Jack Lutz Program Notes, Capital Ideas - Live!, July 15, 2015
What are IRR, NPV and PV?
- IRR = Internal Rate of Return
- Provides a percent rate of return
- If I invest $10,000 (or $10,000,000) replanting this stand, what rate of return
will I get? What will I earn on the money I invest?
- NPV = Net Present Value
- Provides a dollar amount
- You have to pick a discount rate (or rate of return)
- If I invest $10,000 (or $10,000,000) fertilizing this stand and I want to earn 5% on that investment, what is the
present value of all the costs and revenues I will incur/receive in the
- Note: the IRR is the discount rate at which the NPV goes to $0.00
- That may sound bad, but as long as the NPV is $0 or positive, you are
getting back all the money you invested and you are earning returns at the
- PV = Present Value
- Provides a dollar amount that does not include the cost of the investment
- If I want to earn 6% on my investment in a timberland
property, how much can I pay for it?
Which is the best measure to use to rank projects?
- Quick answer: both IRR and NPV—they usually provide the same answer.
- What happens if they disagree?
- If the goal is to maximize your wealth, the NPV is better because it tells
you just how much your wealth will increase.
- A common example considered a low NPV and a high IRR, vs a high NPV and a low IRR
Assume there is $50,000 to invest and there are two projects from which to choose.
- Project A involves an investment with an NPV of $1,000 and has an IRR of 9%.
- Project B involves an investment with an NPV of $55,000 and has an IRR of 7%.
- Note: Under the right conditions, the IRR calculation process can produce
- I haven’t seen it happen, but is supposed to occur when the cash flows switch
back and forth from negative to positive several times over the life of the
How does the PV (present value) work?
- The Present Value is the discounted value of all the future cash flows.
- When appraisers run discounted cash flow models to determine the value of a
timberland property, they are really calculating the Present Value, not the Net
- When people talk about the net present value of a property, they often really
mean the present value.
- You fill your DCF model (can use a spreadsheet) with all the costs and revenues
you expect for the next few years and calculate some sort of end value (perpetual
cash flow or property sale) and put in a discount rate.
- But don’t put in a purchase price.
- The DCF model will calculate a value
- That value is what you can pay for that property using that discount rate.
- Suppose you use a 6% discount rate and the model spits out a number of $1,500/acre
- This means you can pay up to $1,500/acre and make a 6% return.
- If the market price is higher, it means that—if you pay the higher
price—you will make less than 6% on your investment.