PMcrunch

Two methods of capital budgeting often used on project and in project portfolio management are internal rate of return (IRR) and net present value (NPV). They are close cousins but take a little bit of a different look at the value of a project. They are both time based and bothrelayed to cash flows over time on a project.

Internal rate of return (IRR) is an average rate of return of all the cash flows over time resulting from a project. The internal rate of return is a rate such as, for example, 10% that reflects the return on investment discounted over the years in which the effect of the project is realized.

Net present value is a little different in a sense that it reflects a  monetary value, not a rate. However, like IRR, it looks at the cash flows over time. It provides the opportunity to estimate financial impact of a project both in terms of cost and revenue over a resaonable period of time in which the product of the project will have an impact on operations.

We obviously will be more interested in projects that have a higher IRR and a higher NPV. Looking at each of these numbers is instructive on helping us to decide on financial basis which projects to do. It is important to estimate our cash flows as accurately as possible and then to monitor closely that accuracy after the project has been implemented. The most important thing is to recognize that, as demonstrated with both the IRR and NPV, that decisions on projects are based on a forward looking criteria. This forward looking criteria is based on enhanced performance as measured by changes in cash flow, both negative and positive, over time.

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John Reiling, PMP
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