Just as investors examine the financial details of businesses they consider putting money into, business leaders must weigh the value of internal investments they make. In both cases, metrics such as internal rate of return (IRR) and net present value (NPV) help differentiate between investments that are worth the cost and risk, and those that are not.
Net present value is the value of a company's internal investment at a given point in time. NPV relies on several pieces of data. They include the time value of money, and the discount rate that affects the investment's value. The value of money is the future value of money that could have been used to earn interest in a bank account instead of paying for an asset. The discount rate accounts for cash flow, placing emphasis on money that the investment will earn in the near future, and placing less value on the money it will generate in the distant future.
Internal rate of return is related to NPV in that it also measures cash flow from an investment. The biggest difference between the two is the fact that IRR is a specific discount rate that gives an investment a net present value of zero. This is the point at which an investment neither costs money, nor makes money. IRR measurements are estimations of when an investment will be worthwhile, and which current investments are set up to make money and justify their costs and risks.
Understanding Investment Risk
Investment risk is a much more broad category or analysis that can incorporate NPV, IRR and other measurements. Investment risk refers not only to the likelihood of an investment producing a positive return, but also to the chance that an investment will earn money. But not as much as it could have if it was managed differently, or if another investment was made instead. Investment risk is based in large part on projections that seek to estimate the future value of an investment.
Analysis and Outcome
IRR and NPV are primarily useful for business leaders who want to determine whether an investment in their own company is worthwhile. However, they also have meaning to investors who are considering buying stock or pursuing other types of investments in companies. A company that makes investments with negative IRRs is taking sizable risks, while one that only makes investments with high IRRs takes on less risk. Determining NPV for an investment requires only a spreadsheet and access to basic accounting data. Calculating an IRR is more complex, and requires a graph that plots discount rates for each NPV value.
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