Question on Appliciation of NPV and IRR

[loadedlongboard]

Hi Guys,

I have a question on the meaning behind IRR and NPV in regards to an investment. Let's say we invest $1,000,000 in Year 0, and have 3 periods with a sale in the 3. We calculate the NPV based on a discount rate of 7%. The NPV is positive. From here, we calculate that the IRR is 12%.

Now if we made the discount rate 12%, then the NPV would equal 0. And then in theory, we are indifferent to investing since the present value of cash flows is essentially the same as our initial investment.

But when I look at this practically, if we really thought the discount rate was 12%, wouldn't that be a great investment? In today's standards that far exceeds anything else offered. Or am I looking at this the wrong way, and really the discount rate used should be comparable to what other like investments are? So if other similar investments are yielding 10%, then this is a good deal. But if other comparable investments are also yielding 12%, then it is not as attractive because you can find others elsewhere?

So my question is when you are solving for the NPV using a specific discount rate, are we evaluating that investment solely using a discount rate matching other comparable investments, and then calculating the IRR? And if the IRR is greater than the NPV, then it is a better investment than the others? Whereas if the discount rate is 12%, and that makes NPV = 0, even though our discount rate (aka desired return) is extremely high at 12%, it is not as good of an investment because the present value of cash flows is just hitting our rate of return.

But would an investment with a positive NPV using a discount rate of 7% always be better than an investment with an NPV of 0 using a discount rate of 12%? We will be getting a better return at 12%. How would you compare those investments? And what makes one investment more attractive then the other?

Thanks!

 

[Ishuda]

Quoting wikipedia,
http://en.wikipedia.org/wiki/Internal_rate_of_return
"Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment."

Or, another way to look at the IRR is, IMO, it is not what rate brings brings the highest present value for one particular investment but which investment will provide the biggest return to bring a particular NPV". That is I want to have a $1000 NPV [but see Note below] and have two different investment schemes. If I invest in scheme one to get the $1000 it will be an effective 12% rate of return on my money. If I invest in scheme two, it will be an effective 11% return on my money. Which is the better investment?

What you are saying in effect is, but I can get a better return, say $2000 NPV, for scheme one if I got 7% on my money, so isn't 7% better. Well yes, it is better for scheme one. However, that is not the question. The question is what is the better scheme considering all schemes make the same amount.

An example:
Scheme (1) Payout $892.86 in two years, Get $1000 in 3 years. IRR=12%
For this scheme, if the discount rate were 7%, my NPV would be $36.44. So 7% is actually a better rate of return than the 12% for this investment.
Scheme (2) Get $1000 in 2 years, Payout $1200 in three years. IRR=20%
For this scheme, if the discount rate were 7%, my NPV would be -$106.12. So 7% is actually a worse rate of return than the 20% for this investment.

That is, if we look at Scheme (1) then if I paid out $892.86 in 2 years and got 12% on my money, I would get $1000 but if I paid out $892.86 in 2 years and got 20% on my money, I would get $1071.43. Or, if we look at Scheme (2) then if i got $1000 in two years and made 20% on that money I would have $1200 (to payout) in three years but if I made 12% on my money, I would have $1120. In both schemes the 20% gives the better result.

Note: The amount you want to make is, by agreement, always the 'break even' amount, i.e. a NPV of 0 so it is really immaterial how much you want to make in comparing investment schemes. You can always do a (theoretical) immediate payout of the amount you want to make (NPV=that amount) for all schemes to make the amended NPV you want equal to zero.