Project Evaluation

Deciding if one should make an investment or undertake a project is one of the most important applications of the time value of money concept.

Net Present Value (NPV)

The sum of the present values of a series of cash flows (for example, all the expected cash flows from a project, including any initial investment) is called its net present value (NPV). It is the key tool in finance to judge if a project is worth investing in or not.

It is customary to do the analysis from the point of view of the investor so that cash flows representing investments are negative. Often the initial cash flow (at time 0) is the investment in the project and is negative even though there may be additional (net) negative cash flows over the years.

Assuming that the discount rate used is appropriate for the risk of the series of cash flows, a positive NPV indicates that over the years the project will generate more cash than will be needed to pay off, with the necessary returns, all the investments the project will require. Therefore, a project with a positive NPV is considered acceptable while one with a negative NPV is not. NPV measures in present value terms the excess cash the project would generate.

Internal Rate of Return (IRR)

The internal rate of return measures the rate of return of a series of cash flows of a project taking into consideration the time value of money. It is the alternate measure used to decide if an investment or project should be accepted. Mathematically speaking, IRR is the rate of return at which the NPV of a project or series of cash flows will equal zero, and it is calculated by iteration from the equation for NPV. If the IRR is greater than the rate of return appropriate for the risk of the project, then the project is considered acceptable (and will have a positive NPV). Otherwise the project should be rejected.

Although many people find the IRR measure intuitively more appealing, it has a few shortcomings, and an alternate measure - modified internal rate of return (MIRR) - has been developed to overcome some of them. In general, though, NPV is the more reliable (and superior) tool for evaluating projects or investments.