IRR vs Net Profit
Understanding the relationship of IRR vs Net Profit is important when analysing the results of a financial model. Although both have their merits it can be confusing which one is correct.
Net Profit is typically just measuring the total amount that revenue exceeds costs and doesn’t take time into account. At a simplistic level you can take a 10 year project and calculate its net profit in this way by adding all the revenue and costs over the 10 years.
The Internal Rate of Return is measuring the returns but taking the timing of the cash flows into account. In this sense it is more accurate in that it takes both the absolute number and the time to receive it.
So as an extreme example which is the better project?
- You invest R1 000 000 and 100 years later you receive R100 000 000 or
- you invest R1 000 000 and 2 years later you receive R2 000 000.
From a Net Profit point of view option 1 is the clear winner with a R99 million net profit verses R1 million for option 2.
However, the one project gives you a return in 2 years and the other takes 100 years. In IRR terms option 1 would generate a 5% IRR and option 2 would generate a 41% IRR.
Although there are some shortcomings with using IRR it is a very good measure to take the time value of money into account and to compare projects of differing lengths against each other.
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