On this occasion we wanted to do a little review of two terms widely used in the world of finance and economics for their incredible functionality when it comes to **yield results on companies** and to know if the investment in a certain project is viable, known as **the NPV and the IRR.** These two tools can make you earn a lot of money or stay away from the bad options of a company.

## What are NPV and IRR

**NPV and IRR are two types of financial tools** from the world of finance very powerful and give us the possibility of evaluating the profitability that different investment projects can give us. In many cases, the investment in a project is not given as an investment but as the possibility of starting another business due to profitability.

Now, we are going to make a small introduction of the NPV and the IRR, these financial concepts separately so that you can see how they are calculated and which is the best option depending on the results you want to know and the *possibilities offered by NPV and IRR.*

## What is NPV

**The NPV or Net Present Value**This financial tool is known as the difference between the money that enters the company and the amount that is invested in the same product to see if it really is a product (or project) that can give benefits to the company

The VAN has a **interest rate** which is called the cutoff rate and is the one used to constantly update itself. Said cut-off rate is given by the person who is going to evaluate said project and that is done in conjunction with the people who are going to invest.

**The NPV cut-off rate can be:**

**The interest**that is in the market. What you do is take a long-term interest rate that can be easily taken out of the current market.**Rate**in the profitability of a company. The interest rate that is marked at that time will depend on how the investment is financed. When it is done with capital that someone else has invested, then*the cut-off rate reflects the cost of borrowed capital.*When it is done with its own capital, it has**a direct cost to the company**but it gives the shareholder profitability

## When the rate is chosen by the investor

This can be any rate of your choice.

It is usually carried out with the **minimum profitability** that the investor intends to have and will always be below the amount in which he is going to make the investment.

If the investor wants a **rate that reflects the opportunity cost**, the person stops receiving money to invest in a certain project.

**if a project is viable or not**Before starting to carry it out and also, within the options of the same project, it allows us to know which is the most profitable of all or which is the best option for us. It also helps us a lot in the buying processes, since in case we want to sell, this option helps us a lot to know what is the amount of real money in which we have to sell our company or if we earn more by keeping our business.

## How can NPV be applied

To know how to use **the NPV we have a formula that is NPV = BNA - Investment**. The Van we already know what it is and the BNA is the updated net profit or in other words, the cash flow that the company has.

This method should always be used with the updated net profit and not with the projected net profit of a company so that our accounts do not fail. To know what is the **BNA you must make a discount of TD or discount rate**. This is the minimum rate of return and is known as follows.

If the rate is higher than the BNA this means that the rate has not been satisfied and we have a negative NPV. If the BNA is equal to the investment, this means that the rate has been met, the NPV is equal to 0.

**When the BNA is higher it means that the rate has been met** and in addition, they have managed to make a profit.

So for us to quickly understand

When the last case, it means that the project is profitable and you can go ahead with it. When there is a case in which there is a draw, the project is profitable because the TD gain is incorporated, but you have to be careful. When it happens the first case, the project is not profitable and you have to look for other options.

You must choose the project that gives us the best additional profit.

## Advantages of NPV

One of the **main advantages** and the reason why it is one of the most used methods is because the net cash flows are homogenized at the present time. The NPV or Net Present Value is capable of reducing the amounts of money generated or that are contributed to a single unit. In addition, positive and negative signs can be entered in the flow calculations that correspond to the **cash inflows and outflows** without the final result being altered. This cannot be done with the IRR in which the result is very different.

However, **NPV has a weak point** And it is that the rate that is used to discount the money may not be entirely understandable or even debatable for many people.

Now, when it comes to homogenizing the interest rate, it is one of the best options with a very high reliability.

## What is IRR and how is it used

**What is the IRR? The IRR or the internal rate of return**, is the discount rate that is had in a project and that allows us that the BNA is at least equal to the investment. When talking about the T**IR speaks of the maximum TD** that any project can have so that it can be seen as apt.

In order to find the IRR in the correct way, the data that will be needed are the size of the investment and the projected net cash flow. Whenever the IRR is going to be found, the NPV formula that we have given you in the upper part must be used. But replacing the Van level by 0 so that it can give us the **discount rate**or. Unlike NPV, when the rate is very high, it is telling us that the project is not profitable, if the rate is lower, this means that the project is profitable. The lower the rate, the more profitable the project is.

## Is this type of method reliable?

You should know that the criticisms that this method has suffered are many due to the degree of difficulty it has for many people. However, nowadays it has already been possible to program in spreadsheets and the most modern scientific calculations also come with this option incorporated. They have achieved that they can be done in seconds.

**This method has a very simple calculation method when you already know how to use it and that gives more efficient results, which is****el****linear interpolation method.**Even so, returning to the most used and the main one, it is done when in a certain project it has been possible to make reimbursements or disbursements that are having, not only at the beginning but during the useful life of the same, either because the project has been having losses or new investments have been included.

## When to use VAN or TIR

Both the NPV and the IRR are two indicators widely used by professionals, but each of these tools has a specific use when using them. And it is convenient to know when to use NPV and when to IRR and how to assess the results you get from both.

Therefore, here we are going to leave you in a practical way when to use each of them.

### When to use the VAN

The NPV, that is, the net present value, **it is the variable used by many companies to be able to homogenize net cash flows.** That is, to reduce all the amounts of money that are generated or that are contributed in a single figure. In addition, it is the tool they use to know if a project is working; in other words, if there are benefits based on what has been invested.

To do this, they use the formula NPV = BNA-Investment. Thus, if the investment is greater than the BNA, the figure obtained from the NPV is negative; and if it is the opposite it means that there is a profit.

So when should it be used? Well, when you want to know if your net profit is really adequate or if you are having losses. In fact, this should be used on an annual basis, although the figures can actually be drawn at any time of the year (but always with data up to that date).

#### What is the NPV formula?

Is the next:

Where:

- Ft are the cash flows in each period (t).
- I0 represents the initial investment.
- n is the number of periods being calculated.
- k is the discount rate.

### What is TIR and what is it for?

Turning now to the IRR, you must bear in mind that, as we have told you, it is not the same as the NPV, they are two totally different tools that measure similar things, but not the same.

El **IRR value is used to assess whether a project is profitable or not, but nothing else**. The formula used is the same as that of the NPV, but in this case the NPV is 0 and the point is to find out the discount rate, or the investment.

Thus, the higher the value that comes out in that formula, it means that the project is less profitable. But the lower it is, the more profitable it is.

#### When is it used?

And when should it be used? In this case, **It is the best indicator to assess the profitability or not of a specific project.** In other words, it gives you a specific data, but this cannot be compared with the data of another project, especially if they are different, because there more variables come into play (for example, that one of the projects starts shortly and then takes off, or that is more durable in time).

In general, both the NPV and the IRR indicate whether a project can be carried out or not, that is, whether benefits will be obtained with it or not. There is no one better tool or another to do this, since both the NPV and the IRR complement each other and investors take into account the results of both before making a decision.

## How to know if the IRR is good

After all that we have told you, there is no doubt that the indicator that can have the most weight when it comes to knowing whether a project is good or not is the internal rate of return, that is, the IRR. But how do you know if the IRR is good or not in a project?

When evaluating this rate, that is, the IRR, it is necessary to take into account two very important factors. These are:

- The size of the investment. That is, the money that is going to be put to carry out that project.
- The projected net cash flow. That is, what is estimated to be achieved.

**To calculate the IRR of a business, the same NPV formula is used**; but instead of getting this, what you do is find out what the discount rate is. Thus, the IRR formula would be:

NPV = BNA - Investment (or discount rate).

Since we do not want to find the NPV, but rather the Investment, the formula would look like this:

0 = BNA - Investment.

BNA would be the net cash flow while the I is what we must solve for.

For example, imagine you have a five-year project. You invest 12 euros and, each year, you have a net cash flow of 4000 euros (except for the last year, which is 5000). Thus, the formula would be:

0 = 4,000 / (1 + i) 1 + 4,000 / (1 + i) 2 + 4,000 / (1 + i) 3 + 4,000 / (1 + i) 4 + 5,000 / (1 + i) 5 - 12,000

This gives us the result that i is equal to 21%, which tells us that it is a profitable project, and that the IRR is good, if it is really what is expected to be obtained. Remember that the lower the value, the more profitable the project you are analyzing will have.

And this is where the expectation of profitability comes into play. For example, imagine you have a project that looks very profitable and is attractive. And that you hope to get a profitability of at least 10% for him. After doing the numbers, you see that the project is going to offer you a return of 25%. That is much more than you expected, and therefore it is something attractive and that is telling you that the IRR is good.

Instead, imagine that instead of that 25%, what the IRR offers you is 5%. If you have scored a 10, and it gives you a 5, your expectations drop a lot, and unless you have thought otherwise, that project would not be so good (and it would not have a good IRR) based on your investment.

En general, **a business that is safe, and that does not involve risks, will report a good IRR, but a low one.** On the other hand, when you bet on businesses that do require a little more risk, as long as you act with head and knowledge, you can expect that there will be an IRR plus something and, therefore, better. For example, right now technology projects, or those related to primary sectors (agriculture, livestock and fishing) can be profitable and beneficial.

## Botton line

The IRR or the internal rate of return is a very reliable indicator when it comes to the profitability of a specific project. When a comparison of the internal rates of return of two different types of projects is carried out, the possible difference that may exist in their dimensions is not taken into account.

Now, after knowing all this we wonder *it's easy to understand? Do we already know what the VAN and TIR?*

At the beginning VAN and IRR may be two terms that confuse you a bit but for the performance of your company and above all so that you do not lose money they are of the utmost importance, since thanks to this you can know when a project is really profitable that you can invest in it or if you have the option between several projects, you can know which project is more profitable.

It also allows you **know when a project is not profitable** what is the difference that you will stop winning.

Therefore, both the **NPV and IRR are complementary financial tools** and they can give us valuable data about the companies or projects in which we are willing to invest, making sure that we always have 100% of the profits in the projects you want to carry out.

Find out what ROE or Return on Equity is:

Hello, it would have been nice if you included formulas and examples

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I would like there to be formulas and examples

THE INFORMATION IS VERY UNDERSTANDABLE, TO SEE IF YOU UPLOAD APPLICATION EXAMPLES, THANK YOU FOR THE INFORMATION

this good, would you please include a small example, an exercise. Congratulations.

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Good morning, very good young man, the explanation and to be more effective it is good examples with formulas and thus be able to put into practice what is exposed in theory, thank you and I hope your good offices.