NPV and IRR

ROI and Payback Period are nice and dandy, but not enough. So what do investors actually use?

NPV: Net Present Value

NPV is the gold standard of performance metrics. It shows what profit you expect, when you get it, and how much risk you assign. Bam. It's the love child of ROI and Payback Period. We already know how to find the Present Value of money coming later; NPV takes one last little step and subtracts what you invest.

NPV = Present Value − Investment

For last lesson's deal, $1,000,000 in now for $2,500,000 in three years, at a 35% discount rate:

NPV = $1,016,105 − $1,000,000 = $16,105

The rule: Accept a project when its NPV is positive. That's it. Since you set the discount rate, your own judgment of the risk is built in. The higher the NPV the better; negative, don't do it. NPV is the best financial performance metric. Period.

IRR: Internal Rate of Return

And yet many VCs use IRR. Why did we go down the NPV rabbit hole, then? Because IRR is built on NPV. IRR is the discount rate that makes NPV exactly zero.

Our NPV at 35% was $16,105, pretty close to zero, so the IRR should be close to 35%. A goal seek in Excel finds the exact rate:

Wow, we really were close. Yeah, I'm a bona fide NPV Whisperer, I am.

What's the rule for IRR? Like NPV, the higher the better. Think of IRR as NPV's bigger, smarter brother.

Many VCs have a standard IRR they look for, often called the hurdle rate: your projected IRR has to clear it. It can easily be 60% or more, and the same VC may use different hurdle rates for different industries, or different stages of the same company. EZ Numbers calculates ROI, NPV and IRR for you automatically.