IRR Vs. ROIDifferences You Need to Know Between the Two!

Written By:
Lisa Borga

There are many methods used to appraise the performance of investments.

However, few are as widely used and effective as the internal rate of return (IRR) and return on investment (ROI).

Both of these metrics provide valuable information for making capital budgeting decisions, but there are significant distinctions between the two.

IRR uses a discount rate to estimate the future performance of a project based on projections of its future cash inflows.

In contrast, ROI measures a particular investment’s total profitability.

ROI is a far easier metric to calculate and understand, making it a more common choice when measuring the expected performance of an investment.

However, businesses do use both of these metrics when they are budgeting for capital and trying to make decisions about whether or not they should pursue a new project.

In fact, whether or not a new project is accepted is often based on the projected IRR or ROI of the project.

The software can make computing the IRR of a project a lot easier, so typically the decision on which metric to use depends on the additional costs a business believes they need to consider.

Another issue that companies consider when choosing whether to use IRR or ROI is that the Return on Investment metric shows the total growth from the beginning to the end of the investment.

These metrics should generally be the same for the first year.

However, there will be some exceptions, and the metrics will not be the same over longer periods of time.

Return on Investment (ROI)

ROI is the percentage growth or loss of an investment for a particular period.

This is calculated by dividing the investment’s growth or loss by the investment’s initial cost and multiplying the resulting number by 100 to convert it to a percentage value.

As an example, consider a stock that was purchased at the start of a year for $100, and now, at the end of the year, it is worth $130.

This stock investment’s ROI is 30% or [{(130 – 100) / 100} * 100]

ROI can be used to appraise an investment over a period of any length; however, it is important to keep in mind that because this metric does not account for the time value of money, it may be less useful when measuring the value of an investment over a longer period of time.

Consider the example above.

A 30% ROI is impressive over a period of one year.

However, this may not be as valuable over a 50-year period.

The ROI formula can also be used for very nearly any investment or project for which a definite investment and outcome can be measured.

However, these figures may be more or less easy to determine depending upon the length of the investment and the particular activity.

The longer the period of the investment, the more difficult it may be to track all costs, including inflation and taxes.

For some particular projects, such as for internal processes creating an accurate estimate of the resulting monetary value may be difficult as well.

For example, estimating the returns from a new company-wide recycling program may be difficult to quantify, both in the short and long term.

For these reasons, ROI may not be the most effective performance measure for some investments, particularly for long-term investments.

Internal Rate of Return (IRR)

The internal rate of return is the discount rate that makes the net present value of all of a project’s or investment’s cash flows equal to zero.

The IRR is often used by companies to help choose the best project or investment among the available options.

Generally, an investment or project with an IRR that is above the company’s acceptable rate of return or hurdle rate will be considered.

The internal rate of return tends to be more useful in comparing projects than when being used to evaluate a single project.

The internal rate of return is the percentage of return an investment or project is expected to generate during a certain period to contribute toward covering the initial investment.

The IRR is a good way for companies to compare different projects or investments and helps companies choose the best project or investment option.

If the internal rate of return is above the discount rate, it means the investment or project should be profitable.

The formula for IRR is:

[{cash Flows Year 1 / (1+IRR)^1} + {cash Flows Year 2 / (1+IRR)^2} + {cash Flows Year 3 / (1+IRR)^3} + {cash Flows Year 4 / (1+IRR)^4}] – Initial investment = 0

The net present value is set to zero in this formula, and it will be solved for IRR.

Fortunately, computers are now used to find IRR.

Without a computer, it is not easy to calculate IRR because it requires a trial and error approach.

The goal of the formula is to find the rate of discount at which the present value of the nominal cash inflows is equal to the initial investment amount.

It is essential to understand how the discount rate and net present value work before trying to compute IRR.

As an example, suppose an individual offers an investor  $25,000; however, they would receive the money in a year.

This means that the investor would need to compute the present value of the $25,000 they would receive in a year.

To do this, the investor would estimate the discount rate and then use it to find the net present value of the $25,000.

With a discount rate of 8%, the net present value of the $25,000 would be $23,148.15 ($25,000 / 1.08).

The IRR is the discount rate that causes the net present value of the future cash flows of a project or investment to be equal to zero.

This means that the IRR gives the annualized rate of return that an investor will receive for their investment with given cash flows regardless of how far into the future the investment extends.

An example of this would be an investor that needs $250,000 to build a storage facility, but the storage facility is expected to provide cash flows of $65,000 per year for the next four years.

The IRR for this project would be the rate that the future cash flows would need to be discounted to equal $250,000.

 One limitation of the discount rate is that it assumes an investor will reinvest any cash flows at the discount rate.

However, this may not be possible.

So, if the cash flows are reinvested at a rate below the discount rate, the project may appear more profitable than it would actually be.

This could make the modified internal rate of return (MIRR) a better financial measurement for judging an investment.

Key Takeaways

• Both IRR and ROI provide an appraisal of performance for investments and projects.
• ROI is a simpler measurement to calculate than IRR. However, computer programs have made IRR calculations easier to perform.
• ROI identifies the total growth of an investment over a particular period of time, whereas IRR calculates the annual growth rate.
• For a particular year, IRR and ROI will generally provide similar results, but over a longer period, they will typically be significantly different.