How do NPV and IRR differ?

NPV, or Net Present Value, and IRR, or Internal Rate of Return, serve different purposes in investment analysis, which is why the statement that NPV estimates the value added by a project while IRR is the discount rate that makes NPV zero is accurate.

NPV is a method used to determine the profitability of an investment by calculating the present value of expected future cash flows, discounted at a specified rate (usually the cost of capital). It reflects the actual dollar value that a project is expected to add to the firm. A positive NPV indicates that the projected earnings (in present dollars) exceed the anticipated costs, thus signaling that the project is expected to generate value for the organization.

On the other hand, IRR is the discount rate that results in an NPV of zero, meaning it represents the maximum rate at which a project can grow without losing value. Essentially, IRR can be thought of as an efficiency measure – if the IRR of a project is higher than the required rate of return, it is considered a good investment.

Both metrics are closely related; however, they offer different insights into the investment decision-making process. Understanding these nuances can help ensure that financial managers select projects that align with the company's financial