TIR vs VAN: Essential comparison of investment metrics

Introduction: Why Investors Must Master These Two Metrics

When it comes to evaluating investment opportunities, financial decision-makers are constantly faced with a fundamental question: how to determine if a project will generate truly attractive returns? The answer is not unique, and this is where two analytical tools that have become standards in project evaluation come into play: Net Present Value (NPV) and Internal Rate of Return (IRR).

These indicators allow investors to quantify the profit-generating potential or the likelihood of losses in an initiative. However, what few know is that NPV and IRR can lead to contradictory conclusions. A project might show a higher NPV but a lower IRR compared to an alternative, raising doubts about which option to choose.

This analysis delves into the operational characteristics of both metrics, their practical limitations, and how to resolve conflicts that may arise between them.

Net Present Value (NPV): Measuring Absolute Gain in Present Terms

How does NPV work in practice?

Net Present Value represents a financial methodology that translates expected future income from an investment into its equivalent in today’s money. Its logic is simple but powerful: how much net cash will the investment actually generate after discounting its initial cost?

To arrive at this answer, the process involves:

1. Project cash flows during the project’s time horizon (expected sales, operational costs, taxes, and other expenses)
2. Select a discount rate that represents the cost of capital or the alternative return that could be obtained in other investments
3. Discount each future cash flow to the present using this rate
4. Sum all present values and subtract the initial investment

A positive NPV means the project returns more capital than was invested, confirming its viability. A negative NPV indicates that returns do not justify the initial investment.

NPV Formula

The mathematical expression underlying this analysis is:

NPV = [CF₁ / (1 + r)¹] + [CF₂ / (1 + r)²] + … + [CFₙ / (1 + r)ⁿ] - Initial Investment

Where:

• CF = Expected cash flow in each period
• r = Applied discount rate
• n = Period number

It is important to highlight that both cash flows and the discount rate are estimates. The investor is responsible for grounding these projections in historical data, market research, and sector analysis.

( Practical Scenarios: When NPV is Positive and Negative

Case 1: Project with positive NPV )acceptance decision(

A company evaluates investing $10,000 in a project that will generate $4,000 annually for 5 years. The established discount rate is 10%.

Calculation of present value of each cash flow:

• Year 1: 4,000 ÷ )1.10(¹ = 3,636.36 USD
• Year 2: 4,000 ÷ )1.10###² = 3,305.79 USD
• Year 3: 4,000 ÷ (1.10)³ = 3,005.26 USD
• Year 4: 4,000 ÷ (1.10)⁴ = 2,732.06 USD
• Year 5: 4,000 ÷ (1.10)⁵ = 2,483.02 USD

NPV = 3,636.36 + 3,305.79 + 3,005.26 + 2,732.06 + 2,483.02 - 10,000 = $2,162.49

Conclusion: The positive NPV indicates that the investment is profitable and should be considered.

Case 2: Project with negative NPV (rejection signal)

An investor allocates $5,000 in a certificate of deposit that will pay $6,000 after 3 years, with an annual interest rate of 8%.

Present value of the future payment: PV = 6,000 ÷ (1.08)³ = 4,774.84 USD

NPV = 4,774.84 - 5,000 = -$225.16

Interpretation: The negative NPV warns that future returns do not compensate for the initial investment, discouraging this option.

( Choosing the Correct Discount Rate: Critical Factor in Analysis

The accuracy of NPV heavily depends on one variable: the discount rate. Choosing the wrong rate distorts the entire analysis. Investors should consider:

Opportunity Cost: What return could be obtained from an alternative investment of similar risk? If the project is riskier, the rate should be increased.

Risk-Free Rate: Treasury bonds often serve as a reference, representing a riskless return. This is the minimum floor.

Sector Benchmarks: Researching commonly used discount rates in the industry provides valuable context.

Expert Judgment: Past experience and analyst intuition are legitimate complements in this decision.

Practical Limitations of NPV Every Investor Should Know

Despite its usefulness, NPV has restrictions that cannot be ignored:

Despite these limitations, NPV remains a reference tool in the industry due to its relative simplicity and because it offers a concrete measure in monetary terms, facilitating comparison between investment alternatives.

Internal Rate of Return )IRR(: Measuring the Percentage Return of the Investment

) Fundamental Concept of IRR

While NPV expresses profit in absolute figures, IRR answers a different question: what is the annual percentage return generated by the investment? In other words, IRR is the discount rate that equates the present value of future cash flows with the initial investment, making NPV zero.

IRR is expressed as a percentage and is mainly used to:

• Evaluate the profitability of a project in isolation
• Compare the relative attractiveness of multiple investments
• Determine if a project exceeds a minimum required return

If the calculated IRR exceeds the established reference rate (for example, the return on treasury bonds or the average cost of capital), the project is considered viable. Otherwise, it should be discarded.

When IRR Arises and How to Interpret It

Unlike NPV, which is calculated directly, IRR requires an iterative process to find the exact rate that satisfies the mathematical condition. In practice, investors use financial calculators or specialized software to obtain this value.

An IRR of 15%, for example, means the investment generates a 15% annual return. To decide if it is attractive, compare it against:

• The profitability of alternative investments
• The project’s financing cost
• The minimum return required by the investor

Significant Limitations of IRR in Real Contexts

IRR also presents challenges that limit its applicability:

Despite these drawbacks, IRR remains valuable especially for investment projects with predictable and uniform cash flows over time.

Frequently Asked Questions in Investment Evaluation

What methods complement NPV and IRR analysis?

Besides these two metrics, analysts use:

• ROI ###Return on Investment(: Measures net benefit percentage relative to initial investment
• Payback Period: Calculates the time needed to recover the initial investment
• Profitability Index: Relates the present value of future flows to the initial investment
• Weighted Average Cost of Capital )WACC###: Weighted average of debt and equity costs

Why don’t professionals rely on a single metric?

Because each indicator captures a different dimension of viability. NPV answers “How much money will I earn?”, IRR answers “At what percentage does my investment grow?”, and ROI answers “What proportion of gains do I obtain?”. A comprehensive assessment requires all these perspectives.

What is the real impact of changing the discount rate?

A higher discount rate reduces both NPV and IRR, making them less attractive. A lower rate increases them. Therefore, the careful selection of this rate is critical.

How to choose between competing projects using these metrics?

Generally, select the project with the higher NPV (if budgets allow) or the higher IRR (if aiming to maximize relative return). When NPV and IRR conflict, priority is given to NPV because it represents absolute value creation.

Conflict Resolution: When NPV and IRR Contradict

( Why do discrepancies occur?

It is possible for a project to have a high IRR but a low NPV, or vice versa. This typically happens when:

• Cash flows are highly volatile
• Projects have significantly different durations
• The chosen discount rate for NPV is particularly high or low

) Resolution Protocol

When conflicts between NPV and IRR arise, analysts should:

1. Review assumptions: Verify that cash flow projections are realistic and that the discount rate adequately reflects the project’s risk

2. Adjust the discount rate: If it seems excessively high or low, recalculate both metrics with a revised rate

3. Analyze volatility: Examine how fluctuations in cash flows impact results

4. Prioritize NPV: If the contradiction persists, NPV should carry more weight because it expresses value creation in absolute terms

5. Evaluate other indicators: Complement with sensitivity analysis, scenario analysis, and other metrics for a comprehensive view

Conclusions: Key Differences Between NPV and IRR

( Structured Comparison

Net Present Value )NPV(:

• Measures net gain in monetary units
• Absolute result )money to be gained###
• Requires choosing a discount rate
• Useful for comparing projects of any size
• Sensitive to changes in the discount rate

Internal Rate of Return ###IRR###:

• Measures performance as a percentage
• Relative result (annual growth rate)
• Calculated internally without external rate
• More intuitive comparison between alternatives
• Can provide multiple solutions in complex cases

( Complementary Use

Modern financial practice recognizes that NPV and IRR are not competitors but complements. NPV indicates whether a project creates value, while IRR indicates the rate at which that value grows. Used together, they provide a robust evaluation.

) Additional Considerations for Investors

Beyond these metrics, investors should consider:

• Alignment of the project with personal financial goals
• Capital availability and budget constraints
• Risk tolerance and investment horizon
• Portfolio diversification
• Economic and regulatory conditions of the sector

Mastering NPV and IRR is an essential component of informed investment decision-making, but they should not operate in isolation. Combining these quantitative analyses with qualitative criteria and strategic considerations is what sets successful investors apart.