NPV, IRR and Payback: How to Decide Whether an Investment Is Worth It

A dollar later is worth less than a dollar now

Money you have today can be put to work: invested, used to pay down debt, spent on something else that earns a return. So a dollar promised a year from now is worth less than a dollar in hand. If you could earn 10% elsewhere, $100 a year from now is worth about $90.91 today, because $90.91 invested at 10% becomes $100 in a year.

That's the time value of money, and converting future amounts into today's dollars is called discounting. The rate you use, the discount rate, is the return you could reasonably get elsewhere for taking a similar risk.

Net present value

Take a $50,000 machine that will save a business $15,000 a year for five years. Discount each year's saving at 10% and add them up, and the five years of savings are worth about $56,900 today. Subtract the $50,000 cost and the net present value is about $6,900.

A positive NPV means the investment earns more than the 10% you could get elsewhere, and $6,900 is how much value it adds, in today's dollars, beyond that. A negative NPV means you'd do better putting the money into the alternative. It's the most direct answer to the question "does this make us richer?"

Internal rate of return

The internal rate of return asks the question backward: what discount rate would make the NPV exactly zero? For the machine it's about 15.2%. The investment pays back its cost plus a return of 15.2% a year.

Compare that with the return you require. The machine's 15.2% clears a 10% hurdle comfortably. It also gives a sense of the margin for error: the business could use a discount rate of 15% and the machine would still just break even.

Payback period

The payback period is the simplest of the three: how long until the savings add up to the cost? $50,000 ÷ $15,000 a year is about 3.3 years.

It's easy to explain and useful when cash is tight, because it tells you how long the money is out of reach. It has two blind spots. It ignores the time value of money, and it ignores everything that happens after the payback date. A project that pays back quickly and then stops earns the same payback score as one that pays back quickly and keeps earning for twenty years.

When the measures disagree

A second option also costs $50,000, but it returns $30,000 in the first year, $25,000 in the second and $5,000 in the third, and then nothing. It pays back in 1.8 years, far faster than the machine. Its NPV at 10% is only about $1,700, and its IRR is about 12.4%.

Payback prefers the second option; NPV and IRR both prefer the machine. If the business can afford to wait and trusts its forecasts, NPV is the better guide, because it measures value added. If cash is so short that getting the money back fast matters more than the total, payback deserves more weight, and that's a legitimate reason to choose differently.

IRR has its own traps. It's a percentage, so it can favor a small project with a high return over a large one that adds far more dollars of value. And cash flows that switch between negative and positive more than once can produce more than one IRR, or none that make sense. When NPV and IRR conflict on a choice between projects, NPV is the one to trust.

Choosing the discount rate

The discount rate carries a lot of weight, and there's judgment in it. Companies often start from their cost of capital, the blended return their lenders and owners expect, known as WACC. Riskier projects deserve a higher rate than safe ones, since the forecasts behind them are shakier.

Run the numbers at more than one rate before deciding. A project whose NPV stays positive across every reasonable rate is a safer bet than one that only works at the lowest.

Key takeaways

• Money now is worth more than money later; discounting converts future cash into today's dollars.
• Net present value is the value an investment adds beyond your required return. Positive means do it.
• IRR is the return at which NPV hits zero; compare it with your required rate, and prefer NPV when the two disagree.
• Payback shows how fast the cost comes back and ignores everything after that. It matters most when cash is tight.

Frequently asked questions

What's the difference between NPV and IRR?

NPV measures the value an investment adds in today's dollars at a chosen discount rate. IRR is the discount rate at which NPV equals zero. NPV answers "how much richer does this make us?" and IRR answers "what return does this earn?"

What discount rate should a small business use?

Start with the return you could reasonably earn on the money elsewhere at similar risk, or your cost of borrowing plus a margin for the extra risk of the project. Test the decision at a few rates, since the answer depends on it.

Is a shorter payback period always better?

Not on its own. A shorter payback means the money comes back sooner, which matters when cash is tight, but it says nothing about what the investment earns afterward. Use it alongside NPV.