Net Present Value or Internal Rate of Return

Discounted cash flow investment analysis can be done in two different ways:

1. Specify a required interest rate and calculate the net present value (NPV) of the investment, i.e. the total of all future cost and revenues discounted to today with the specified interest rate. The alternative having the highest NPV is best. Inflation can be included in the specified interest rate or be taken into account separately;

2. Calculate the internal rate of return (IRR), i.e. the interest rate giving a zero Net Present Value (NPV= 0). The alternative having the highest IRR is best.

The latter is easier to work with because it is a non-dimensional figure, but the NPV can also be made non-dimensional by, for instance, relating it to the up-front investment. The IRR is nevertheless preferable, because it is the criterion that determines how easy or difficult the financing of the project will be. Quite contrary to general belief, there is an overabundance of money in this world along with a shortage of good projects. Investors have to invest, they have to do something with their money. They will, in general, invest into the projects giving the best return, i.e. showing the best IRR.

It should be noted that the NPV criterion and the IRR criterion will produce the same preference when comparing two competing projects as long as the yearly cash flows do not vary too much. Only in the case of widely varying yearly cash flows the NPV criterion is to be preferred. In Open Design practice, the condition of fairly constant yearly cash flows is always satisfied.

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