🔑 Key Takeaways
- NPV (Net Present Value): Measures total value in dollars ($). It tells you how much wealth a project creates.
- IRR (Internal Rate of Return): Measures efficiency in percentage (%). It tells you how fast your money grows.
- Consensus: When they disagree, trust NPV for decision making, but use IRR for communication.
IRR and NPV are the two most important metrics in investment analysis. Usually they agree. But when they don't, which one should you trust?
📚 Related Guides: Learn how to calculate IRR step-by-step or compare ROI vs IRR.
Quick Definitions
- NPV (Net Present Value): Dollar value a project adds. Positive = profitable.
- IRR (Internal Rate of Return): Annual percentage return. Higher than your hurdle rate = worth doing.
Need to calculate both? Use our NPV Calculator and IRR Calculator to see them in action.
IRR vs NPV Comparison Table
| Feature | IRR (Internal Rate of Return) | NPV (Net Present Value) |
|---|---|---|
| Output Units | Percentage (%) | Currency Amount ($) |
| Question Answered | "How efficiently is my capital working?" | "How much total wealth will this create?" |
| Reinvestment Assumption | Reinvested at the project's own IRR (often unrealistic) | Reinvested at the Cost of Capital (more realistic) |
| Best Used For | Comparing capital efficiency; Communication | Mutually exclusive projects; Final decision making |
| Reliability | Medium (Can give multiple answers for non-conventional cash flows) | High (Always gives a single, correct value) |
When Do IRR and NPV Agree?
For most independent, conventional investment projects (one initial outflow followed by a series of inflows), IRR and NPV will lead to the same "accept" or "reject" decision. If a project has a positive NPV, its IRR will be higher than the discount rate, and vice versa. In these simple cases, both metrics are your friends.
The Conflict Zone: When IRR and NPV Disagree
The real debate begins when you are evaluating mutually exclusive projects—meaning you can only choose one. In these scenarios, IRR and NPV can sometimes give conflicting rankings. The project with the higher IRR might not be the one with the higher NPV.
This conflict typically arises due to two main reasons:
- Differences in Project Scale: IRR, as a percentage, ignores the absolute size of the investment. A small project can have a very high IRR but generate little actual wealth.
- Differences in Cash Flow Timing: Projects with large cash flows early in their life will have a higher IRR, but projects with larger (but later) cash flows might have a higher NPV.
Example: The Scale Problem
Imagine you have $10,000 to invest and two options (assuming a 10% discount rate):
- Project A: Invest $1,000, get $1,500 back in one year.
- Project B: Invest $10,000, get $13,000 back in one year.
Let's analyze:
- Project A: IRR = 50%, NPV = $363.64
- Project B: IRR = 30%, NPV = $1,818.18
Here, Project A has a much higher IRR (50% vs 30%), but Project B creates five times more actual value ($1,818 vs $363). The IRR rule would incorrectly suggest choosing Project A.
The Verdict: Why NPV is Academically Superior
In cases of conflict, the academic and professional consensus is clear: the NPV rule is superior.
The primary goal of a company is to maximize shareholder wealth, which is measured in absolute dollar terms, not percentages. NPV directly measures how much value a project adds to the bottom line.
The IRR's reinvestment rate assumption (that all cash flows are reinvested at the IRR) is also often seen as less realistic than the NPV's assumption (reinvestment at the cost of capital). (Note: To address some of IRR's shortcomings, practitioners sometimes use MIRR (Modified IRR), but even then, NPV remains the preferred metric for ranking mutually exclusive projects.)
A Caveat on NPV: Of course, NPV's accuracy depends entirely on using an appropriate discount rate. This makes accurate cost-of-capital estimation critically important—garbage in, garbage out.
So, Why Do We Still Use IRR?
Despite its theoretical flaws, IRR remains incredibly popular in the business world. Why? Because managers and investors often find it more intuitive to think in terms of percentage returns. It's easier to communicate that "this project has a 22% return" than "this project has an NPV of $2.3 million." It provides a simple, easy-to-understand benchmark.
The best approach is not to choose one over the other, but to use them together. Use IRR as a quick gauge of a project's efficiency and to communicate its potential, but always use NPV as the ultimate decision-making tool when comparing mutually exclusive projects.