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NPV and IRR are key tools used in making investment decisions.
© iStockphoto/jwohlfeil
Imagine that your organization is considering buying a machine costing $450,000. The machine is expected to yield $100,000 a year for five years, but your board decides not to go ahead with it.
The investment is pretty much risk-free, the money is available, and the business is almost guaranteed a profit of $10,000 a year. So, why have they decided not to invest?
At first glance, investment decisions like these can seem to be "no brainers" – make the investment, and then collect the profit. But the value of money received in the future is less than the value of that money now (because of inflation and interest rates). So it's possible that the return from an investment might actually be worth less than the investment itself, once you have compared the value of money today, and in the future.
There are also other investment opportunities to consider. Would investing the money elsewhere provide a better return?
In this article, we'll look at three key approaches used in making investment decisions:
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