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IRR Vs payback vs NPV

Posted: Sat Jun 02, 2018 7:02 pm
by ya3thane
Pl clarify in simplest way.

Re: IRR Vs payback vs NPV

Posted: Mon Jun 04, 2018 7:00 am
by seema.sonkiya
let's first start with understanding of time value of money.

Time value of money: The money you get in 5 years isn't worth as money you get today.
If you have an option to get USD 5000 today and another option is getting the same amount after two years, definitely you will choose option one.

Because you need to calculate money after two years in present value by a discount rate. You can deposit that USD 5000, and after two years you can get interested out of it.
You can calculate the present value of money by FV/ (1+i)^n

i = discount rate
n = period
FV = Future Cash Inflow/ outflow

It is the value in today time of the future cash flow.

You calculate the present value of all future cash flow of all available options to decide which option is better. Higher the PV the better the investment.

This PV calculation can be used as a base for calculating the Net Present Value.

Then what is NPV: It is a measure of how much money a project can be expected to return (in today's present value)

It is the sum of inflow and outflow in present value term (discounted based on duration)

it considers multiple cash inflows and outflows which are brought to the present value term to see what is net present value by summing up all inflows and outflows (in minus form)

A negative value indicates that we are losing money. Higher the PPV better the initiative.

Now come to the IRR: IRR is a measure of how quickly the money invested in a project will increase in value. It is the rate of return which is calculated based on inflow and outflows.

While calculating IRR, we assume one discount rate, and on that basis, we calculate the end value of the project. To calculate the rate, we need to compute the rate which equalizes the inflow and outflow. It means we calculate at what particular rate NPV becomes zero. It's like if I discount cash inflow and outflow(bring in present value term) both of them become equalize that is the rate of return I am getting from this investment.

Payback period: Time required to get the initially invested amount back. Smaller is better, earlier we get money, better it is. It is the time when cost and benefit become equal. You need to calculate how money is flowing back.