in finance are Net Present Value (NPV) and Internal Rate of Return (IRR). Both play a vital role in capital budgeting, investment appraisal, and financial planning. While they rely on the same cash flow data, they provide different perspectives on whether an investment is worthwhile.

In this blog, we will explore what NPV and IRR are, how they work, how they differ, and when to use them. We will also look at simple examples to bring each concept to life, and finally, consider whether using both together can strengthen your decision-making process.

What is Net Present Value (NPV)?

Net Present Value is the difference between the present value of future cash inflows and the present value of cash outflows related to an investment. In other words, it tells you how much value an investment will add, expressed in today’s money.

The core idea behind NPV is that money today is worth more than the same amount in the future, due to its earning potential. This is known as the time value of money. If the NPV of a project is positive, it indicates that the investment is expected to generate more money than it costs, and therefore adds value. If it is negative, the investment would reduce value and is generally not recommended.

What is Internal Rate of Return (IRR)?

The Internal Rate of Return is the discount rate that makes the NPV of an investment equal to zero. Put simply, it is the break-even interest rate that the project is expected to earn. If the IRR is higher than the required rate of return or the cost of capital, the project is considered financially viable. If it falls below that threshold, the project is likely to destroy value. The IRR is particularly useful for comparing investment opportunities, as it provides a single percentage figure that reflects the potential return.

A Simple Case Study

Imagine you are considering starting a small coffee cart business.

Initial investment: £5,000

Expected cash inflows: £2,000 per year for three years

Required rate of return (discount rate): 10 percent

Let’s calculate both NPV and IRR to assess the opportunity.

NPV Calculation

Using the formula:

NPV = Σ (Cash Flow / (1 + r)^t) - Initial Investment

We discount each year’s cash inflow back to its present value.

Year 1: £2,000 / (1 + 0.10)^1 = £1,818

Year 2: £2,000 / (1 + 0.10)^2 = £1,653

Year 3: £2,000 / (1 + 0.10)^3 = £1,503

Total present value of inflows = £4,974

NPV = £4,974 - £5,000 = -£26

In this example, the NPV is slightly negative, meaning the project does not meet your required return of 10 percent.

IRR Calculation

To calculate IRR, we use the same formula but solve for the rate that sets NPV to zero.

0 = (2,000 / (1 + IRR)^1) + (2,000 / (1 + IRR)^2) + (2,000 / (1 + IRR)^3) - 5,000

Using financial software or an IRR calculator, we find:

IRR ≈ 9.8 percent

This means the project is expected to return approximately 9.8 percent per year. Because this is slightly below the required return of 10 percent, it would not be advisable to go ahead.

Key Differences Between NPV and IRR

While NPV and IRR are closely related, they answer different questions. NPV tells you the amount of value an investment adds in monetary terms. IRR tells you the rate of return the investment is expected to generate.

NPV is generally more reliable, especially for comparing projects of different sizes or durations, because it focuses on actual value creation. IRR, on the other hand, is useful when you want to compare investments based on return percentages or communicate performance in a more intuitive way. However, IRR can be misleading in cases where the project’s cash flows are irregular or change direction more than once (for example, switching between positive and negative). This can result in multiple IRRs or make the IRR calculation unreliable.

Can You Use NPV and IRR Together?

Yes, and in fact, you should. These two tools are most powerful when used alongside each other. NPV provides a clear picture of how much value a project creates, while IRR tells you the rate of return you can expect. When both point to the same conclusion, your decision is backed by two strong indicators.

If the NPV is positive and the IRR is higher than your required rate of return, the project is both valuable and efficient. However, if the two metrics conflict, it is usually safer to rely on NPV because it reflects actual monetary gain rather than relative performance.

Using both together allows you to consider both the scale and the efficiency of an investment, which is especially useful when making long-term or strategic financial decisions.

Everyday Applications

Small Business Decision

You are considering purchasing a new pizza oven for your home-based catering business. The oven costs £3,000 and is expected to bring in £1,200 per year in profit over three years. By calculating both NPV and IRR, you can determine whether the oven pays for itself in value and whether it does so at a rate that justifies the risk.

Property Investment

You are planning to buy a flat for £150,000 and expect to sell it in five years for £180,000 after spending £10,000 on improvements. The NPV helps you assess whether the value of future sale proceeds justifies today’s costs. IRR shows whether the return rate beats what you might earn elsewhere, such as in the stock market or a pension plan.

Personal Development

You are thinking about taking a short course that costs £1,000 and could increase your freelance income by £500 a year for three years. Using NPV and IRR, you can determine whether it’s a financially sound investment in your future.

Final Thoughts

Net Present Value and Internal Rate of Return are essential tools for making confident, informed investment decisions. NPV helps you understand the value an investment adds, while IRR tells you the rate at which that value is generated. Each method has its strengths and weaknesses, but together they provide a more complete financial picture. By learning how to apply both, you gain the ability to evaluate opportunities with greater clarity and precision. Whether you are launching a new venture, expanding your business, buying property, or planning your retirement, using NPV and IRR together will help you make better, more financially sound decisions.

For more tips and guidance related to the Finance industry, register here to subscribe to our newsletter and be sure to check out our YouTube channel. Together, we’ll help you achieve your goals, one step at a time.