Internal rate of returns (IRR) and net present value (NPV) are crucial in consideration of any investment. IRR is a rate at which the value of an investment is equal to the present value of the returns on an investment. IRR is very useful when we need to minimize investment risks. IRR is the rate where the input cash flow equals the output cash flow (the investment). When applied to the cash flow, the IRR yields a null net present value.

It is easy to see that a high IRR is better than a small one. A high IRR means that an investor or a firm earns an important profit yield over and above interest. If the investor of the firm has an estimated IRR target and the actual IRR is greater than the pre specified IRR value, the investment is the result of a positive option. The net present value (NPV) is an important indicator; it states that the investors or a company executive can accept all future projects that are worth more that their estimated cost. In other terms, the investors or company executives can accept without worries all projects with a NPV greater than zero. The NVP is the difference between the value of cash flow and the investment.

The NVP method recognizes that the money received right away is better than more money received in the future. This means that the time value of the investors’ money is very important and is therefore taken into consideration. If NVP is less than zero, it should be rejected. If there are many projects to consider and only one can be accepted, the best choice is the project with the highest NVP. This is the means by which you take into account opportunity cost.

The NVP and IRR equations inter relate accordingly; if IRR = the firm expenses, then NVP =0; if IRR < the firm expenses, then NVP < 0 and if IRR > the firm expenses, then NVP > 0. These relationships also indicate the disadvantages and the advantages of the IRR and NVP method. A disadvantage is that IRR is not applied to all proposals; NVP can be applied to any investment project. If the project is accepted, IRR does not present an investment improvement and as such is of less value. If the project is really large, IRR is easily affected. If NVP becomes zero or less than zero during project development, IRR affects the project evaluations accuracy. Multiple IRR is also a major disadvantage of this method.

There are also other major advantages, such as IRR considers all cash flows, and is therefore comparable with company expenses and considers the time value of the investment - a method often overlooked by other models. IRR measures the investments profitability in percentage terms, and shows what the investment will bring to a company. The wiser solution is to use NVP and IRR rates simultaneously. The time value of investment is considered, as well as accounting measures of the company’s profits. It is therefore easy to obtain direct evaluations; another advantage is that mutually exclusive proposals are ranked using the same criteria.