The Difference Between IRR, NPV & Investment Risk
Net Present Value is the difference between the present value of benefits and present value of costs of a capital investment. IRR is the projected returns of a capital investment over its economic life. It is the percentage figure at which an investment’s PVB and PVC are equal. In capital budgeting, investment risk is the probability of a fixed asset or a project failing to achieve its expected outcomes. According to Dr. Richard L. Constand, Professor of Finance at the University of West Florida, “Project risk is partitioned into systematic and un-systematic risk using the theoretical risk framework that CAPM uses.”
Unit of Measure
NPV is expressed in currency value, while IRR is expressed in percentage value. Investment risk is not restricted to any particular unit of measure because it signals the magnitude of the negative consequences of pursuing any particular investment. For example, assets investments with high NPV discount rates signal higher levels of investment risks.
Whereas NPV has a straightforward calculation formula, IRR is calculated on trial-and-error basis. Moreover, NPV is calculated using a market-based discount rate -- also known as hurdle rate, while IRR is calculated using returns generated by invested capital. As such, NPV accounts for the opportunity cost of capital -- that is, the cost of foregoing alternative investments -- while IRR does not. The calculation of investment risk is entirely dependent on the nature of the capital investment and the capital budgeting method that is used to appraise it.
NPV is more realistic than the IRR by virtue of its assumption that discount rate is earned from the reinvestment of cash inflows generated by a capital investment. Indeed, IRR’s assumption that the reinvestment of cash inflows earns the IRR is unrealistic, especially when the IRR for a capital investment is high. Investment risks are straightforward and are not based on assumptions. Rather, they are used only to evaluate the assumptions made by the capital budgeting methods.
Whereas NPV maintains consistency of solutions regardless of periodical changes in cash flows, IRR gives varied solutions with changes in cash flows from one period to another. For example, if one period has positive cash flows, the next period has negative cash flows. IRR gives various probable solutions. This is confusing because it would suggest that there are multiple percentage values at which an investment’s PVB and PVC would be equal. Investment risks show consistency regardless of the type of risk at hand -- that is, systematic or unsystematic risks.
Paul Cole-Ingait is a professional accountant and financial advisor. He has been working as a senior accountant for leading multinational firms in Europe and Asia since 2007. Cole-Ingait holds a Bachelor of Science Degree in accounting and finance and Master of Business Administration degree from the University of Birmingham.