Net Present Value discounts a series of future cash flows back to today's dollars using a chosen discount rate, then subtracts the initial investment — a positive NPV means the investment creates value. Internal Rate of Return (IRR) is the discount rate at which NPV equals exactly zero.
Why It Matters
NPV and IRR are the two standard yardsticks for capital budgeting and investment decisions across corporate finance and private equity — a positive NPV project should be accepted (given the assumptions hold), and IRR lets investors compare very differently-sized and differently-timed opportunities on a common percentage basis, which is why it's the headline return metric LPs use to evaluate fund performance.
How It Works in Practice
- 1Project the expected cash flows an investment will generate over its life
- 2Discount each cash flow back to present value using the appropriate discount rate (often WACC for corporate projects)
- 3NPV = sum of discounted cash flows − initial investment
- 4IRR is found by solving for the discount rate that makes NPV = 0 (typically computed iteratively, not algebraically)
Common Pitfalls
IRR implicitly assumes interim cash flows are reinvested at the same IRR, which is often unrealistic — Modified IRR (MIRR) corrects for this
IRR can be gamed by timing (a fund that returns capital early and recycles it into new deals can post a high IRR on a modest multiple of invested capital — always check IRR alongside MOIC/multiple)
Comparing projects by IRR alone ignores scale — a small project with a very high IRR may create far less absolute value than a large project with a lower one