VAN or IRR? Discover which is the key indicator for your investment decisions

Whenever you have money ready to invest, the same question arises: how to know if it’s really worth it? Two tools dominate the financial world to answer this: the Net Present Value (NPV) and the Internal Rate of Return (IRR). But here’s the tricky part: both can give you contradictory answers. A project may look outstanding with IRR and mediocre in NPV, or vice versa. Which one should you believe? How to choose correctly?

The indicator showdown: NPV vs IRR in real numbers

When comparing investment projects, NPV and IRR are the main players, but they play in different leagues. NPV tells you how many dollars of value you will generate in present terms. IRR, on the other hand, gives you a percentage of profitability. It seems simple, but the consequences of choosing poorly can be costly.

To illustrate: imagine investing $10,000 in a project that promises $4,000 annually for five years, with a discount rate of 10%. The resulting NPV is approximately $2,162, which sounds positive. But what if another project offers an IRR of 15% but a lower NPV? That’s where confusion begins.

Understanding NPV: the money you will actually earn

Net Present Value answers a fundamental question: how much is the cash flow I will receive tomorrow worth today? To calculate it, you take all expected cash flows, apply a discount rate (that reflects risk and opportunity), and subtract your initial investment.

The formula is:

NPV = PV1 + PV2 + … + PVn - Initial Cost

Where each present value (PV) is calculated as: CF / ((1 + Discount Rate)^n

A positive NPV means gains; a negative one, losses. It seems straightforward, but there’s a problem: the discount rate you choose is subjective. Two investors can get radically different NPVs for the same project just by choosing different rates.

) Practical example: when NPV says “no”

Suppose you invest $5,000 in a deposit certificate that will pay $6,000 in three years, with an annual interest of 8%.

PV = $6,000 / ###1.08(³ = $4,775

NPV = $4,775 - $5,000 = -$225

The result is negative. Your initial investment exceeds the present value of future returns, indicating it’s not profitable. Inflation and opportunity cost erode the value of that money.

Deciphering IRR: the percentage that seems to be the answer

The Internal Rate of Return is the percentage return you expect to get. It’s the rate that makes the NPV exactly zero. If it’s higher than your reference rate )for example, the yield of a Treasury bond(, the project is viable.

IRR answers: what is the actual performance of my investment? It’s intuitive because it’s expressed as a percentage, making it easy to compare with other options.

Hidden traps: why NPV and IRR disagree

This is where things get fascinating. NPV and IRR can contradict each other when:

1. Projects have very different sizes: A small project may have a very high IRR but a low NPV. A larger one might invest this.

2. Cash flows are irregular: If there are changes in the pattern of inflows and outflows, IRR can have multiple solutions or none at all.

3. The timing of returns differs: A project that pays quickly vs. one that pays slowly will generate different rankings depending on whether you use NPV or IRR.

Weak points of both tools

Limitations of NPV:

• Fully depends on the chosen discount rate )very subjective(
• Ignores the actual uncertainty of the project
• Does not capture changes in direction during execution
• Biases results if there is significant inflation

Limitations of IRR:

• Can have multiple solutions in unconventional cash flows
• Assumes you will reinvest future flows at the same rate )unrealistic(
• Does not work well with irregular negative flows
• May overestimate profitability in complex scenarios

Which to choose in practice?

The uncomfortable truth is that you shouldn’t choose only one. Professional financial analysts use NPV and IRR together to triangulate decisions. Here’s the practical criterion:

Use NPV when: you want to compare projects of radically different sizes, or need to know the absolute value you will generate.

Use IRR when: you want to compare relative profitability, or need a metric that is independent of the invested capital.

When NPV and IRR contradict each other:

1. Check the discount rate used )Does it truly reflect the risk?(
2. Examine the cash flows )Are they realistic?(
3. Consider other indicators like ROI, payback period, or profitability index
4. Ultimately, prioritize NPV if the decision is critical

Complementary tools to decide with confidence

Other indicators that should be in your toolkit:

• ROI )Return on Investment(: the relative profitability concerning invested capital
• Payback Period: how long it takes to recover your initial investment
• Profitability Index: value generated per peso invested
• Weighted Average Cost of Capital )WACC(: the correct discount rate for your project

The key conclusion

NPV and IRR are indispensable but incomplete. NPV gives certainty in absolute numbers; IRR offers perspective in relative percentages. Using them together provides a 360° view.

As an investor, never make decisions based on a single metric. Combine these indicators with sector analysis, risk assessment, your personal goals, and portfolio diversification. The money you save tomorrow depends on the decisions you make today with correct information.