The Investor’s Dilemma: A Story of NPV, IRR & Discounted Cash Flow


Meet Aryan, a young entrepreneur in Pune who just sold his first business and now has ₹50 lakh to invest. Two opportunities catch his eye:

1️⃣ A Boutique Hotel – A trendy staycation spot near the city center, promising steady profits.
2️⃣ A Solar Energy Project – A sustainable venture with long-term government incentives.

Both require ₹50 lakh upfront and promise good returns. But which one is the smarter financial choice?

Aryan consults his finance-savvy friend, Neha, to figure it out.

Step 1: Why Future Money Isn’t the Same as Today’s Money (Discounted Cash Flow - DCF)

💡 Neha: "Aryan, ₹1 lakh today is not the same as ₹1 lakh five years later. Inflation, investment opportunities, and risk all reduce its value over time. You must discount future cash flows to see what they're worth today."

This method is called Discounted Cash Flow (DCF) and uses this formula:

PV=CF1(1+r)1+CF2(1+r)2+CF3(1+r)3+...+CFn(1+r)nPV = \frac{CF_1}{(1+r)^1} + \frac{CF_2}{(1+r)^2} + \frac{CF_3}{(1+r)^3} + ... + \frac{CF_n}{(1+r)^n}

where:

  • PVPV = Present Value
  • CFnCF_n = Cash flow in year nn
  • rr = Discount rate (cost of capital)
  • nn = Number of years

Step 2: Applying DCF to Both Investments

Aryan estimates future cash flows for each project and uses 8% as the discount rate (his expected return from other investments).

Boutique Hotel Project (₹ in lakhs):

  • Year 1: ₹15
  • Year 2: ₹20
  • Year 3: ₹25
  • Year 4: ₹30

Using the DCF formula, the total Present Value (PV) of the hotel’s cash flows was:

PVHotel=15(1.08)1+20(1.08)2+25(1.08)3+30(1.08)4PV_{\text{Hotel}} = \frac{15}{(1.08)^1} + \frac{20}{(1.08)^2} + \frac{25}{(1.08)^3} + \frac{30}{(1.08)^4}

📊 Present Value of Hotel’s future cash flows = ₹62 lakh

Solar Energy Project (₹ in lakhs):

  • Year 1: ₹10
  • Year 2: ₹18
  • Year 3: ₹28
  • Year 4: ₹35

PVSolar=10(1.08)1+18(1.08)2+28(1.08)3+35(1.08)4PV_{\text{Solar}} = \frac{10}{(1.08)^1} + \frac{18}{(1.08)^2} + \frac{28}{(1.08)^3} + \frac{35}{(1.08)^4}

📊 Present Value of Solar Project’s future cash flows = ₹68 lakh

Step 3: Calculating Net Present Value (NPV)

Neha: 

💡 Net Present Value (NPV) tells us how much value an investment adds in today’s terms by discounting future cash flows to the present.

"Now, let's check how much value each project creates today by subtracting your ₹50 lakh investment."

NPV=PVcash flows−Initial InvestmentNPV = PV_{\text{cash flows}} - \text{Initial Investment}

📌 Hotel NPV = ₹62 lakh - ₹50 lakh = ₹12 lakh
📌 Solar Project NPV = ₹68 lakh - ₹50 lakh = ₹18 lakh

🔹 Higher NPV = More absolute profit.
🔹 Solar Project has a higher NPV → It adds ₹18 lakh in today’s terms, vs. ₹12 lakh for the Hotel.

Step 4: Calculating Internal Rate of Return (IRR)

💡 Aryan: “What if I want to compare the efficiency of each investment in percentage terms?”

Neha smiled. “That’s where Internal Rate of Return (IRR) comes in! IRR is the discount rate at which NPV becomes zero.”

0=∑CFn(1+IRR)n−Initial Investment0 = \sum \frac{CF_n}{(1+\text{IRR})^n} - \text{Initial Investment}

The formula for IRR is:

0=CF1(1+r)1+CF2(1+r)2+CF3(1+r)3+...+CFn(1+r)n−Initial Investment0 = \frac{CF_1}{(1+r)^1} + \frac{CF_2}{(1+r)^2} + \frac{CF_3}{(1+r)^3} + ... + \frac{CF_n}{(1+r)^n} - \text{Initial Investment}

Let’s apply this to both projects.

1️⃣ Hotel Project IRR Calculation

💰 Investment = ₹50 lakh
📊 Cash flows:

  • Year 1: ₹15 lakh
  • Year 2: ₹20 lakh
  • Year 3: ₹25 lakh
  • Year 4: ₹30 lakh

We need to find rr (IRR) that satisfies:

50=15(1+r)1+20(1+r)2+25(1+r)3+30(1+r)450 = \frac{15}{(1+r)^1} + \frac{20}{(1+r)^2} + \frac{25}{(1+r)^3} + \frac{30}{(1+r)^4}

Solving for rr, we get:
📌 IRR ≈ 14%

2️⃣ Solar Project IRR Calculation

💰 Investment = ₹50 lakh
📊 Cash flows:

  • Year 1: ₹10 lakh
  • Year 2: ₹18 lakh
  • Year 3: ₹28 lakh
  • Year 4: ₹35 lakh

The equation becomes:

50=10(1+r)1+18(1+r)2+28(1+r)3+35(1+r)450 = \frac{10}{(1+r)^1} + \frac{18}{(1+r)^2} + \frac{28}{(1+r)^3} + \frac{35}{(1+r)^4}

Solving for rr, we get:
📌 IRR ≈ 11%

📊 After calculation:

  • Hotel IRR = 14%
  • Solar Project IRR = 11%

🔹 Higher IRR = Higher return per rupee invested.
🔹 Hotel has a higher IRR → More efficient in generating returns.

Final Decision: NPV vs. IRR

Aryan now faces a choice:

✔ If he wants more total wealth, the Solar Project (NPV ₹18 lakh) is better.
✔ If he wants a better percentage return, the Hotel (IRR 14%) is better.

After careful thought, Aryan chooses the Solar Project—it aligns with his long-term vision and generates more wealth overall.

Takeaways from Aryan’s Story

✅ NPV shows the total value added today—higher NPV is better for wealth creation.
✅ IRR shows how efficient an investment is—higher IRR means better returns per rupee.
✅ Discounted Cash Flow (DCF) helps compare future earnings in today’s terms.

Before investing, always check NPV & IRR together!

[Finance]

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