In financial terminology, there are many specialized concepts that are completely unknown to a large part of the population: TIN, APR, ROI… Have you heard of IRR and NPV and don't know what they refer to?
If you are thinking about embarking on an investment, you will be interested in knowing what these indicators consist of and how the Internal Rate of Return and Net Present Value are calculated.
Internal Rate of Return and Net Present Value
The Internal Rate of Return and the Net Present Value refer to two financial formulas to measure the profitability of a real estate project or any other type of project. These are financial ratios that are not limited to the purchase of a home.
The IRR and NPV have in common that, unlike other static models (such as cash flow), where the time or duration of the investment is not taken into account, they are dynamic systems that allow obtaining a future projection of the possible gains or losses of a project as a whole.
Therefore, these two measures are very useful for assessing whether or not it is appropriate to launch an initiative, especially in the business field, helping us to make the best decisions.
Thus, the Internal Rate of Return and the Net Present Value are applicable in diverse situations, ranging from taking out a deposit or other financial product, to buying a home to rent it out , investing in a start-up or the launch by an entrepreneur of a new line of products.
But how does each of these parameters work and how should they be interpreted?
What is NPV
Net Present Value consists of the sum of the present values of all net cash flows (i.e. receipts less payments) expected during the execution of the project, less the value of the initial investment and discounting an interest rate.
In other words, it is the difference between the value of the income that the company expects to receive in the future and the capital it invests to obtain that income. Thus, what the NPV does is discount future cash flows at present value.
How NPV is calculated
Specifically, NPV is calculated using the following mathematical formula:
NPV= -Initial Investment + (Operating cash flows in the first year/(1+ Interest rate) + (Operating cash flows in the second year/(1+ Interest rate)2+ (Operating cash flows in the third year/(1+ Interest rate)3 + …+ (Operating cash flows in the last year/(1+ Interest rate)n
For example, imagine that you want to make an investment of 5,000 euros in the purchase of a parking space, with the intention of renting it out for the next 4 years. These 5,000 euros, therefore, are the initial investment and the project execution period will be those 4 years.
Now, it's time to calculate the cash flow, which is how much you will earn each year from the operation.
If you rent it for 300 euros, you will make 3,600 euros in profit per year, although you will have to subtract the expenses you have, such as the community fee, the IBI , small repairs to put it on the market, months without finding tenants or correcting damage due to use. If instead of a parking space it was a house and you needed a mortgage for a rental property, you would also subtract that expense.
So, after deducting these amounts, let's say that the profit reaches 1000 euros in the first year, 2000 in the second, 1500 in the third and 3000 in the fourth. That would be the cash flow or effective flow of this operation.
Finally, to find the NPV you will need to calculate the discount rate. This parameter refers to the amount that you will stop earning by spending the money on buying a property, instead of making an investment that generates interest, such as taking out a fixed-term deposit, for example.
This is what is known as opportunity cost.
Although the weighted average cost of capital of a company is used in the financial field, if you do not have this data, you can also apply the rate of return on a savings account or a stock investment; let's say it is 0.03%.
In this way, we can now complete the NPV formula, which would be as follows:
NPV= –5,000 + (1,000/(1+0.03) + (2000/(1+ 0.03)2+ (1,500/(1+ 0.03)3 + (3,000/(1+0.03)4= 1,894.24 euros.
How to interpret NPV
The key to NPV and any other indicator is its usefulness and knowing how to interpret it.
In this case, how can you tell if an investment is profitable based on its NPV? Very easy. If the NPV is greater than 0, the project will generate profits.
Also, you should keep in mind that the higher the Net Present Value, the better the return. This makes it easier to analyze different investment options with a positive NPV.
On the contrary, if the NPV is negative, the investment will generate losses, so it is advisable to reject it.
Finally, a NPV equal to 0 will not result in profits or losses. Since the NPV of the previous example is 1,894.4 euros, buying that parking space to rent it out is a good decision or, at least, an operation that will generate profits.
The way to evaluate any project is by comparing it with other similar options.
This method is one of the most used, due to its easy calculation.
However, it also has some drawbacks. The most obvious one is the difficulty in calculating the applicable discount or interest rate or the fact that the formula implicitly understands that positive net cash flows are directly reinvested, since you may spend the 1000 euros of profit you get in the first year on that dream trip.
What is the IRR
The Internal Rate of Return is a relative measure and, as such, consists of a percentage that will indicate the degree of profit or loss that an investment will have.
Net Present Value and Internal Rate of Return are closely related, since the IRR is calculated by assuming that the NPV of an investment is equal to zero. In this sense, it could also be defined as the interest rate required for the NPV to equal zero.
How IRR is calculated
To calculate the IRR, the first thing you must do is equal the NPV to 0 and replace the interest rate concept with an unknown (K).
This is the mathematical formula for the IRR:
NPV= -Initial Investment + (Operating cash flows in the first year/(1+K) + (Operating cash flows in the second year/(1+K)2+ (Operating cash flows in the third year/(1+K)3 + …+ (Operating cash flows in the last year/(1+K)n= 0
Continuing with the example of buying a parking space to rent:
NPV= –5,000 + (1,000/(1+K) + (2000/(1+ K)2+ (1,500/(1+ K)3 + (3,000/(1+K)4= 0
It is precisely this K that is the unknown that you must solve to obtain the IRR of that investment. If you remember the second degree equations, that is the operation that you must perform.
It is true that it can be a bit complex to find the IRR, but you can find financial calculators on the Internet to solve this formula. Using one of them, the K is equal to 0.16 (0.15708, to be exact), that is, when the NPV is equal to 0, the IRR is equal to 0.16.
How to interpret the IRR
The IRR also provides a specific result that you must know how to interpret properly. In a very brief way, this is what the IRR of an investment means according to its sign:
- If the IRR is higher than the established interest or discount rate, the project is profitable.
- If the IRR is lower, it will lead to losses.
- Finally, if the IRR equals the interest rate, there will be neither a gain nor a loss.
In the example above, the IRR is 0.16, while the interest rate we used to calculate the NPV was 0.03, remember? Therefore, the IRR confirms the convenience of the investment in the parking space, as it is higher than the interest rate.
The main problem with the IRR is that it is difficult to calculate and that it is not entirely accurate if cash flows vary between negative and positive numbers.
However, it is useful to complement other methods of evaluating profitability and to see which project is more interesting based on risk and profit forecast.
For example, the bank may offer a low-risk product with a 5% return, but you can also invest in a company. Calculated for its IRR, it is 10%, so it would be a more profitable option.
Differences between NPV and IRR
Both NPV and IRR are two complementary measures for evaluating projects and investments.
Both are able to tell when it is interesting to invest in an asset, such as buying a home, and even add the mortgage to the calculation. The main difference between NPV and IRR is that the former calculates the profitability in monetary terms (in euros) and the latter in percentage terms.
Furthermore, NPV is calculated based on cash flow maturities, something that IRR does not value.
In any case, both are interesting formulas for evaluating different investments.
For example, if you are thinking of buying a house to rent out as an investment, you can calculate the NPV and IRR of the investment and even add the cost of financing for the mortgage.