1. Using NPV & IRR
So probably two of the most common metrics used to evaluate investments
are the NPV and the IRR functions. First of all, the NPV or
net present value, it's the value of all future cash flows,
both positive and negative over the entire life of an investment that are
discounted back to the present. So that was a lot. But how do
we evaluate NPV? Well, it's relatively simple. Any project with a positive
NPV will add value to a company. Now, another very common function which
gets used is the IRR function or internal rate of return,
and that's the expected compounded annual rate of return that would be earned
on a project or investment over its life.
So once we have the internal rate of return, how do we use
that to evaluate a project? Well, if the internal rate of return is
greater than the company's cost of capital, then the project will add value
for the company. So again, it's good to know this theory about NPV
and IRR, but even better is knowing how to calculate it.
Let's jump ahead and look at the Excel template and figure out exactly
how to calculate these two really common metrics.
2. Let's practice!