What is the difference between NPV and IRR?

What is the difference between NPV and IRR?

NPV (Net Present Value) calculates the value of future cash flows in today's terms, while IRR (Internal Rate of Return) is the discount rate that makes the NPV of all cash flows equal to zero.

Which one is better to use for investment decisions?

It depends on the context. NPV provides a dollar amount that indicates how much value an investment adds, while IRR gives a percentage return. Generally, NPV is preferred for its clarity.

Can you give an example of how to calculate NPV?

Sure! To calculate NPV, you subtract the initial investment from the present value of future cash flows, discounted at a specific rate. For example, if you invest $1,000 and expect $300 annually for 5 years at a discount rate of 10%, you would calculate the present value of those cash flows and subtract $1,000.

What are the limitations of using IRR?

IRR can be misleading if cash flows are non-conventional (i.e., alternating between positive and negative) or if there are multiple IRRs. It also assumes reinvestment at the IRR rate, which may not be realistic.