Which is a better measure for capital budgeting, IRR or NPV?

In capital budgeting, there are a number of different approaches that can be used to evaluate
any given project, and each approach has its own distinct advantages and disadvantages.

All other things being equal, using internal rate of return (IRR) and net present value (NPV)
measurements to evaluate projects often results in the same findings. However, there are a
number of projects for which using IRR is not as effective as using NPV to discount cash flows.
IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate
every investment.

Although using one discount rate simplifies matters, there are a number of situations that cause
problems for IRR. If an analyst is evaluating two projects, both of which share a common
discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably
work. The catch is that discount rates usually change substantially over time. For example, think
about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills
returned between 1% and 12% in the last 20 years, so clearly the discount rate is changing.

Without modification, IRR does not account for changing discount rates, so it's just not
adequate for longer-term projects with discount rates that are expected to vary. (To learn more,
read Taking Stock Of Discounted Cash Flow, Anything But Ordinary: Calculating The Present
And Future Value Of Annuities andInvestors Need A Good WACC.)

Another type of project for which a basic IRR calculation is ineffective is a project with a mixture
of multiple positive and negative cash flows. For example, consider a project for which
marketers must reinvent the style every couple of years to stay current in a fickle, trendy niche
market. If the project has cash flows of -$50,000 in year one (initial capital outlay), returns of
$115,000 in year two and costs of $66,000 in year three because the marketing department
needed to revise the look of the project, a single IRR can't be used. Recall that IRR is the
discount rate that makes a project break even. If market conditions change over the years, this
project can have two or more IRRs, as seen below.
 Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are
multiple rates of return for the project that produce multiple IRRs. The advantage to using the
NPV method here is that NPV can handle multiple discount rates without any problems. Each
cash flow can be discounted separately from the others.

Another situation that causes problems for users of the IRR method is when the discount rate of
a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it
must be compared to a discount rate. If the IRR is above the discount rate, the project is
feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or
cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases
like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to
be financially worthwhile.

So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a
direct result of its reporting simplicity. The NPV method is inherently complex and requires
assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The
IRR method simplifies projects to a single number that management can use to determine
whether or not a project is economically viable. The result is simple, but for any project that is
long-term, that has multiple cash flows at different discount rates, or that has uncertain cash
flows - in fact, for almost any project at all - simple IRR isn't good for much more
than presentation value.

Perils of the Internal Rate of Return

Copyright © 2000 Samuel L. Baker

The two most-used measures for evaluating an investment are the net
present value and the internal rate of return. (Two earlier tutorials
discussed these concepts. See the tutorials list for links to tutorials for
discounting future income and the internal rate of return.)
It is often assumed that higher is better for both of the net present value
and the internal rate of return. In particular, it is usually stated that
investments with higher internal rates of return are more profitable than
investments with lower internal rates of return.
However, this is not necessarily so. In some situations, an investment
with a lower internal rate of return may be better, even judged on
narrow financial grounds, than an investment with a higher internal rate
of return. This interactive lecture explores why and when this reversal
takes place.
To review, both the net present value and the internal rate of return
require the idea of an income stream, so let's start there. An income
stream is a series of amounts of money. Each amount of money comes in
or goes out at some specific time, either now or in the future. The
income stream represents the investment; the income stream is all you
need to know for financial evaluation purposes.
In real life, individuals, charitable institutions, and even for-profit
businesses have social or other goals when selecting investments. For
businesses, the benefits of community good will are no less real for being
difficult to measure precisely. For enterprises with social as well as
financial goals, the measures discussed here are still useful: They tell
you how much it costs you to advance your social goals.

Here is an income stream example, from the interactive lecture about

the internal rate of return.

Year 0 1 2 3 4 5 6

Income - $20 $20 $20 $20 $20 $20

amounts $100 0 0 0 0 0 0
0

Here we see seven points in time and, for each, a dollar inflow or
outflow. At year 0 (now), the income amount is negative. Negative
income is cost, or outgo. In this example, the negative income amount in
year 0 represents the cost of buying and installing the machine.

In the future, at years 1 through 6, there will be net income of $200 each
year.
All of the amounts in the income stream are net income, meaning that
each is income minus outgo, or revenue minus cost. In year 0, the cost
exceeds the revenue by $1000. In years 1 though 6, the revenue will
exceed the cost by $200.
This investment evidently has no salvage value. That is, there is nothing
that can be sold in year 6, the last year. If there were, the amount that
could be realized from the sale would be added to the income amount for
year 6.
For simplicity, all my examples have the incomes and outgoes at one-year
intervals. Real-life investments can have income and expenses at
irregular times, but the principles of evaluation are the same.
Now let's discuss our two measures in connection with this income
stream:
Net Present Value
The net present value of an income stream is the sum of the present
values of the individual amounts in the income stream. Each future
income amount in the stream is discounted, meaning that it is divided by
a number representing the opportunity cost of holding capital from now
(year 0) until the year when income is received or the outgo is spent. The
opportunity cost can either be how much you would have earned
investing the money someplace else, or how much interest you would
have had to pay if you borrowed money. See the interactive lecture on
discounting future income for more explanation. That tutorial has a
nifty spreadsheet setup for calculating present values that you can copy
and use in your own spreadsheet.

The word "net" in "net present value" indicates that our calculation
includes the initial costs as well as the subsequent profits. It also
reminds
us that all the amounts in the income stream are net profits, revenues
minus cost. In other words, "net" means the same as "total" here.

The net present value of an investment tells you how this investment
compares either with your alternative investment or with borrowing,
whichever applies to you. A positive net present value means this
investment is better. A negative net present value means your
alternative investment, or not borrowing, is better.

Consider again this income stream:

Year 0 1 2 3 4 5 6

Income - $20 $20 $20 $20 $20 $20

amounts $100 0 0 0 0 0 0
0
Let's assume that the discount rate (the interest rate that you could earn
elsewhere or at which you could borrow) will not change over the life of
the project. This makes the calculation simpler. With this assumption, we
can use the usual formula:
Present Value of any one income amount = (Income amount) / ( (1 +
Discount Rate) to the a power)
a is the number of years into the future that the income amount will be
received (or spent, if the income amount is negative).
The net present value (NPV) of a whole income stream is the sum of these
present values of the individual amounts in the income stream. If we still
assume that income comes or goes in annual bursts and that the discount
rate will be constant in the future, then the NPV has this formula:

Varying future interest rates

The future interest rate does not have to be constant for this theory to
apply. The interest rate can vary, but that makes the formulas messier.
For example, if r1 is the expected interest rate next year, and r2 is the
expected interest rate the year after that, then the present value today
of I2 income in year 2 is
I2/(1+r1)(1+r2).

The I 's are income amounts for each year. The subscripts (which are also
the exponents in the denominators) are the year numbers, starting with
0, which is this year. The discount rate -- assumed to be constant in the
future -- is r. The number of years the investment lasts is n.

Three properties of the net present value of an income stream are:

1. Higher income amounts make the net present value higher. Lower
income amounts make the net present value lower.
Try it yourself. Click on a box in the Income row. Edit the number there, deleting or adding some
digits. Then press Enter.

The NPV box on the right shows the net present value, which is the total of the amounts in the
boxes in the Discounted row. (The total may be slightly off, due to rounding.)

2. If profits come sooner, the net present value is higher. If profits come
later, the net present value is lower.
Try it yourself. This applet lets you move the income amounts to later or earlier. You can see how
that changes the net present value of the income stream.

3. Changing the discount rate changes the net present value. For an
investment with the common pattern of having costs early and profits
later, a higher discount rate makes the net present value smaller.

Try it yourself. Click on the discount rate box and change the number there. Then press Enter.
You can also change the income amounts, if you want.

To summarize what was just illustrated, the net present value is higher if
the income amounts are larger, or if they come sooner, or if the discount
rate is lower. The net present value is lower if the income amounts are
smaller, or if they come later, or if the discount rate is higher.
Internal Rate of Return
In the example we've been using, if you keep the income amounts at their
original -1000, 200, 200, 200, 200, 200, and 200, and set the discount
rate to 0.0547, the net present value becomes 0. This discount rate,
0.0547 or 5.47%, is the internal rate of return for this investment -- it is
the discount rate that makes the net present value equal 0. You can try
this below, by setting the discount rate to 0.0547.

If you now raise any of the income amounts in years 1 through 6 (feel free
to edit an income amount and see for yourself), you will need a higher
discount rate to bring the net present value back to 0. That would seem
to imply that projects with higher incomes have higher internal rates of
return.

Similarly, if you lower any of the income amounts in years 1 through 6,

then a lower discount rate will be needed to bring the net present value
back up to 0. That would seem to imply that projects with lower incomes
have lower internal rates of return.
These seeming implications are actually often true, if the projects being
compared have about the same shape, with the costs coming early and
the benefits coming late, and if the projects being compared switch from
net outgo to net income at about the same time. Otherwise, though, the
implications might not be true.
Before we go on to that, a little review:
Which of these measures (net present value and internal rate of return)
requires you to know the future income and outgo amounts?

Which of the measures requires you to know what the discount rate will
be in the future?

Please do not scroll down past this area until you have
answered the question.

The text
resumes
here:

The internal rate of return does not require you to predict future
discount rates. That would seem to make the internal rate of return the
more useful (or less uncertain) measure. Sometimes, though, the
internal rate of return can fool you.
Contradictory Results
A few years ago, the New England Journal of Medicine published a study
that evaluated various types of professional education as if they were
financial investments.

The article is: Weeks, W.B., Wallace, A.E., Wallace, M.M., Welch, H.G.,
"A Comparison of the Educational Costs and Incomes of Physicians and
Other Professionals," N Engl J Med, May 5, 1994, 330(18), pp. 1280-1286.

The idea was to see if doctors were overpaid, by considering primary and
specialty medical education as investments and comparing them with
investing in education in business, law, and dentistry (but not university
professors -- that would have been too embarassing). Adjustments were
made for differences in average working hours. The authors found that
primary medicine was the poorest investment of all of these. Specialty
medicine did better, but was not out of line with the other professions.
In the results was this oddity: By the criterion of the net present value of
lifetime educational costs and income benefits, specialist physicians tied
for highest with attorneys. Both were ahead of business school
graduates. However, by the criterion of the internal rate of return,
specialty physicians, with a 21% average return, were well behind the
attorneys' 25% average return, while the business school graduates' 29%
average return was the highest of all. The present value and the internal
rate of return ranked the alternatives differently!
By the way, since this article's 1994 publication, managed care has forced
specialty physician incomes down by perhaps one-third. This has sharply
lowered the investment value of a specialty medical education.
The NPV Curve
One way to understand how the net present value and the internal rate of
return can give seemingly different advice is to use what I will call the
net present value curve, or NPV curve. The NPV curve shows the
relationship between the discount rate and the net present value for a
range of discount rates. The present value at a given discount rate, such
as 5%, and the internal rate of return are each points on the NPV curve.

The NPV curve, the relationship between the discount rate and the net
present value has a formula that can be written like this:

This, of course, is the formula we saw already for the net present value,
for annualized costs and revenues and a constant discount rate. Each I is
an income amount for a specific year. The subscripts (which are also the
exponents in the denominators) are the year numbers, starting with 0,
which is this year. The constant discount rate is r. The number of years
the investment lasts is n. In Weeks's study of professionals'
incomes, n was about 44, because costs and incomes were calculated
from age 21 to age 65.
We'll use an example with an n of 6, so the formula fits on your screen:

This is our machine investment example that we have been using all
along. The NPV is a function of r. Graphed, it looks like this:
The blue curve shows the net present value for discount rates (r) from 0
to 0.1 (0% to 10%). The red dots are the two points we get from our
measures. The left red dot shows the net present value at the discount
rate of 0.05 (5%). The right red dot shows the internal rate of return,
because it is where the curve crosses the horizontal line indicating an
NPV of 0. That right red dot is between the 0.05 and 0.06 marks on
the r axis, so the internal rate of return is between 0.05 and 0.06. (The
actual internal rate of return is about 0.0547, as we saw earlier.)
Imagine we have another possible investment, which has this NPV
equation:

This investment is like the first, except that the net profit in years 1
through 6 is $220 per year, rather than $200. I would say that this
investment has a similar "shape" to the first, because the costs and profits
come at the same times. Also, the size of the initial outlay is the same
for both. The only difference is the amount of profit. Here's a graph
with both investments on it:
The green curve is the second investment. It is above and parallel to the
first investment's blue curve. The left orange dot shows the net present
value of the second investment at the discount rate of 0.05. The net
present value there is a little over $100. This is higher than the left red
dot, so the net present value at r=5% of the green-line investment is
higher than the net present value at r=5% for the blue-line investment.
The right orange dot shows where the second investment's curve crosses
the NPV=0 line. This is well to the right of the first investment's internal
rate of return dot. The internal rate of return for the second investment
is much higher (further to the right).
In this example, our two measures, the net present value at r=0.05 and
the internal rate of return, tell us the same thing. They both say the
second investment is better. A look at the graph above confirms that the
second investment is better at all discount rates, so it is fair to say that
the second investment is unequivocably better than the first.
Can You Do Both Investments?
Doing an investment increases your wealth if its net present value is
greater than 0 at the discount rate relevant to you. If your discount rate
is less than 5.47%, both NPV curves are in positive territory, and you
should do both, if you can.

Sometimes, though, the alternative investments are mutually exclusive.

For example, there may be two ways to build a dam across a particular
river. You can do one or the other, but not both. There may be several
alternative ways to address a workplace safety problem. There is no
point to doing more than one if any one way solves the problem.
Deciding on a professional education involves somewhat mutually
exclusive choices. A few people do go to medical school and then law
school, but the additional return from the second degree is not the same
as what someone going to law school fresh out of college would expect.
If you can only do one investment, you should choose the one with the
highest net present value at the discount rate appropriate to you. A
problem with that advice, though, is that discount rates can change with
general economic conditions. You are therefore more confident about
choosing one investment over another if your chosen investment has a
higher net present value over a broad range of possible discount rates. In
our example so far, the green-line investment has a higher net present
value at all discount rates, so we would choose it with confidence.
Regardless of what happens in the future to discount rates, we'll be
better off with the green-line investment than with the blue-line
investment.
Can NPV Curves Cross?
Yes, they can. If the NPV curves cross, then the choice of investment
depends on the discount rate.

To create an example, I'll change the blue line investment so that its
profits come much later. This increases the effect of the discount rate
on the net present value. Below are the two income streams, now. Also
shown are their net present values at a 5% discount rate and their
internal rates of return.
Year 0 1 2 3 4 5 6 NPV at 0.05 Internal
discount rate of
rate return

Green line - $22 $22 $22 $22 $22 $220 $117 0.086
investment $100 0 0 0 0 0
0

Blue line - $0 $0 $0 $0 $0 $155 $157 0.076

investment $100 0
(modified) 0

The green line invesment has the higher internal rate of return, but the
blue line investment has the higher net present value at a 5% discount
rate. Our two measures are giving us opposite advice!
The graph shows what's going on, by showing the Net Present Value
curves for both investments for discount rates between 0% and 10%. The
curves cross at a discount rate of about 0.064, or 6.4%.
Now, to choose which investment we want to do, assuming we cannot do
both, we have to make a guess about what future discount rates will be.
If we expect discount rates to be less than 6.4%, where the curves cross,
we choose the blue line investment. For discount rates above 6.4%, but
below 8.56% (the internal rate of return of the green line investment --
the discount rate at which the net present value of the green line
investment is $0), we choose the green line investment. At higher
discount rates than 8.56%, we don't do either, because the net present
values are below $0 for both investments.
If Costs Come Later Than Profits
If costs come later than profits, the NPV curve can tilt the other way,
making it even more problematic to use the internal rate of return to
compare investments.

Costs can come later than profits if an investment creates environmental

problems that will have to watched or cleaned up later. Nuclear power
plants are a good example. After about 40 years of service (sometimes
less than that), they become too contaminated with radiation to continue
in service. They must then be closed and either guarded where they are
for thousands of years or dismantled and moved to a disposal site.
Consider this income stream:
Year 0 1 2 3 4 5 6

Income - $20 $20 $20 $20 $20 -

amounts $20 0 0 0 0 0 $90
0 0

I've reduced the initial cost, but added a big cost at the end. Let's see
what a difference this makes in how the NPV changes when the discount
rate changes. In the applet below, the starting discount rate 5%. The
net present value (NPV) is -$6. That's negative six dollars, so if your
discount rate really were 5%, you would not want to do this investment.
Try changing the discount rate, by clicking in the discount rate box and
changing the 0.05 to something else. Try 0.04 or 0.03. In the examples
above, the NPV goes up when the discount rate is lowered. Is that true
for this project? Then try 0.06 or 0.07. What happens to the NPV?

(Keep the discount rates reasonably small, like between 0.00, which is
0%, and 0.3, which is 30%.)
The relationship between the discount rate and the NPV is the reverse of
what we see with "normal" investments! With this kind of income stream,
higher discount rates make the net present value bigger, and lower
discount rates make the net present value smaller.
Before leaving the applet above, see if you can find the internal rate of
return, the discount rate that makes the net present value equal to $0.
Here is the NPV graph:

The left blue dot shows the net present value at a 5% (0.05) discount
rate. It is at -$6 on the net present value scale.
The right blue dot is where the curve crosses the discount rate axis,
which is where the net present value is $0. The discount rate here, 0.054
(5.4%), is the internal rate of return.
Or, at least, it fits the standard definition of internal rate of return.
However, unlike the usual situation, this project is profitable at interest
rates above this IRR and unprofitable at interest rates below this IRR.
Suppose we have an alternative project which also has this shape, with a
big cost at the end, but slightly lower profits in the intermediate years.
I'll call the new alternative the "green line investment."

Year 0 1 2 3 4 5 6 NPV at 0.05 Internal

discount rate of
rate return

Red line - $20 $20 $20 $20 $20 - -$6 0.054

investment $20 0 0 0 0 0 $90
0 0

Green line - $19 $19 $19 $19 $19 - -$27 0.070

investment $20 5 5 5 5 5 $90
0 0

The green line investment has a lower NPV than the red line investment
at all discount rates, because it has lower profits in years 1 through 5,
and the same costs in years 0 and 6. In particular, as the table above
indicates, it has a lower NPV at the 0.05 discount rate. The graph below
shows the NPV curves for both investments, with the green line lying
below the red line at all discount rates.

The green line investment is clearly inferior, but it has the higher internal
rate of return. The green line investment's IRR is 0.07. The red line
investment's is 0.054.
Thus, for projects with big late costs, the better projects will have lower
internal rates of return, the opposite of the rule for normal projects that
have their costs early and their positive returns later.
Now let's discover something even more strange. Here's another applet
that lets you change the discount rate and see the effect on the red line
investment's value. This one, though, allows you to take the discount
rate over 0.3 (30%) and all the way up to 1.0 (100%). Those rates are
much higher than, hopefully, we will ever see in the U.S., but they are
theoretically possible, and they show a strange phenomenon.
Try raising the discount rate to 0.3, and notice what happens to the net
present value. Then, raise the discount rate some more above that. In
which direction does the NPV move now?

See if you can find the second IRR, where the NPV is zero again!
Please do not scroll down past this area until you have
answered the question.

The text
resumes
here:

Here's the NPV curve for the red line investment for discount rates from
0% to 100%.

At discount rates below 0.054, the NPV is negative, and this investment is
worse than doing nothing.
At a discount rate of 0.054, the NPV is 0. The first IRR for this investment
is 0.054.
If the discount rate rises above 0.054, the NPV turns positive, and this
investment switches to being profitable.
At a discount rate of 0.262 (26.2%), the NPV for this investment reaches
its maximum. If the discount rate rises further than that, the NPV falls.
The NPV reaches 0 again at a discount rate of 0.86. This is the second IRR
for this investment.
If the discount rate were rises even more, above 0.86, the NPV turns
negative again. This investment reswitches to being unprofitable.
Lesson: The NPV curve gives better guidance than the IRR alone
The lesson I would like you to get from this is that the internal rate of
return, by itself, can fool you. If the investments you are considering
have different shapes (that is, very different timing of costs and benefits)
or if the project has large late cleanup costs, then the higher-IRR-is-
better rule can steer you to the wrong investment. Ideally, you want the
NPV curve, if you want to evaluate an investment.
Additional notes
My use of the terms "switch" and "reswitch" refers to the reswitching
controversy of the 1960's. This was between economists in Cambridge,
England, and Cambridge, Massachusetts, over whether capital markets
can be analyzed just like other commodity markets. The English
economists, led by Joan Robinson, argued that capital markets were
special because of the possibility of reswitching, which raises basic
questions about the standard view that the return to owning capital is a
society's reward for abstaining from consumption.

Some economists would say that only the second of our IRR's is the true
IRR, by defining the IRR as the place where the NPV is 0 and where the
NPV is falling. The problems with that are: (1) this distinction is usually
lost in practice, and (2) by making the pattern of costs and profits more
complex, I can make up an investment that has multiple discount rates
where the NPV is 0 and the NPV is declining.
The oldest discussion of this tutorial's issues that I have found in the
economics literature is Lorie JH, Savage LJ, "Three Problems in Capital
Rationing," Journal of Business, Vol. 28, October 1955.

That's all for now. Thanks for participating! Your comments would be
appreciated! E-mail: sam.baker@sc.edu
http://hspm.sph.sc.edu/Courses/Econ/Invest/invest.html
 The views and opinions expressed in this page are strictly those of the
page author. The contents of this page have not been reviewed or
approved by the University of South Carolina.

Calculate NPV and IRR in Excel

Applies to: Microsoft Office Excel 2003
Print

APPLIES TO

Microsoft Office Excel 2003

Have you been losing sleep figuring out the best way to maximize profitability and minimize risk on your business
investments? Stop tossing and turning. Relax and go with the flow.

Cash, that is. Take a look at your cash flow, or what goes into and what goes out of your business. Positive cash
flow is the measure of cash coming in (sales, earned interest, stock issues, and so on), whereas negative cash
flow is the measure of cash going out (purchases, wages, taxes, and so on). Net cash flow is the difference
between your positive cash flow and your negative cash flow, and answers that most fundamental of business
questions: How much money is left in the till?

To grow your business, you need to make key decisions about where to invest your money over the long term.
Microsoft Excel can help you compare options and make the right choices, so you can rest easy both day and
night.

Asking questions about capital investment projects

If you want to take your money out of the till, make it working capital, and invest it in the projects that make up
your business, you need to ask some questions about those projects:

• Is a new long-term project going to be profitable? When?

• Is my money better invested in another project?

• Should I invest even more in an ongoing project, or is it time to cut my losses?

Now take a closer look at each of those projects, and ask:

• What are the negative and positive cash flows for this project?

• What impact will a large initial investment have, and how much is too much?

In the end, what you really need are bottom-line numbers you can use to compare project choices. But to get
there, you must incorporate the time value of money into your analysis.
My papa once told me, "Son, it's better to get your money as soon as possible and hold on to it as long as
possible." Later in life, I learned why. You can invest this money at a compounded interest rate, which means
your money can make you more money — and then some. In other words, when cash goes out or comes in is
just as important as how much cash goes out or comes in.

Answering questions by using NPV and IRR

There are two financial methods you can use to help you answer all these questions: net present value (NPV)
and internal rate of return (IRR). Both NPV and IRR are referred to as discounted cash flow methods because
they factor the time value of money into your capital investment project evaluation. Both NPV and IRR are based
on a series of future payments (negative cash flow), income (positive cash flow), losses (negative cash flow), or
"no-gainers" (zero cash flow).

NPV
NPV returns the net value of the cash flows — represented in today's dollars. Because of the time value of
money, receiving a dollar today is worth more than receiving a dollar tomorrow. NPV calculates that present
value for each of the series of cash flows and adds them together to get the net present value.

The formula for NPV is:

Where n is the number of cash flows, and i is the interest or discount rate.

IRR
IRR is based on NPV. You can think of it as a special case of NPV, where the rate of return calculated is the
interest rate corresponding to a 0 (zero) net present value.

NPV(IRR(values),values) = 0
When all negative cash flows occur earlier in the sequence than all positive cash flows, or when a project's
sequence of cash flows contains only one negative cash flow, IRR returns a unique value. Most capital
investment projects begin with a large negative cash flow (the up-front investment) followed by a sequence of
positive cash flows, and, therefore, have a unique IRR. However, sometimes there can be more than one
acceptable IRR, or sometimes none at all.

COMPARING PROJECTS
NPV determines whether a project earns more or less than a desired rate of return
(also called the hurdle rate) and is good at finding out whether or not a project is
going to be profitable. IRR goes one step further than NPV to determine a specific
rate of return for a project. Both NPV and IRR give you numbers that you can use to
compare competing projects and make the best choice for your business.
Choosing the appropriate Excel function

What Excel functions can you use to calculate NPV and IRR? I thought you'd never ask. There are five: NPV,
XNPV, IRR, XIRR, and MIRR. Which you choose depends on the financial method you prefer, whether or not
cash flows occur at regular intervals, and whether or not the cash flows are periodic.

NOTE Cash flows are specified as negative, positive, or zero values. When you use these functions, pay
particular attention to how you handle immediate cash flows that occur at the beginning of the first period and all
the other cash flows that occur at the ends of periods.
FUNCTION SYNTAX USE WHEN COMMENTS
YOU WANT TO

NPV(rate,value1, value2, …) Determine the net Each cash flow, specified

present value as a value, occurs at the
using cash flows end of a period.
that occur at If there is an additional
cash flow at the start of
regular intervals, the first period, it should
such as monthly or be added to the value
annually. returned by the NPV
function. See Example 2
in theNPV Help topic.
XNPV(rate,values, dates) Determine the net Each cash flow, specified
present value as a value, occurs at a
using cash flows scheduled payment date.
that occur at Requires the Analysis
ToolPak add-in.
irregular intervals.

IRR(values, guess) Determine the Each cash flow, specified

internal rate of as a value, occurs at the
return using cash end of a period.
flows that occur at IRR is calculated through
an iterative search
regular intervals, procedure that starts with
such as monthly or an estimate for IRR —
annually. specified as aguess —
and then repeatedly
varies that value until a
correct IRR is reached.
Specifying
a guessargument is
optional; Excel uses 10%
as the default value.
If there is more than one
acceptable answer, the
IRR function only returns
the first one it finds. If the
IRR doesn't find any
answer, it returns a
#NUM! error value. Use
a different value for
the guess if you get an

XIRR(values,dates, guess)
MIRR(values,finance_rate,reinvest_rate)
error or if the result is not
what you expected.
NOTE A different
guess might return a
different result if there is
more than one possible
internal rate of return.
Determine the Each cash flow, specified
internal rate of as a value, occurs at a
return using cash scheduled payment date.
flows that occur at XIRR is calculated
through an iterative
irregular intervals. search procedure that
starts with an estimate
for IRR — specified as
aguess — and then
repeatedly varies that
value until a correct
XIRR is reached.
Specifying
a guessargument is
optional; Excel uses 10%
as the default value.
If there is more than one
acceptable answer, the
IRR function only returns
the first one it finds. If the
IRR doesn't find any
answer, it returns a
#NUM! error value. Use
a different value for
the guess if you get an
error or if the result is not
what you expected.
NOTE A different
guess might return a
different result if there is
more than one possible
internal rate of return.
Requires the Analysis
ToolPak add-in.
Determine the Each cash flow, specified
modified internal as a value, occurs at the
rate of return using end of a period, except
cash flows that the first cash flow, which
specifies avalue at the
occur at regular beginning of the period.
intervals, such as The interest rate you pay
monthly or on the money used in the
annually, and cash flows is specified
consider both the in finance_rate. The
cost of investment interest rate you receive
on the cash flows as you
and the interest
reinvest them is specified
received on the inreinvest_rate.
 reinvestment of
cash.

More information

To learn more about using NPV and IRR, see Chapter 8, "Evaluating Investments with Net Present Value
Criteria," and Chapter 9, "Internal Rate of Return," inMicrosoft Excel Data Analysis and Business Modeling by
Wayne L. Winston. Visit Microsoft Learning to learn more about this book

There are two financial methods you can use to help for evaluation of a project:
net present value (NPV) and internal rate of return (IRR). Both NPV and IRR
are referred to as discounted cash flow methods because they factor the time
value of money into capital investment project evaluation. Both NPV and IRR
are based on a series of future payments (negative cash flow), income (positive
cash flow), losses (negative cash flow), or "no-gainers" (zero cash flow).

NPV
NPV returns the net value of the cash flows — represented in today's rupees.
Because of the time value of money, receiving a rupee today is worth more than
receiving a rupee tomorrow. NPV calculates that present value for each of the
series of cash flows and adds them together to get the net present value.

IRR
IRR is based on NPV. You can think of it as a special case of NPV, where the
rate of return calculated is the interest rate corresponding to a 0 (zero) net
present value.

COMPARING PROJECTS
NPV determines whether a project earns more or less than a desired rate of
return (also called the hurdle rate) and is good at finding out whether or not a
project is going to be profitable. IRR goes one step further than NPV to
determine a specific rate of return for a project. Both NPV and IRR give you
numbers that you can use to compare competing projects and make the best
choice for your business.

Active vs. Passive Stock Investing

Passive stock investing is the strategy of buying stocks and hanging on to them.
In contrast, active stock investing involves buying and selling stocks on a
regular basis.
Before choose an active or passive strategy, investing in stocks requires an
honest self-assessment. Ask:
What do you want from your investments?
How much attention will you pay them?
How good is your judgment?
What's your tolerance for risk?
Passive investing relies on the fact that over time the market has always gone
up. If you're not passionately interested in the stock market and you're investing
mainly for retirement, a passive strategy may be your best bet.
Passive investing can deliver a decent return in the long run with a minimum of
involvement. Two things are critical to this strategy:
Choose stocks that have good potential to increase steadily in value over the
term of your investment.
Select a diversified portfolio, so you're not tied to the fate of one particular
company or market sector. Consider adding instruments such as bonds, which
tend to go up in value when stocks are going down, as a hedge.
Passive investors regard short-term fluctuations in stock prices as minor
compared to long-term growth, they still can't just pick a portfolio and forget
about it. Even passive investors should re-evaluate the performance of their
stocks periodically and respond to long-term market changes.
Active investing takes advantage of those short-term fluctuations in the market.
Pursuing an active approach takes a lot more time and involves more risk. Most
active traders check on the prices of their stocks several times each day!
Active traders hope to "outperform the market" by exploiting minor ups and
downs — picking up stocks that are experiencing temporary drops in value at
reduced prices, and selling them when they're on their way up again.
Active investing can feel a lot more like gambling, where quick decisions can
have major consequences. If your reason is often overwhelmed by your
emotions, active investing probably won't work well for you.