Npv and IRR, a link to Project Management

How to calculate Net Present Value and Internal Rate of Return of the Project?

1. Net Present Value Decision Rules
IRR (Internal Rate of Return)
in Project Management
The two most-used measures for evaluating projects are
the net present value and the internal rate of return!

2. Agenda
2

3. Net Present Value
•The difference between the present value of the future cash flows from
an investment and the amount of investment. Present value of the
expected cash flows is computed by discounting them at the required rate
of return.
Where,
N=total number of periods
T= the time of the cash flow
i= the discount rate (the rate of return that could be earned on an
investment)
R
t
= the net cash flow i.e. cash inflow – cash outflow at time t (R
0
: it is
subtracted from the whole as any initial investments during first year is
not discounted for NPV purpose)
3

4. The NPV Decision Rules
4

5. Example
An Investment of $1,000 in year 1
The discount rate is 10%
In Year 2, we receive $110 in year 2
You expect to receive $1,200 in year 3
Therefore, NPV= ($ 1,000) + $ 100 + $ 991.74= $ 91.74
Hence, we can do this investment.
1 2 3
Investment($ 1,000)
Cash Inflows$ 0 $ 110 $ 1200
Discounting
Factor
1 1.10 1.21
Discounted
Cash Inflow
0 $ 100 $ 991.74
5

6. Internal Rate of Return
•The internal rate of return of a project is
known as the rate of return where the
particular project’s net present value
equals to zero.
•Formula:
–CF: Cash Flow
–r: Internal Rate of Return
6

7. Internal Rate of Return Rules
In IRR decisions, if we have only one project, most
of the time we need the basic rule «independent
project»:
IRR > Cost of capital (should be accepted)
IRR = Cost of capital (provides the minimum return)
IRR < Cost of capital (shouldn’t be accepted)
In addition, we need to take other situations into
account too. Especially, eventhough NPV and IRR
will generally give us the same decision, there are
some exceptions:
•Nonconventional cash flows – cash flow signs
change more than once
•Mutually exclusive projects
7

8. Example: Independent Project
If we want to decide on to accept the project or not, we
should consider the comparison of IRR & cost of capital
for an individual project.
In this example;
•when the cost of capital is 15%, then the NPV is
-227,53 (don’t accept)
•Alternative: IRR < Cost of capital
•when the cost of capital is 10%, then the NPV is 34,27
(accept)
•Alternative: IRR > Cost of capital
8

9. Example: Mutual Projects
9

10. NPV versus IRR
Project A Project B
Invest -10.000 -25.000
Return +25.000 +50.000
IRR IRR 150% IRR 100%
NPV by i=8%13.148 21.296
compare two mutually
exclusive projects
Key differences:
• NPV Method is preferred over other methods since it calculates additional wealth and
the IRR Method does not
• The IRR Method is more used in evaluating short-term projects and NPV is more used
in evaluating long-term projects.
• one significant advantage of IRR -- managers tend to better understand the concept of
returns stated in percentages and find it easy to compare to the required cost of capital
• Applying NPV using different discount rates will result in different recommendations.
The IRR method always gives the same recommendation.
10

11. Link to Project Management
Methods to evaluate a project
estimate the value of the project
choosing which project gets priority
By applying
NPV as time value of money (money figure)
IRR calculate the investments profitability as an interest rate
(percentage figure)
NPV and IRR in the decision taking process
included in a business case prepared by the
controlling department
11

12. ContactContact
Ujjwal Kumar JoshiUjjwal Kumar Joshi
[email protected]@gmail.com
12