Can anyone explain to me how net present value relates to irr and discount rate
What’s the difference between discount rate and IRR
And in what situations can I use IRR instead of discount rate when I’m trying to calculate the value of future cash flows
Extra points if someone can tell me the difference between interest rate and discount rate
Can I use the interest rate as my discount rate when calculating NPV?
In: 0
NPV = value of a bunch of future cash flows right now.
Cash in the future isn’t worth as much as cash right now, so you reduce (discount) future cash flows by some percent to reflect that. That’s the discount rate.
You do not need IRR to calculate NPV, you just need the cash flows and the discount rate. The discount rate that makes sense for you depends on lots of things…how risk averse (or not) you want to be, what it costs you to borrow money, how your business works, how much you can earn by investing cash you have sitting around, etc. The discount can and will vary depending on who’s doing the analysis. Most companies will have established set discount rates for whatever it is they’re doing. Two companies assessing exactly the same cash flows may come up with different NPVs because they’re using different discount rates.
For any given set of cash flows (assuming they’re not all positive or all negative), there’s some discount rate that will give you NPV=0. That value is the IRR, internal rate of return. It’s basically the interest you’d have to actually get on your cash (on average) so all discounted cash flows balance out to zero, which is a fancy way of saying “you’ll be even…you won’t make or lose money.”
The IRR does *not* depend on the discount rate…it just depends on the cash flows (and has NPV=0 by definition).
Don’t use IRR to calculate the value of future cash flows. You only use discount rate for that.
Comparing IRR to discount rate tells you how good (or bad) the deal is. You’re comparing what the actual rate would need to be (to at least break even) to what you’re assuming it will be. It tells you how much trouble (or not) you’ll be in if your discount rate is wrong.
Interest rate is what you actually pay to borrow money (or receive if you’re saving money). Discount rates are typically higher than interest rates because you’re taking a bunch of other stuff into account, including opportunity cost, risk of putting money into higher return investments, etc.
For example, discount rates of 10-15% are fairly typical for large capital projects. Nobody’s paid that kind of interest rate on institutional loans for decades. So you shouldn’t use interest rate as your discount rate either, unless you’ve got a hyperconservative model that’s just going to stick your money in a bank account for years (bad idea…the treasury group will get mad at you).
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