Evaluating Alternative Capital Investments with NPV and IRR
The two most-used measures for evaluating an investment are the net present value (NPV) and the internal rate of return (IRR).
The net present value of an income stream is the sum of the present values of the individual amounts in the income stream. Each future income amount in the stream is discounted, meaning that it is divided by a number representing the opportunity cost of holding capital from now (year 0) until the year when income is received.
The internal rate of return (IRR) is the interest rate for which the NPV is equal to zero. IRR measures a project's profitability in a rate of return after adjusting for the time value of money. A project is acceptable if the specified required rate of return is less than the IRR but not profitable if the rate is greater than the IRR. Higher IRR means you are earning a greater interest rate on your investment.…