Question

How can a company utilize tools like NPV and IRR to optimize decisions about which projects to invest in? Why is this particularly important when cash flows are earned over many years, and especially when the cash flows are uneven? How can different degrees of risk among projects be factored into the decision? How so we optimize the value of our proposed capital investments if (a) there is a set maximum amount of capital dollars to be invested vs. (b) there is no theoretical maximum and potentially all projects which “make financial sense” could be funded?

Answer 1

It’s impossible to understand the concept of IRR without understanding net present value (NPV), so let’s begin with NPV. The cash that we have today is more valuable than the cash that we will receive after five years due to inflation. Hence, when you decide to invest money each year, you need to first check how much that money is worth today. This is called net present value of money.

Assume your friend tells you about a project ‘A’ in which you invest Rs. 10 lakh today and from next year the project will start generating cash flows without any further investment. The below table provides information on the money invested today and the cash flows generated in future.

Number of years & cash flows

Period	Project A
Today	Rs. -10 lakh
Year 1	Rs. 2 lakh
Year 2	Rs. 3 lakh
Year 3	Rs. 3 lakh
Year 4	Rs. 3.5 lakh
Year 5	Rs. 3.5 lakh
Total of cash flows	Rs. 15 lakh

You surely want to know whether project ‘A’ is worth investing, than depositing money with banks. To compare benefits, you need to find out the net present value (NPV) of these cash flows. Assume IRR is around 8% for project ‘A’. IRR is also called discount rate. To calculate NPV of this project, discount each cash flow with IRR keeping in mind the time lapse. The formula to compute NPV is cash flow / discount rate + 1^N. The term ‘N’ stands for the number of years

Compute NPV

Period	Project A	Discount rate	NPV* (Rs)
Today	Rs. -10 lakh	8%	(10 lakh)
Year 1	Rs. 2 lakh	8%	1,85,185
Year 2	Rs. 3 lakh	8%	2,57,202
Year 3	Rs. 3 lakh	8%	2,38,150
Year 4	Rs. 3.5 lakh	8%	2,57,260
Year 5	Rs. 3.5 lakh	8%	2,38,204
Total of cash flows			11,76,001

NPV = Cash flow / discount rate + 1^N

The above table shows that project ‘A’ has an NPV of Rs. 11.76 lakh, while you are investing Rs. 10 lakh today. This shows that the project ‘A’ is not worth investing as the value of its cash flows today is Rs. 11.76 lakh—which is Rs. 1.76 lakh extra than what you are investing today (Rs. 10 lakh). NPV should always be more than zero i.e. the project is giving us more returns than the money invested today.

What is IRR?

Internal rate of return or IRR is that rate of return at which NPV from the above investment & cash flows will become zero. IRR is the rate of interest that makes the sum of all cash flows zero, and is useful to compare one investment to another.

IRR is usually used to calculate the profitability of investments made in a financial product or projects. Higher the IRR, the more profitable it is to invest in a financial scheme or project. Assume all financial products require the same amount of up-front investment, the product with the highest IRR would be considered the best. Of course, one also needs to understand the risk factors before investing.

a) If there is set maximum amount of capital dollars to be invested: Amount should be invested only in the projects where NPV is maximum considering the constrains of amount to be invested.

b) If there is no theoretical maximum and potentially all projects could be funded, the project with maximum IRR should be considered.