Net present value and internal rate of return are useful analytical tools. In this video, learn all about them and see how they are related.
- [Instructor] Before I dive into the mechanics of calculating net present value and internal rate of return, I wanted to give you an overview of the two concepts and how they relate. With regard to net present value, let's recall that present value is the value of cash flows that have the following characteristics. They occur at regular intervals. They are all of the same amount. And, they are discounted using the same factor for each period. So in other words, you know that you will get $1,000 every month and that your risk-free rate into which you could invest the funds remains the same.
Net present value is similar, but there are a couple of important differences. The first is that the cash flows can vary in amount. So, instead of giving a single input to a formula, you give a series of cash flows over time. They do however occur at regular intervals. Second is that you must subtract the original investment from your calculation. That's why it's called net present value. The rule of thumb is that any project with a positive NPV is a profitable investment and one that you should continue taking on.
There are limitations of course. You might not have the money to take on every positive NPV investment available to you, in which case you need to choose. It's also possible that the return would be low enough that you would rather eliminate all risk and take the risk-free investment. Internal rate of return is a related concept. NPV reduces the value of future cash flows by a discount rate. Internal rate of return usually just referred to as IRR calculates the break-even discount rate.
In other words, the IRR for project is where the NPV equals zero. So that means if you believe that the IRR is higher than what you can earn through a risk-free investment, you should take on the project. If you can invest in US Treasury bonds for 3% a year but you can make 5% on another project, then you should definitely take on that project. With that context in mind, let's go ahead and move on to calculating NPV and IRR.
- Calculating the effect of interest rates and inflation
- Finding the arithmetic and geometric means of growth rates
- Calculating the future and present value of an investment
- Calculating loan payments for a fully amortized loan
- Calculating the effect of paying extra principal with each payment
- Finding the number of periods required to meet an investment goal
- Calculating net present value and internal rate of return
- Building a cash tracking worksheet
- Visualizing cash flows using a waterfall chart