NPV vs IRR vs ROI: Which Metric Should You Use?

What is NPV (Net Present Value)?

Net Present Value (NPV) calculates the total value of an investment in today's dollars, accounting for the time value of money. It answers: "How much wealth does this investment create?"

NPV Example

You're considering a $100,000 investment that will generate $30,000 per year for 5 years. Assuming a 10% discount rate:

Interpretation: NPV of $13,724 means the investment creates $13,724 in value above the required 10% return. ✅ Positive NPV = Good investment

When to Use NPV

• ✅ When comparing investments of different sizes
• ✅ When you have a specific required rate of return (discount rate)
• ✅ For capital budgeting decisions
• ✅ When maximizing total value is the goal

What is IRR (Internal Rate of Return)?

Internal Rate of Return (IRR) is the discount rate that makes NPV equal to zero. It's the "break-even" rate of return for an investment. It answers: "What percentage return does this investment yield?"

IRR Example

Using the same $100,000 investment with $30,000 annual returns for 5 years:

IRR = 15.2%

This means the investment yields a 15.2% annual return. If your required return is 10%, this investment beats your hurdle rate by 5.2%.

When to Use IRR

• ✅ When comparing investments of similar size and duration
• ✅ When you want a percentage to communicate returns
• ✅ When comparing against a hurdle rate
• ✅ For quick go/no-go decisions

IRR Limitations

• ❌ Can give multiple values with irregular cash flows
• ❌ Assumes reinvestment at the IRR rate (often unrealistic)
• ❌ Doesn't show absolute value created
• ❌ Can be misleading for mutually exclusive projects

What is ROI (Return on Investment)?

Return on Investment (ROI) is the simplest measure—the percentage gain or loss on an investment relative to its cost. It answers: "What's my total return as a percentage?"

ROI Example

Same $100,000 investment generating $30,000/year for 5 years:

• Total Gain = $30,000 × 5 = $150,000
• ROI = ($150,000 - $100,000) / $100,000 × 100%
• ROI = 50% (over 5 years)
• Annualized ROI = 10%/year

When to Use ROI

• ✅ For quick, simple comparisons
• ✅ When time value of money isn't critical
• ✅ For short-term investments
• ✅ When communicating to non-financial stakeholders

ROI Limitations

• ❌ Ignores time value of money
• ❌ Doesn't account for investment duration
• ❌ Can be manipulated by timing
• ❌ Doesn't consider risk

Head-to-Head Comparison

Which Should You Use?

Use NPV When:

You're making a go/no-go decision and want to know the absolute value created. NPV is the "gold standard" in corporate finance because it directly measures wealth creation.

Use IRR When:

You're comparing multiple investment opportunities and want a percentage to rank them. It's intuitive ("this investment returns 25%") and useful for communication.

Use ROI When:

You need a quick, simple calculation for short-term investments or when explaining returns to non-financial stakeholders.

Best Practice: Use All Three

Professional feasibility studies include all three metrics because they provide different perspectives on the same investment.

Common Mistakes

1. Using ROI for long-term investments - Always use NPV/IRR for multi-year projects
2. Ignoring discount rate selection - Your discount rate significantly impacts NPV
3. Comparing IRR across different durations - A 20% IRR over 2 years isn't the same as 20% over 10 years
4. Not considering cash flow timing - When money comes in matters as much as how much