When a person decides to start a business, one of the most important things to pay attention to is investing in capital . However, as we all know, the goal we want to achieve is to obtain profits much greater than the investment we have made. In this way, we will obtain a favorable balance. It is normal to feel fear when we embark on a project of these characteristics. However, there is a way to estimate how successful a business is going to be . Of course, we are not talking about predicting the future and having the data totally clear, but it is possible to get an idea of the profits that we can obtain later. This will make it easier to take a step forward. All this is related to the calculation of the VAN and the IRR .
What is the VAN and the TIR?
It is likely that at this point you are wondering, not only how the calculation is made, but also what the NPV and the TIR are . Well, these are two financial instruments that allow those who are thinking of setting up a company to make an evaluation of the profitability of the project they want to carry out . In this way, they can reach the conclusion of whether or not it is going to be profitable.
Usefulness of calculating the VAN and the TIR
The NPV, whose acronym stands for “Net Present Value”, is used to calculate the flows of income entering a company, the investment made to generate the product again and the expenses . After calculating this amount, we have to analyze if it is greater than or equal to the investment that has been made at the beginning of the venture. If so, the project will be viable.
On the other hand, the IRR represents the percentage of loss or profit that will be had when carrying out an investment in a project that we are about to start . Depending on the figure we obtain after developing the formula, the balance will lean towards the loss or profit side of the company.
What are the differences between the NPV and the TIR?
Although they are presented jointly among the calculations that have to be carried out when we start to set up a business , it must be clear that the NPV and the IRR are not the same . Therefore, it is calculated in a different way and boasts several differences. These are the following:
- The calculation of the VAN invites the interested person to get an idea of the gross profits that their company can have
- For its part, the calculation of the IRR determines to what extent a project will be profitable or not.
- Likewise, by calculating the NPV it is possible to make a measurement of the profit that the person who invests will have.
- In addition, whoever carries out the IRR formula should know that it is recommended mainly for projects that have a shorter duration or, also, for those that have a high cash flow.
Formulas to calculate the NPV and the TIR in Excel
It is true that, at first, the calculation of the NPV and the IRR seems very complicated . However, as practice is gained, the formulas develop in a simpler way.
To carry out the calculation of the VAN and the IRR through Excel , the Net Internal Flow is needed. To get the result of the latter, it is enough to subtract the company’s income for each period from the expenses for each period. It is the way to get the cash flow. In order to carry out this calculation properly, it is essential to know the meaning of each letter. Thus, we can say that they mean the following:
- N : Number of periods or years
- F : Net cash flow
- I : Interest rate
- IO : Initial Investment
Example of calculation of the VAN and the TIR
The Income Flow would be the profits of the year 2020. From this amount, the money that was spent throughout that year would have to be subtracted, which would be the Expense Flow. Once we have subtracted the two amounts, we would obtain the result of the Net Cash Flow . Once we have this information at our fingertips, numerous data must be formulated. Each of them is listed by flows, that is, Flow 1 (f1), Flow 2 (f2)… and so on, depending, of course, on the years being calculated.
If what we want is to obtain the NPV quickly , we only have to select the numbers of each period, placing the negative in the value of the investment that has been developed at the beginning of the project. In Excel, the formula would be: NPV (I; f1; f2)-IO . However, right now you may be wondering what the meaning of these numbers and letters is. We explain it to you:
=Function Net Present Value (interest rate; flow of the first year; flow of the last year) less initial investment.
Solving the previous formula, the result it will give you will be the NPV. If this is less than zero, it is best not to continue with the project , as it will not be profitable. The reason is that the investment is greater and, therefore, the project will not be viable when it is carried out.
In the event that it is equal to zero, the project is going to be profitable . The reason is that it establishes a profit for the company. On the other hand, if it is greater than zero, the project will also make a profit . The reason would be that the Net Present Value would be higher than the investment made at the beginning.
Calculate the IRR
When calculating the Internal Rate of Return, that is, the IRR , this forces the Van to become 0. In this way, it is intended to identify the interest rate that transforms the Net Present Value into zero. In this case, the formula that we would need to reach this result in Excel would be the following:
=IRR(IO;F2)
These numbers and letters mean the following:
= Internal Rate of Return (Initial investment; last period)
The result of this formula corresponds to the IRR percentage . Now, once the calculations have been made, we must bear in mind that when IRR is greater than K, the investment project is viable . The reason is that the internal rate of return obtained is higher than the initial investment. However, if it is equal to K, only if the sales of the product or service offered are multiplied, or if the position of the company within the market improves, it would be recommended to make the investment . Finally, when the result is less than K, the project is not viable . At this point, the reason is obvious, and it is that it does not have the necessary profitability.
Formula to calculate the NPV manually
If you want to calculate the NPV manually, it will be essential to carry out the following formula:
This formula means that the NPV, that is, the Net Present Value, is equal to the number of flows (represented by the letter “f” and a number) divided by one, plus interest rates, raised to the number of periods (represented by the letter “n” and a number), minus the initial investment .
