30 years: Financial markets trader

Abdulla introduces the concept of Net Present Value, or the NPV, and the Internal Rate of Return also known as the IRR.

Abdulla introduces the concept of Net Present Value, or the NPV, and the Internal Rate of Return also known as the IRR.

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5 mins 39 secs

Overview

Investments normally require upfront payments that lead to expected future benefits. Calculating net present value and internal rates of return are essential to determine projects that generate future cash flows. NPV finds the nominal value of a project while IRR finds the minimum required rate of return.

Key learning objectives:

Define NPV and its shortcomings

Define an IRR

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Summary#### What is NPV and what are its shortcomings?

#### What is IRR?

The net present value (NPV) is the difference between the initial cost of the investment and the present value of those future returns discounted at a minimum required rate of return. If the investment has a 0 or positive NPV, it’s worth considering. If the NPV is 0, investors are earning their required rate of return. What NPV doesn’t quantify is what that means in terms of a divergence from a required rate of return. It effectively gives a yes or no answer, accept or reject. This is where the Internal Rate of Return (IRR) is useful.

One of the issues with NPV is that it doesn’t rank the desirability of investments; the results are not ordinal. A higher NPV does not necessarily mean one investment is superior to another. The higher number could be the result of the size of the cash flows associated with it. It might have the higher NPV but a lower IRR than a smaller investment.

The Internal Rate of Return is another way of assessing the profitability of an investment. It is referred to as the break-even rate i.e. the discount rate that produces an NPV of 0. It reflects the difference between the actual rate of return of the cash flows against the required rate.

It is sometimes possible to derive more than one IRR depending on the pattern of the cash flows. It also assumes that when returns are received they can be re-invested at that same rate, which might not be possible. The advantage IRR has over NPV is that it ranks investments in terms of return. Presumably, given the same risk and limited funds investors would prefer to invest in the opportunity with the higher IRR.

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Expert### Abdulla Javeri

Abdulla’s career in the financial markets started in 1990 when he entered the trading floor of the London International Financial Futures Exchange, LIFFE, and qualified as a pit trader in equity and equity index options. In 1996, Abdulla became a trainer for regulatory qualifications and then for non-exam courses, primarily covering all major financial products.

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