Two of the most commonly known financial metrics to evaluate investments are the internal rate of return (IRR) and return on investment (ROI). However, IRR and ROI are different from each other, having separate meanings and calculations.
ROI is a simple method to measure profitability on any investment. On the other hand, IRR is a bit complex and requires know-how of other financial concepts.
This guide will thoroughly explain the concepts of both IRR and ROI to increase your financial knowledge. Let's start with ROI.
What is return on investment (ROI)?
ROI is the most popular and fundamental financial metric to measure the profitability of a project. ROI compares the investment in a project with the return it generates.
ROI is a key performance indicator for individual investors to evaluate the potential return on businesses. Its formula proves helpful in assessing an investment's performance, as it expresses a clear profit or loss percentage.
How to calculate ROI?
Calculating ROI is pretty straightforward. Here's the formula to calculate ROI:
- Gross Return = profit before costs deduction
- Cost of Investment = Total amount spent on the project
Example To ROI
Suppose a project has yielded a gross return of $100,000 while incurring costs of $75,000. The project's return by using the above ROI formula would be:
Project’s ROI = ($100,000 - $75,000) / $75,000 = 33.33%
The above 33.33% makes it easy to comprehend that the project has yielded a profit of $25,000 on an investment of $75,000.
What does ROI tell?
Knowing the profit or loss is essential for anyone running a business. The ROI is the perfect indicator of a business's performance against the amount invested. A higher ROI percentage reflects a profitable investment and vice versa.
ROI is also valuable for future planning, deploying cost-cutting strategies, and ensuring the business is on the right track.
Unlike IRR, the ROI is easy to interpret and doesn't involve core financial concepts, like the time value of money, discounted cash flow technique, etc.
To understand IRR, you must first have a firm hold over the following financial terms.
Understand these financial terms to learn IRR
There are four financial terms that one must understand to grasp IRR properly. These include the time value of money, discounted cash flow technique, net present value, and minimum acceptable rate of return. Let's have a quick look at them.
Time value of money (TVM)
The TVM is an important financial concept that states that a sum of money is worth more today than the sum to be received in the future. The idea behind TVM is solid. You can invest your money to get a return today, which can ultimately turn into a more significant sum in the future.
Discounted cash flow (DCF) technique
DCF is an investment valuation technique that estimates the growth of an investment by considering its future cashflows. Investors use this technique to convert future cashflows of any project to their present equivalent amount.
Minimum acceptable rate of return (MRR)
The MRR, also known as the hurdle rate, is the least profit an investor expects from an investment.
NPV is the most common DCF technique. It analyzes the viability of a project by discounting the future cash flows using the discount rate equal to the MRR required by the investor.
Investors usually take a bet on projects whose NPV results in a positive value. In contrast, a negative NPV is a clear sign to not opt for the project.
Let's now jump to the concept for which the above financial terms were described.
What is the internal rate of return (IRR)?
The IRR is a discount rate used to assess an investment's profitability. Using IRR, the present value of future cash flows of a project becomes equal to its initial investment amount. In other words, the project falls at its breakeven point.
Companies use IRR to evaluate whether or not an investment is worth taking. They usually go for the project if it yields a breakeven point or above after using IRR.
How to calculate IRR?
Here's the interpolation formula used to calculate the IRR:
A% = First discount rate
B% = Second discount rate
NPV-a = NPV at A%
NPV-b = NPV at B%
It might be tricky to understand the IRR if you look at the above formula. To cope with this situation, let's learn IRR with the help of an example.
Example of IRR
Suppose a company wants to purchase new machinery that costs $500,000. The company expects the machine to produce an additional $160,000 in annual profits. The company estimates the life of the machinery to be four years. In the fifth year, the company intends to sell the machinery at its book value of $50,000.
Meanwhile, there's another investment opportunity that can give a return of 15%, which is higher than the company's MRR, i.e., 12%. The management needs to ensure that the company makes the best use of its cash.
For this purpose, the management runs an IRR test on whether they should purchase machinery.
Their first step is to calculate NPV at two different discount rates. Here are its results:
Now, let's put the above NPV calculations into IRR's formula.
IRR = 10% + (38,090/38090 - 36,480) x (15 - 10)% = 11.18%
Since the IRR is less than the company's MRR of 12%, the company will not purchase the new machinery costing $500,000 and will opt for the other investment opportunity that yields a 15% return.
What does IRR tell?
IRR tells the investors whether a project is a good fit for their investment or not. Practically, companies run a test comparing IRR vs. MARR of multiple projects to choose the most profitable investment opportunities.
Suppose the project provides an IRR that is just aligned or higher than the MARR. In that case, the company can undertake that project because of its ability to grow in the future.
On the contrary, a company would not invest in a project whose IRR is lesser than the MARR.
IRR vs. ROI: Which is better?
There's yet to be a definite answer to let you identify whether IRR is better or ROI. These concepts serve different purposes and contexts. Here is a table that can assist you in understanding more about IRR vs. ROI:
What is the difference between IRR and ROI?
Both IRR and ROI are useful in making investment decisions. However, they both are detached from each other.
For example, as an individual, you would never use IRR if intending to buy stocks as a day trader in the stock exchange. Whereas, if you operate as a venture capitalist, you will find yourself using IRR more often.
ROI backs up individual investors in measuring the profitability potential of a business. On the other hand, big corporations always base their decision-making on IRR to capture long-term investment opportunities.
As for the calculation of both IRR and ROI, there is no doubt that ROI is easy to calculate, while IRR is difficult and requires knowledge of finance.
IRR and ROI might be overwhelming to understand at first. However, you won't see yourself struggling with making investment decisions once you capture their core idea.