hello everyone hi welcome to the channel of Wallstreetmojo Friends today we
are going to learn at tutorial NPV vs IRR so everyone or the investor
who is trying to invest his money or let's say who is planning to make
investment decision is always confused how to know its profitability so well
there are two most important approaches which are used and they are NPV and IRR
so let's assume that your organization has asked you to to do some analysis
whether the new project will be beneficial or not so in this scenario
you would first analyze the project cost the you will first analyze what the
first is the case of the project cost and then try to evaluate its cash
inflows and outflows which is known as the cash outflow it's called as present
value of the cash inflow and cash outflow that is called as free cash
flows next you will check in how many years the cost of the project would be
recovered and by what period of the time that project will start providing
benefits so in order to measure a lucrativeness of the project or long term
investment plans there are some capital budgeting tools used by many
organization and individuals to find out the profitability of the project and the
most common tool which is used is NPV and IRR and IRR okay both of these
tools are majorly used to evaluate the profits from the investments and they
both have their own pros and cons see but the primary question is that which tool
is beneficial is it N is it NPV that is beneficial is it NPV that is beneficial
or is it IRR so there are lot of debate and you must you must read which states
NPV is better and measurable tool well other states that IRR so in this
tutorial I will be guiding you through the differences between the two and also
which tool has more relevance now let's go through some of the differences of
NPV vs IRR let's see so this guy is in question that what should be used for
buying for evaluating assets for many other reasons so let's start evaluating
first is the meaning so NPV is the acronym that is a synonym for the net
present value acronym for the net present value net present value is the
amount of present value of the cash outflow and cash inflow it's like the
present value of the cash outflow less the present value of the cash inflow so
it's like PVCI present value the cash inflow less the present value of the
cash outflow PVCO if this is positive then you get NPV now IRR IRR means is
the acronym for internal rate of return it is known as the discount rate that
makes NPV of all cash outflow and projected cash inflow equal so it's it's
like it's PVCO that is present value of the cash outflow and present value of
the cash inflow are equal in case of IRR so second the explanation part NPV
see it is the expression in the form of the currency return okay it is a form of
in the form of the currency return which our company expects from a project so
over here the portion is involved in terms of numerical value so even if you
receive the the NPV will be in terms of like $10,000 or to $12,000 of $1,000,000
and so on and so forth over here IRR is expressed in terms of percentage of
return a form expects from the project so basically IRR is like you know they
will they will tell you that you know a 10% interest rate your present value the
cash outflow and present value of the cash inflow is equal now the measure NPV is
the absolute measure okay it represents the value of the currency
that is either added or lost by undertaking the project so present value
of the cash inflow let's say if this is 10000 then present value of the cash
outflow is let's say 5,000 then in this scenario what is the difference 5,000
5,000 is your profit and if not if it is vice versa then it will be lost so it
gives an absolute measure IRR is this basically a relative measure it's you
can relate that it is a rate of return of project offers over its lifespan cash
flow changes NPV method can be used to evaluate the project or
investments where there are changes in the cash flows okay so if
there are changes like you know in the year 1 you have different cash flow like in year 1
there is 100 million in year 2 you have 200 million year 3 there is 300
million and so on and so forth so it can be used to evaluate projects or
investment where there are changes in the cash flow but IRR method cannot be
used to evaluate projects where there is changing in the cash flow it should be
constant the additional wealth so NPV takes into account the additional
shareholders wealth for calculating the profitability of the project so the
additional wealth that has been created IRR does not take into account the
additional shareholders wealth for calculating the profitably of the
project because over there the only analysis which has done is whether the
at what rate the PVCO is equal to the PVCI acceptability NPV
method is better under stable by general public as it is easy to easy to grasp
yes absolutely because it's like the outflow less the inflow or you can say
whatever is coming in your pocket and whatever is going on to the profit the
balance is your profit or loss the IRR method is more used by the business
managers and it is better to understand the concept of the return stated in the
percentages so over here in case of NPV people understand this whole thing in in
terms of numbers over here they understand in terms of percentage and it
is you more used by the business managers over here it is used for
general public or as for as layman the discount rates if discount rates changes
NPV produces different results for the same project absolutely like if there is
10% discount rate the NPV will be different at 11% discount rate it
NPV will be different it's like as the discount rate increases your cash flow
will decrease so that is the case with NPV IRR produces the same result even if
the discount rate changes for the same project so that is what the difference
is for the discount rates now the pro tip if you pro tip if you are planning
to invest in the long term projects or any other investments like you know
buying machineries or let's say for investment purpose NPV is considered as
a better measure to analyze the profitability of that investments rather
than IRR as NPV considers considers the different discount rates for the same
project and also takes into account the cost of capital because at the end of
the day discount rate includes everything the discount rate is
basically your weighted average cost of capital it includes your KE cost of
equity cost of debt the cost of preferential everything it includes
everything so now let's get into the advantages and disadvantages of NPV
let's so quickly get into the area of advantages and disadvantages of NPV see
net present value at the end of the day is calculation of the present value of
the cash inflow that is cash inflow less the cash outflow cash inflow and the
present value of the cash outflow which we have just arrayed PVCI less the PVCO
so that is your NPV the difference is NPV so if you are investing in
certain investments of project if it if it is positive that means if your NPV
that is net present value if that is positive that is greater than 0 then you
can accept that project and this will show that the NPV value to your wealth
but in case if your NPV is less than 0 then in that scenario you should not
accept the project so let's evaluate some of the advantage and disadvantage
of NPV see in case of the advantage of NPV the first thing the foremost thing
is that time value of money is given more importance TVM time value of money
is given more importance that is the value of money today is more than the
value of money received and year after now second is that the project
profitability and risk factors are given high priority so profit and you can say
the risk are taken into consideration more into consideration it helps you to
maximize your wealth as it will show your returns greater than the cost of
capital so WACC over here basically forth it takes into consideration both
before and after cash flow over the life span of the project so basically the
consideration is both the after and before the before and after the cash
flow or the lifespan of the project now let's see some of the disadvantage now
but the disadvantage the first one let's discuss see it might not give you the
first one is it might not give you the accurate decision when the two or more
projects or are our unequal life so if if there is only
unequal life you won't be having exact answer so that is one it one
disadvantage it will not give you the clarity how long a project or investment
will generate positive NPV you do simple calculation third you can say that you
know NPV method suggests to accept that investment plan which provides positive
NPV but it does not provide accurate answer at what period the time you will
achieve the positive NPV so the last one fourth one is like you know calculating
appropriate discount rate is difficult so you can see WACC calculation
you can say is difficult because at the end of the day there is a lot of
estimation process so there are some of the disadvantage and advantage of IRR
let's discuss that in case of the IRR the first one is that
at the end of the day first you cannot use this approach of iron as an
alternative method to NPV this method entirely depends on estimated cash flow
as it is a discount rate which tries to make NPV of the cash flows of a project
equal to zero so if you are using this method to make decision between two
projects then accept the project if the IRR is greater than the required rate of
return so basically you can see the event IRR is greater than the RE you
should accept the project now let's see some of the advantages see this approach
is mostly used by the financial managers as I told you and as it is expressed in
terms of percentage form so it is very easy for them to compare the required
cost of capital it will provide you an excellent
guidance on the project value and the risk you can say the project value and
the associated risk so this is one more advantage IRR method third one irr
method gives you the advantage of knowing actual return of the money which you have
invested today so actual return can be tracked very easily with the help of
this particular driver the disadvantage of the IRR is that you know IRR tells
you to accept the project or or investment plan where the IRR is greater
than the weighted average cost of capital but in case of the discount rate
changes every year then it is very difficult to make such comparison and if
there are two or more mutually exclusive projects they are projects where
acceptance of one project rejects the other one and you can say in that case
the IRR is not very effective now let's see one example let's say over here XYZ
company is planning to invest plant it generates the following cash
flows from the above information calculate the NPV and IRR if the
discounting rate is 10% over here which is given so and suggest whether
the XYZ limited should invest in this plant or not you can download this on
the IRR calculation so NPV is basically your cash inflow divided by 1
plus R raised to the n that is T less the cash outflow so over here we have
couple of things cash outflow is equal to the total project cost the first
step over here is the projected cash flows expected discounted and apply the
NPV formula in the Excel so this is number of here over here this is the
cash outflow and this is the cash inflow this is the discount rate where you have
to use and then after use the NPV formula the rate value the first value
and the second value so rate includes the discount rate the value one includes
the cash inflows okay and value to include the cash outflow and when you
apply this you get your NPV the next step is to add the cash outflow to the
NPV formula this step two is basically once you calculate the NPV you just need
to add the cash outflow NPV step three sum total to find the net present value
so this this is how the NPV a value has been found the IRR formula is basically
cash flow divided by one plus IRR rate raised to n is equal to cash outflow so
in this step the IRR step one is first you have to list down all the details
the discount rate is 10% you have the NPV so IRR is equal to
value and guess so value will include all the cash flows of the projects okay
all the it includes everything that is cash outflow and inflow so basically
from the above calculation you can see that the NPV generated by the plant is
positive and IRR is close enough to you can say 14% IRR close enough to you can
say c33 to c-38 once you do that you you see
the IRR is close enough to 14% so this implies that when discounting rate will
be around 14% the NPV will become zero hence XYZ company can invest in this
plant so the final conclusion is that as I can conclude that if you are
evaluating two or more mutually exclusive projects so better go for NPV
method instead of IRR method because it is safe to
depend on NPV method for selecting the best investment plan due to its
realistic assumption and better measure of profitability so even you can make
your use of IRR method it is greater compliment to NPV and will provide you
an accurate analysis for investment decision and also NPV finds its usage in
discounting that is discounted cash flow matter which is not DCF valuation to
find the present value of the cash flows to the form thank everyone
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