Two CFP® exam topics that could be tested are Internal rate of return (IRR) and net present value (NPV). IRR and NPV are two discounted cash flow techniques used in capital budgeting to evaluate various investment options. Capital budgeting usually pertains to a company deciding on alternatives for capital spending. Examples might be the purchase of a large piece of industrial machinery or perhaps an expansion opportunity for the business. These techniques also have applications with other types of investment options.

**What is net present value (NPV)? **

NPV is the difference between a series of discounted cash inflows and discounted cash outflows over a specific period of time. If the project or investment’s NPV is greater than zero, this is considered a positive outcome and the project may be worthwhile to go forward with.

To calculate the NPV for a project, a firm would estimate the net future cash flows of the project over a specific period of time. This would include net inflows such as additional revenues or cash inflows from the project. These net cash flows are then discounted to a single present value number. The discount rate used is important as it can impact the present value of the project’s cash flows. A higher discount rate results in a lower present value of these cash flows.

Note the discount rate used in the NPV calculation should be a rate that equates to the firm’s cost of capital. Cost of capital could equate to an interest rate for borrowed funds or the opportunity cost on using internal funds on project A versus project B.

The discounted net cash flows of the project are then compared to the initial cash outlay or investment in the project. If the present value of the discounted cash flows are greater than the initial cash outlay, then the project offers a positive investment return and should be considered.

**What is internal rate of return (IRR)?**

IRR also uses the cash flows from a project over time as well as the initial investment or cash outlay. The difference from using these factors to calculate the project’s NPV is that when calculating the IRR, you set the discount rate to zero.

Instead of solving for NPV, you are looking for the discount rate versus the net present value.

IRR can be used to compare the IRR on different investment options being considered. It can also be used to determine if a project exceeds the hurdle rate, or minimum rate of return set by the firm for investment projects.

Note a key difference between using NPV and IRR. In the case of NPV, there could conceivably be multiple cash outlays over the life of the project. For example, there might be an initial cash outlay to purchase the land for a project like a business expansion. There might then be several progress payments at various intervals for construction or equipment purchases. These staggered outlays can be discounted back to the present with NPV, however IRR does not allow for multiple cash outflows.

**Which is better? **

The answer to this is that both have merit. On an applicable project that lends itself to both calculations, using both calculations can help solidify the firm’s decision process. In the case of a project with multiple cash outlays over time, then the NPV is the alternative to use. It’s unlikely that you’ll be asked on the CFP® exam which one is better, but it’s possible you’ll be asked to calculate either IRR, NPV or both.