The internal rate of return (IRR) and the net present value (NPV) are both discounted cash flow techniques or models. This means that each of these techniques looks at two things: 1) the current and future cash inflows and outflows (rather than the accrual accounting income amounts), and 2) the time at which the cash inflows and outflows occur. In other words, these models consider the time value of money: a dollar today is more valuable than a dollar in one year, a dollar received in three years is more valuable than a dollar received in five years, and so on.
The internal rate of return or IRR is the rate that will discount all cash inflows and outflows to a net present value of $0. In other words, the IRR model provides you with the true, effective interest rate being earned on a project after taking into consideration the time periods when the various cash amounts are flowing in or out. If you use present value tables to calculate the internal rate of return, it will require some trial and error or iterations to determine the exact rate the project is earning. Software or some financial calculators will provide a quicker and more accurate answer.
The net present value (NPV) discounts all of the cash inflows and outflows by a specified interest rate. The net amount of all of the discounted amounts is the net present value. If the net present value is $0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value means the project is expected to earn less than the specified interest rate.
After working as an accountant, consultant, and university accounting instructor for more
than 25 years, Harold Averkamp formed AccountingCoach.com in 2003. His goal was to
share his knowledge and passion for teaching accounting and with people throughout the
world at a very low cost. Read More...