NPV vs. IRR: Two Ways to Judge the Same Investment
NPV measures the dollars of value an investment creates today. IRR measures the annualized return it generates on its own terms. They usually agree on a simple accept/reject call, and can disagree on which of two projects is better.
What is the difference between NPV and IRR?
NPV measures the dollars of value an investment creates today; IRR measures the annualized rate of return it generates. NPV discounts future cash flows at a required rate you choose and nets off the initial outlay. IRR is the discount rate at which NPV equals zero. They agree on accept-or-reject decisions, and can disagree when ranking mutually exclusive projects.
Key takeaways
- NPV = Σ [cash flow ÷ (1 + r)^t] − initial investment; IRR is the r that makes NPV zero.
- For a standalone project, NPV > 0 and IRR > hurdle rate are equivalent tests.
- IRR is a percentage and ignores scale, so a small high-IRR project can create less value than a large modest-IRR one.
- NPV is the more reliable rule when the two conflict, because it measures value in dollars.
- Cash flows that change sign more than once can produce multiple IRRs, or none; NPV never has this problem.
What do NPV and IRR each measure?
Net present value (NPV) and internal rate of return (IRR) both evaluate the same thing, an investment's future cash flows, but they answer different questions. NPV answers “how many dollars of value does this create today,” discounting every future cash flow back at a required rate of return and netting out the initial investment. IRR answers “what annualized rate of return does this investment itself generate,” with no reference to any external required rate at all.
IRR = the discount rate r at which NPV = 0
The mechanics are the same present-value discounting used throughout a DCF; IRR is simply the rate that zeroes out that same calculation instead of applying an externally chosen one.
How do you decide whether to accept a project using NPV or IRR?
For a standalone project with a normal cash flow pattern (an upfront outflow followed by inflows), the two rules agree: accept the project if NPV is positive when discounted at the required rate, which is exactly equivalent to the project's IRR being higher than that same required rate (often called the hurdle rate, and typically set at the cost of capital).
Worked example: an investment of $100 today returns $115 in one year, evaluated at a 10% required return.
IRR: solve $115 ÷ (1 + IRR) = $100 ⇒ IRR = 15%, above the 10% hurdle, accept
When do NPV and IRR disagree, and which one wins?
For mutually exclusive projects, where you can only pick one, NPV and IRR can rank them differently. A smaller project with a very high IRR can still create fewer total dollars of value than a larger project with a more modest IRR, simply because IRR is a percentage and says nothing about scale. Timing differences (one project's cash flows arrive earlier, another's later) can also flip the ranking depending on the discount rate assumed.
NPV is the theoretically preferred rule when the two conflict, because it directly measures the dollar value created, which is what actually matters to an investor, rather than a rate of return that ignores how much capital was put to work or for how long.
IRR has one further complication: if a project's cash flows change sign more than once (an outflow, then an inflow, then another outflow, for instance), the equation that solves for IRR can have more than one valid answer, or none at all, a problem NPV never runs into since it's evaluated at one fixed, externally chosen rate.
| NPV | IRR | |
|---|---|---|
| What it outputs | A dollar amount of value created | A percentage rate of return |
| Needs an external discount rate? | Yes, you choose it (usually WACC) | No, it is solved for from the cash flows |
| Sensitive to project scale? | Yes, larger projects can produce larger NPVs | No, scale is invisible to it |
| Multiple-solution risk | None | Possible when cash flows change sign more than once |
| Preferred when the two conflict | Yes | No, but it is still quoted for comparability |
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Common NPV and IRR interview questions
Why can NPV and IRR give conflicting rankings for mutually exclusive projects?
IRR is a percentage return with no reference to the scale of the investment or the actual holding period, while NPV directly measures total dollars of value created. A smaller project can have a much higher IRR than a larger one while still creating fewer total dollars of value, so the two metrics can rank the same set of projects differently.
Why is NPV considered the more reliable rule when NPV and IRR disagree?
NPV measures value creation directly in dollar terms at the required rate of return, which is ultimately what an investor cares about. IRR can be misleading when comparing projects of different scale or cash flow timing, and can even fail to produce a single sensible answer for certain cash flow patterns.
What is the multiple IRR problem?
If a project's cash flows change sign more than once over its life (for example, an outflow, then inflows, then another outflow for a decommissioning cost), the equation defining IRR can have more than one mathematically valid solution, or none at all. NPV doesn't have this issue since it's calculated at one fixed discount rate rather than solved for.
What discount rate should you use to calculate NPV?
The rate that reflects the required return for the risk being taken, most commonly WACC for a company evaluating its own operating investments, since that's the blended return the company owes its capital providers. See the WACC guide for how that rate itself gets built.
Why do private equity returns get quoted in IRR rather than NPV?
IRR gives an annualized rate of return that's easy to compare across investments of different sizes and holding periods, which is useful for comparing a fund's performance across many deals. It's typically paired with MOIC (multiple of money), which captures the total dollar multiple IRR alone doesn't show; see the LBO guide for how both are calculated.