NPV and IRR: what they measure and when they can mislead you

What NPV is

Net present value adds up all of a project's cash flows after bringing them to the present with a discount rate. If the initial investment is €1,000 and you then receive €300, €400 and €500 over three years, at a 10% rate each cash flow is worth less the later it arrives: €272.73, €330.58 and €375.66. NPV is the sum including the investment: −€21.04.

A positive NPV means the project returns more than the required rate; a negative one, that it returns less. The rate isn't a technical detail: it represents the opportunity cost of your money and the project's risk, and it changes the result completely.

What IRR is

The internal rate of return is the rate that makes NPV exactly zero. In the example above it's about 8.90%. If your required rate is higher than the IRR, NPV is negative.

When the IRR misleads

The IRR is convenient because it gives a percentage, but it has well-known limits:

• If all cash flows have the same sign, there's no IRR. Our calculator says so instead of making up a value.
• If the cash flows change sign several times (for example, an expensive decommissioning at the end), there can be several IRRs.
• Comparing projects of different sizes by IRR alone can lead you to choose the one that creates less value in euros.
• The IRR implicitly assumes that you reinvest the intermediate cash flows at the same rate.

Payback period

It tells you how long it takes to recover the investment without discounting. It's intuitive but ignores what happens after the payback and the time value of money, so it's best used alongside NPV, not instead of it.