Updated: Jan 29, 2022
One is Net Present Value - NPV
If you are a seasoned investor, you have often heard people talk about NPV and IRR all the time. What is NPV? NPV is Net Present Value, it is the difference between the present value of cash inflows and the present value of cash outflows over time. NPV calculates the current value of all future cash flows that will be generated by a project based upon the total initial capital investment. It is widely used in capital budgeting and to analyze the profitability of an investment or project, particularly commercial real estate investments.
The following is the formula for calculating NPV:
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, or expected return rate
t = number of time periods
When you look at this formula, you may be totally confused and have no clue what this is about. Don’t worry if you don’t understand the formula right away, just start with the basic definitions and concepts. If you invest in a project, you know or can estimate your initial total investment cost. That is Co in the formula[L1] . For example, if you buy an investment house you pay the purchase price plus closing and other inspection, appraisal, survey and other out of pocket costs. The purchase price plus your other costs is the total initial cost of your investment, which is Co in the formula.
After you incur these costs and complete your purchase, you rent out the house. Every year you have rental income and you pay your property management fee, repairs, taxes, and insurance. The rental income minus your expenses is the net cash flow for your investment property, which is Ct. For example, you rent your property for 10 years, first year net cash flow is C1 and second year net cash flow is C2. The 10 years will be the period of time t. The symbol r generally is called the discount rate, which is your expected return rate on your investment property. For example, your expected investment return rate is 6%. r is equal to 6%. If your expected investment return rate is 8%. r is equal to 8%. We use NPV to calculate whether a proposed investment is profitable or not profitable. We can also use it to compare projects and see which project will be the most profitable.
NPV value provides the present dollar value of the estimated net income of the project and it is used to calculate today’s value of a future stream of income payments. In the above example, the net rent after expenses is the future steam of payments. The easiest way to remember this concept is that NPV=Today’s value of the expected cash flows -Today’s value of invested cash.
A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. Of course, you should only make investments that result in positive NPV values.
NPV involves calculating projected cash flow or anticipated earnings. Determining the value of a project can be challenging because there are different ways to measure the value of future cash flows. Because of the time value of money (TVM) and inflation, money in the present is worth more than the same amount in the future. A dollar today is worth more than a dollar tomorrow because the dollar can be used earning a return. Because of inflation, a dollar in the future will not be worth as much as a dollar in the present.
The discount rate r in the NPV formula is quite different depending on the investor’s expectation. Investors or companies may often have different ways of identifying the discount rate. Common methods for determining the discount rate include using the expected return of other investment choices with a similar level of risk (or comparing the expected return to investment choices with less or more risk), or the costs associated with borrowing money needed to finance the project.
There are drawbacks to using NPV to measure the projected return on an investment. One primary issue in using NPV to measure an investment’s profitability is that NPV relies heavily upon multiple assumptions and estimates, so there can be substantial room for error. Estimated factors include investment costs, discount rate and projected returns. Some unforeseen expenditures or events can cause additional costs or reduced revenue at the project’s beginning, during the project or at its ending. Therefore, discount rates and cash inflow estimates may not reflect the risk associated with the project and may assume the maximum possible net cash flow over the investment period. The failure to account for unforeseen costs or events may artificially increase investor confidence. As such, these factors may need to be adjusted to account for unexpected costs or losses or for overly optimistic cash inflow projections.
Another is Internal Return Rate-IRR
Because of the drawback of the NPV, investors often use IRR as an alternative measurement for the projected investment.
The IRR formula is as follows:
Calculations of IRR rely on the same basic formula as NPV does, except with slight adjustments. IRR calculations assume the NPV equals zero and try to find the discount rate. That means the present cash inflow is equal to the present cash outflow. When NPV is zero, the discount rate of an investment is the investment’s IRR, essentially representing the projected rate of growth for that investment. IRR refers to projected returns on a yearly basis. It allows for the simplified comparison of a wide variety of types and lengths of investments. For example, IRR could be used to compare the anticipated profitability of a 3-year investment or a 10-year investment.
Similarly, to NPV, IRR helps investors estimate how profitable an investment is likely to be over time. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. All other things being equal, an investment with a higher IRR is preferable to an investment with a lower IRR. Unlike net present value, the internal rate of return does not give you the return on initial investment in terms of real dollars. For example, knowing an IRR of 30% alone does not tell you if it’s 30% of $10,000 or 30% of $1,000,000 or if the investment is for 2 years or 30 years. If you only choose a higher IRR and neglect the initial investment amount or investment period, especially if comparing two projects with different durations, it can lead you to make poor investment decisions. For example, a $100 investment that returns $300 in a year has a higher IRR rate than a $10,000 investment that returns $20,000 in a year. However, the $10,000 investment would have much greater positive effect on the investor’s income. In addition, an investment that has a slightly lower IRR paid out over a longer term may provide more certainty and less risk than a short-term investment with a higher IRR.
Sophisticated commercial real estate investment analysis requires examination of both the net present value (NPV) and the internal rate of return (IRR). IRR gives the yield on the investment while NPV foresee how a given investment will affect overall wealth. Although you can calculate everything perfectly, investment always involves risks that cannot always be anticipated or budgeted. Real estate is a relatively safe long-term investment in comparison to other types of investments.