Key Difference – IRR vs ROI
There are a number of factors that should be considered when making investments, where returns play a vital role. Investments should be evaluated for their returns not only after the investment is being made, but prior to assigning capital in the form of forecasts. IRR (Internal Rate of Return) and ROI (Return On Investment) are two widely used measures for this purpose. The key difference between the IRR and ROI is that while IRR is the rate at which the present value of a project is equal to zero, ROI calculates the return from an investment as a percentage of the original amount invested.
CONTENTS
1. Overview and Key Difference
2. What is IRR
3. What is ROI
4. Side by Side Comparison – IRR vs ROI
5. Summary
What is IRR
IRR (Internal Rate of Return) is the discount rate at which the Net Present Value of a project is zero. This amounts to the forecast of the return expected from a project.
Net Present Value (NPV)
NPV is the value of a sum of money today (at present) in contrast to its value at a future date. In other words, it is the present value of future cash flows.
E.g: A sum of $100 will not be valued the same in the time of 5 years, it will value less than $100. This is due to the time value of money where the real value of money is reduced as a result of inflation.
Discount Rate
Rate of discount used for the present value of future cash flows
Decision Rule of NPV
- If the NPV is positive this means that the project will create shareholder value; thus, accept it.
- If the NPV is negative this means that the project will destroy shareholder value; thus, reject it.
To calculate IRR, cash flows of the project should be taken to calculate the discount factor which results in an NPV of zero. IRR is calculated using the following formula.
IRR = r a + NPV a/ (NPV a – NPV b)* (r 2a –r 2b)
The decision whether to proceed with the project is dependent on the difference between the target IRR expected from the project and the actual IRR. For instance, if the target IRR is 6% and the IRR generated is 9%, then the company should accept the project.
The main advantage of using IRR is that it uses cash flows instead of profits which provide an increased accurate estimate since cash flows are not affected by accounting practices. However, predicting the future cash flows for a project is subjected to a number of assumptions and it is very difficult to predict accurately due to unforeseen circumstances. Thus, this limitation can reduce the effectiveness of this measure as an investment tool.
Figure_1: IRR (Internal Rate of Return) Graph
What is ROI
ROI can be categorized as an important tool to derive the return from an investment. This is a frequently used formula by investors to calculate how much return is received for a particular investment as a proportion of the originally invested amount. This is calculated as a percentage as per below.
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
E.g: Investor A purchased 50 equity shares of XYZ Ltd for a price of $7 each in 2015. On 31.01.2017 shares are sold for the price of $11 each, making a gain of $5 per share. Thus, the ROI can be calculated as,
ROI= (50*11) – (50*7)/ 50*7=57%
ROI also assists in comparing returns from different investments; thus, an investor can select which one to invest in between two or more options.
Companies calculate ROI as an indication of how well the capital invested is utilized to generate revenue.
ROI = Earnings Before Interest and Tax / Capital Employed
What is the difference between IRR and ROI?
IRR vs ROI |
|
| IRR is the rate at which the Net Present Value is zero. | ROI is the return from an investment as a percentage of the original amount invested. |
| Use | |
| This is used to decide the viability of a future investment. | This is used to decide the viability of a past investment. |
| Elements in Calculation | |
| This uses cash flows | This uses profit. |
| Formula for Calculation | |
| IRR = r a + NPV a/ (NPV a – NPV b)* (r 2a –r 2b) | ROI = Earnings Before Interest and Tax / Capital Employed |
Summary – IRR vs ROI
The key difference between IRR and ROI is that they are used for two types of investments; IRR to evaluate future projects and ROI to assess the viability of already made investments. Since IRR is subjected to forecast of future cash flows, its effectiveness depends on how accurately they can be predicted. ROI, on the other hand, does not have such complications. However, ROI does not take into account the time period of the investment which is very important since some investors prefer to acquire a gain within a shorter period of time as opposed to waiting for a long time even to gain a comparatively higher return.
Reference:
1. http://www.accaglobal.com, ACCA -. “ACCA – Think Ahead.” The internal rate of return | FFM Foundations in Financial Management | Foundations in Accountancy | Students | ACCA | ACCA Global. N.p., n.d. Web. 13 Feb. 2017.
2. “Calculating Present Value | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 13 Feb. 2017.
3. “Return on Investment (ROI): Advantages and Disadvantages.” YourArticleLibrary.com: The Next Generation Library. N.p., 13 May 2015. Web. 14 Feb. 2017.
Image Courtesy:
1. “IRR1 – Grieger”By User: Grieger – Own work (Public Domain) via Commons Wikimedia