Petroleum Economics: Understanding Internal Rate of Return and Net Present Value

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What is IRR or the Internal Rate of Return?

IRR is the interest rate at which the net present value of a project’s cash flow equals zero.

IRR is used to evaluate the attractiveness of a project or investment.

The Pros & Cons Of IRR

IRR makes it easy to rank projects by their overall rates of return rather than their net present value.

IRR only works for investments that have an initial cash outflow (investment) followed by one or more cash inflows.

IRR does not measure the absolute size of the investment return. (IRR can favor investments with high rates of return even if the dollar amount is small).

IRR can’t be used if the investment generates interim cash flows.

What Is Net Present Value (NPV)?

Net present value is the value of projected (future) cash flows, discounted to the present.

NPV = cash flow/ (1+ discount rate)^number of time periods.

NPV can be used to compare profitability of different projects or investments.

Net present value translates the amount of money you expect to make from a project or
investment into today’s dollars.

It takes into account the time value of money.

$1 million per year for 20 years is not worth $20 million today (NPV is less than $20 million).

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