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Discounted Cash Flow vs IRR

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow vs IRR

A lot of people get confused about discounted cash flow vs IRR and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a project’s estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact, the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

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discounted cash flow vs irr

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NPV vs IRR

See also:
Net Present Value Method
NPV Versus Payback Method
Internal Rate of Return Method
Capital Budgeting Methods
Discount Rate
Weighted Average Cost of Capital
Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

NPV vs IRR

Key differences between the most popular methods, NPV vs IRR (the Net Present Value Method and Internal Rate of Return Method), include the following:

NPV Method

Calculate NPV in terms of currency. Then express IRR in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.


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Other Variations of NPV vs IRR

Adjusted Present Value (APV)

The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields. Furthermore, it is designed for firms with active debt and a consistent market value leverage ratio.

Profitability Index (PI)

The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment. This method tends to favor smaller projects. Therefore, it is best used by firms with limited resources and high costs of capital.

Bailout Payback Method

The Bailout Payback Method is a variation of the Payback Method. Furthermore, it includes the salvage value of any equipment purchased in its calculations.

Real Options Approach

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

ROCE

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NPV vs IRR

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Internal Rate of Return Method

See also:
Internal Rate Of Return Example
NPV versus IRR
Owner’s Equity
Net Present Value (NPV) vs Payback Method
Cost of Capital
Valuation Methods

Internal Rate of Return Method Definition

The Internal Rate of Return method is the process of applying a discount rate that results in the present value of future net cash flows equal to zero. This is the base internal rate of return calculation formula and will be described later in this wiki. Internal rate of return assumes that cash inflows are reinvested at the internal rate. Investment projects with a return greater than the cost of capital or hurdle rate should be accepted. The greater the internal rate of return the more attractive the investment. Below is the IRR hurdle rate comparison.

IRR > hurdle rate, accept the investment
IRR < hurdle rate, reject the investment
IRR = hurdle rate, the investment is marginal

The internal rate of return meaning is described in more detail below.

Internal Rate of Return Method Explanation

Internal Rate of Return is a method to compare and evaluate different investments based on their cash flows. A proper internal rate of return calculation provides an interest rate equal to the total gains expected from a given investment. After discovering the internal rate of return for one project other IRRs can be compared in order to find the most valuable investment choice. Additionally, one compares an internal rate of return to the weighted average cost of capital of a project to decide whether the investment will create profit. IRR also accounts for the time value of monetary gains. It is generally used to evaluate a series of cash flows but can also be applied for other needs. Many equity investors, including angels and venture capitalists, have a required rate of return which must be met or exceeded by the IRR of a company seeking investment. This ensures the investment warrants the associated risk and will provide the cash flows necessary for profit.

Internal Rate of Return Formula

The internal rate of return formula can be found algebraically by using the Net Present Value formula below. In this:

NPV = (CF 1 / (1 + r) ^1) + (CF 2 / (1 + r)^2) + (CF 3 / (1 + r) ^ 3) + …

Where:
NPV = Net Present Value
CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc.
r = The Rate of Return

The rate of return (r) for which NPV = 0 is the internal rate of return calculator. So, if:

0 = (Cash flow in period 1 / (1 + IRR) ^1) + (Cash flow in period 2 / (1 + IRR)^2) + (Cash flow in period 3 / (1 + IRR) ^ 3) + …

Where:
NPV = Net Present Value
CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc.
IRR = Internal Rate of Return

Internal rate of return can be found algebraically using this method as the IRR calculator. Below is a common internal rate of return calculation example.

Internal Rate of Return Method

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Internal Rate of Return Method

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Internal Rate Of Return Example

See Also:
Internal Rate of Return Method
Discounted Cash Flow vs. IRR
NPV vs IRR
Required Rate of Return

Internal Rate of Return Example

An internal rate of return example is quite common in capital markets. The internal rate of return example below will be seen by anyone seeking angel, venture capital, equity mezzanine, or other forms of Owner’s Equity.

For example, Techco has developed a revolutionary online shopping cart for e-commerce. It believes that, with an investment for marketing expenses, the company concept can be quickly grown to profitability.

Capco is a venture capital firm that invests in early-stage companies that serve the business to business market. Furthermore, Capco invests only in companies with an existing product and an expectation of quick return on equity. They use the internal rate of return method and only invest in companies which currently have a rate of return of 30% or more. So, their IRR hurdle is 30%.

Initial Investment -$5000 Cash flow in Year 1 $1,000 Cash flow in Year 2 $3,000 Cash flow in Year 3 $6,000

Techco and Capco had a great first meeting. Techco would love to gain marketing expertise and funding from the Capco team. Capco appreciates the experience of the Techco management team, feels the company concept fits well into their field of interest, and knows that this investment has the growth potential necessary. The only concern is whether Techco can yield the required IRR calculation of 30%.

IRR Calculation

To make the final decision, Techco and Capco run the following IRR formula calculation as an internal rate of return financial calculator:

0 = -$5000 + ($1000 / (1 + IRR) ^1) + ($3,000 / (1 + IRR) ^ 2) + ($6,000 / (1 + IRR) ^ 3)

IRR = 32.979%

Techco and Capco mutually come to the conclusion that Techco’s IRR is 32.979%. As a result, Capco is confident that since Techco’s internal rate of return model is currently above 30%, it will probably grow with additional marketing. Capco and Techco, because of this, decide to become partners.

Private equity markets regularly deal with the above internal rate of return formula example and IRR formula calculation. As a matter of survival, they must have a strong grasp of the IRR definition, IRR formula, and IRR limitations.

Limitations of Internal Rate of Return

The internal rate of return calculation assumes that you will reinvest cash flows each year at a constant rate. For those internal rate of returns that are high (greater than 25%), it is impractical to think that you will find alternative investments at that same higher rate. This limitation is the biggest drawback to using the internal rate of return method. In order to compensate for the high return of the internal rate of return calculation, the Modified Internal Rate of Return (MIRR) was created so that the annual cash flows are reinvested at a lower, more probable reinvestment rate.

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Internal Rate of Return example

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Internal Rate of Return example

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Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow versus Internal Rate of Return

A lot of people get confused about discounted cash flows (DCF) and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a projects estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value. Don’t let the destroyers take money away from you!

Discounted Cash Flow versus Internal Rate of Return

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Discounted Cash Flow versus Internal Rate of Return

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