Definition of IRR
The internal rate of return (IRR) method or model determines the interest rate that discounts all cash inflows and cash outflows to a net present value of $0. In other words, the IRR model provides you with the true, effective interest rate earned on a project after taking into consideration the time value of money and the periods when the various cash amounts flow in and out.
If you use present value tables to calculate the internal rate of return, it will require some trial and error (iterations) to find the exact rate the project is earning. Software, financial calculators, and online calculators provide a quicker and more accurate answer.
Definition of NPV
The net present value (NPV) method or model discounts all of the cash inflows and outflows by a specified interest rate. The net (or combined) amount of all of the discounted amounts is the net present value. If the net present value is $0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value means the project is expected to earn less than the specified interest rate.
Comparison of IRR and NPV
Both IRR and NPV use a company’s cash inflows and cash outflows that are discounted to a present value. (Neither use the accrual accounting income statement amounts.)
IRR calculates the true interest rate earned based on the cash flows. NPV calculates the present value amount based on a stated/specified interest rate.
