The meaning of the metrics NPV and IRR for an NPD project

Net Present Value (NPV)

Net Present Value has several meanings on the NPD project as follows. First, NPV is used because the time-value of money. Specifically, the $40,000 net cash flow earned in Year 2 is less valuable than it would be in Year 1 because if it were earned earlier we could invest it and earn income at the rate of return during the year. Conversely, an expense paid out in the future is less costly than one paid now because we could invest the money and earns return until it was time to pay the expense.

Net Present value analysis presents the various predicted cash flows of the project as a single number, called the NPV. All the projected expenditures and income, all the projected sales quantities, cost of units sold, etc. are wrapped up and distilled into one number. NPV is calculated by this formula.

Where i is the number of time periods from the start, r is the expected rate of return, and value is the cash flow for time period i.

Internal rate of return (IRR)

IRR is a close cousin of NPV. In fact, the definitions are such that NPV of a series of cash flows, evaluated with an r equal to the IRR of the same series of cash flows, is zero. The IRR of a series of cash flows gives the rate of return that would result in an NPV of zero, hence it is the rate of return of the project itself, with no comparison to any other investment’s rate of return.

The importance of the metrics to the attractiveness of an NPD project proposal

Companies face many challenges in new product development, not the least of which is choosing the best projects. Many factors must be considered. Thus, NPV and IRR are used as measures to capture a product’s financial goodness. For example, to understand how to evaluate the results, the first is the project NPV, $91,812, This tells us that, compared to some other investment opportunity with a rate of return of 10%, this project will return $91,812 over and above the 10% return. The IRR, 16%, shows us the rate of return of this project, a rate that we can compare to other investment opportunities. Looking at IRR as well as NPV will get a feeling for profitability of the project in relative terms.

Comparing projects and alternative investments

Comparison is at the heart of this kind of financial analysis. Even when modeling one project, we are comparing it to an alternative investment via the rate of return used in the NPV analysis, while the IRR gives us a rate of return which we compare to that of other opportunities

While it is useful to look at each project individually, an analysis like this is most useful when we are trying to choose which of several proposed projects to develop. It is important to compare projects of similar risk and to use a rate of return that corresponds to the project risk. A variant or line extension project (perhaps tested against a 10 to 20% rate of return) usually has lower risk than a new platform project (which might be compared with a rate of return of 20 to 30%).