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Difference between IRR and ROI in Evaluating Investment Opportunities

by Jason Varner Financial Projections Template
Businesses need to make the optimum decision when it comes to their investment. To maximize their returns, companies have to decide which investment metric to rely on. The most common financial metric lies between Return on Investment (ROI) or Internal Rate of Return (IRR); both are useful in making an investment decision; however, it has to be clear when should you use ROI and IRR. In this article, let us clarify the difference between IRR and ROI.

When to use ROI?

Return on Investment or ROI is a widely used profit metric used to measure the effectiveness of your investment in generating income. This is a measure of what you get back from what you put in in the simplest term. In general, it is important to note that once you invest your money, you need to ensure you’re making a profit.  Calculating your investment’s profitability using ROI is an excellent way to measure whether your investment decision is paying off. ROI is especially useful in evaluating the number of competing projects that allow decision-makers to explore potential returns of different investment opportunities. ROI simplicity often used as a standard universal measure of profitability.  However, ROI is not suitable in all situations. It does not consider the time value of money and holding period of investment, which can be an issue when comparing investment alternatives. Let’s assume an investment A generates ROI of 30% and investment B generates ROI of 20%. At first glance, investment A seems favorable; however, one cannot assume that easy unless the time-frame is given in both investments. It could be possible that 30% from investment A was generated over three years while the latter was generated in just a year. ROI most effective on short period investment and not on a multi-year investment. ROI is simply calculated as the profit divided by the cost of investment.

IRR: What is used for?

Internal Rate of Return or IRR is also a widely used metric to evaluate new investment opportunities. IRR is the required discount rate that makes the net present value of all cash flows equal to zero for a particular investment. It considers the expected cash flows during the lifetime of a project and interpreted as a percentage return metric used to compare competing investment prospects. Once the IRR is known, it would then be compared to the company’s hurdle rate, which is the minimum return required usually set higher to ensure greater profitability. The hurdle rate serves as the breakeven discount, which indicates investment profitability. Thus, IRR should be higher than the hurdle rate in order for an investment project to be accepted. If there are several competing projects, the highest IRR is usually preferred. However, like ROI, it also has its limitations. IRR does not measure the absolute size of investment or return. Thus, it may also favor investment with a high return rate even if the return is quite small.

The Bottom Line: IRR and ROI are both useful in evaluating investment opportunities

In analyzing different investment opportunities, it is essential to know the right metric to use. Different variables have to be taken into account before deciding which metric is best for your investment. ROI works best on short-term investment, while IRR is mostly effective in long-term and larger investment opportunities. Thus, before making an investment decision, you need to be well-versed about the difference between IRR and ROI so you could maximize your returns effectively.

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About Jason Varner Innovator   Financial Projections Template

25 connections, 1 recommendations, 92 honor points.
Joined APSense since, February 16th, 2018, From Zurich, Switzerland.

Created on Sep 8th 2020 19:47. Viewed 272 times.

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