NPV vs. ROI; IRR or Break-even: which should I use?

Question

Dear Community,

Can any of you advise, with solid justifications, the appropriate case scenarios to use specific metrics of financial evaluation?

I typically use 4 metrics (see below), and match them based on a justification system I use, but I would appreciate validation from you guys. :-)

My 4 metrics, and when I use them, are:

1) Net Present Value
I use this for very large investments whose projected financial benefit is expected to endure far into the future and for whose short-term benefit it is less relevant to consider.

Example: assessing whether the construction of a sub-strait tunnel in the Straits of Gibraltar to connect the European and African continents with a high-capacity motored traffic link is a worthwhile investment.

2) Break-even (time or money)
I use this for smaller investments where resources are scarcer, where the time factor is finite, and where other worthy projects are competing for the same funds and only 1 can be greenlit.

Example: deciding if a popular restaurant on the Bosphorous in Istanbul should choose between:

i) expanding the restaurant to go from a dining capacity of 80 to 115;
OR
ii) setting up a satelllite location in a secondary area with lower traffic but higher prices targeted at a more discerning customer base;
OR
iii) acquring a luxury boat to be able to offer concierge pick-up and drop-off from partner hotels and thereby expand patronage within certain customer segments.

3) Return on Investment (simple, non-time-weighted value of forecast gains divided by projected investment -1)
I also use this when the time-frame is finite, but when there is less sensitivity to the timing of the returns, and when there are a greater number of seemingly-similar options from which to choose.

Example: a lottery winner wishes to invest $5 Million of his surplus for a pre-defined, 5-year investment time-frame and is considering a choice of several investment vehicles.

4) Internal Rate of Return
I very rarely use this.
I mostly consider it a reverse NPV (or FV discount rate) where projected cash flows are known across options and other risk factors have been defined.

Example: deciding between 2 acquisitions across a range of factors, and using the IRR as an added filter to complete the selection. The ultimate selection is made either because the IRR is superior to other projects of similar risk profiles, OR the IRR exceeds the projected default option of staying the course.

So, I ask you:
i) What am I doing right?
ii) What am I doing wrong?

Answer 1

Hi there,

Q: Can any of you advise, with solid justifications, the appropriate case scenarios to use specific metrics of financial evaluation?

As simple as it sounds, you should use the one required by the client.

Some clients might want the highest NPV, some might want to break even as soon as possible, some might want the highest ROI in a certain amount of time. Once you have clarified that, you can choose the relevant metric to measure the best opportunity.

If they list them and ask which one you would choose, I would say that we should ask the client what they want to achieve. Based on that, you should be able to extrapolate which metric is the most suitable for that objective.

Best,

Francesco

Answer 2

Hello!

Precisely for the high amount of questions (1) asked by my coachees and students and (2) present in this Q&A, I created the “Math & Formulas - Economic and Financial concepts for MBB interviews”, recently published in PrepLounge’s shop (https://www.preplounge.com/en/shop/prep-guide/economic_and_financial_concepts_for_mbb_interviews).

After +5 years of candidate coaching and university teaching, and after having seen hundreds of cases, I realized that the economic-related knowledge needed to master case interviews is not much, and not complex. However, you need to know where to focus! Hence, I created the guide that I wish I could have had, summarizing the most important economic and financial concepts needed to solve consulting cases, combining key concepts theorical reviews and a hands-on methodology with examples and ad-hoc practice cases.

It focuses on 4 core topics, divided in chapters (each of them ranked in scale of importance, to help you maximize your time in short preparations):

Economic concepts: Profitability equation, Break even, Valuation methods (economic, market and asset), Payback period, NPV and IRR, + 3 practice cases to put it all together in a practical way.
Financial concepts: Balance sheet, Income statement/P&L and Performance ratios (based on sales and based on investment), +1 practice case
Market structure & pricing: Market types, Perfect competition markets (demand and supply), Willingness to pay, Pricing approaches, Market segmentation and Price elasticity of demand, +1 practice case
Marketing and Customer Acquisition: Sales funnel, Key marketing metrics (CAC and CLV) and Churn, +1 practice case

Feel free to PM me for disccount codes for the guide, and I hope it helps you rock your interviews!

Answer 3

Hi there,

What a great breakdown of the key formulas!

Let me help you a bit….

Use the formula that the interviewer wants you to use.

It's really that simple! You can “propose” one or 2, but say something like “I think an NPV formula might make sense here, but I'd be happy to use whatever metric the client prefers, be it NPV, ROI, Breakeven, etc.”

That's it!

Edit (In Response to Your Comment):

What a great question from the interviewer! I love these types fo questions (and asking them when I case candidates).

Now, most important is how you react to a question like this. Stay calm, think through the question/response, and give an organized, thoughtful response.

Importantly, this question you posed me is unlikely to be asked to you again! But another will. So, train the how/why more than the what :)

Onto the “What”….

I like your logic in the above. It's quite sound.

A couple things to consider:

Hints from the prompt/case will be important
You have to take into account the clients objective (maybe they say 5% ROI somewhere, or 5 year breakeven)
In general, I'll use NPV when valuing a company, or when looking at the value of an investment…NPV most common in M&A cases
ROI is the “best” metric and my prefered…most common in Investment cases
Breakeven isn't a good metric, but a lot of cases have it
IRR you likely won't see

Answer 4

Hi there!

Use the one the client wants.

And one more point - you're not expected to know these formulas by heart. It's totally ok to ask the interviewer for the formula.

Best,
Cristian

Answer 5

Great response by Ian (as always!).

If I could follow-up, I also had a Case like this, but the interviewer actually wanted me to BRAINSTORM which would be the best metric to use and why.
It ended up being about 3 minutes of going back and forth. The interviewer finally accepted my chosen metric and told me it was the correct one to use.

So, back to the original question: if identifying the correct formula is part of the case, what would you say is a good way to go about it?