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IRR vs ROI - Understanding Investment MetricsIRR (Internal Rate of Return) and ROI (Return on Investment) are financial metrics used to evaluate investment profitability. However, they differ in complexity and application.
1. Internal Rate of Return (IRR)Definition: The discount rate at which the Net Present Value (NPV) of investment cash flows equals zero.
Formula: NPV = Σ(Cash Flow_t / (1 + IRR)^t) = 0
Key Drivers:- Time value of money (TVM)
- Cash flow timing and amounts
- Discount rate
- Project duration
- Risk factors
Uses:- Evaluate investment profitability
- Compare different investments
- Determine the discount rate at which an investment breaks even
When NOT to Use:- When cash flows fluctuate between positive and negative, leading to multiple IRR values
2. Return on Investment (ROI)Definition: A financial ratio used to measure the profitability of an investment as a percentage of the initial investment.
Formula: ROI = (Investment Profit / Initial Investment) * 100
Key Drivers:- Investment revenues
- Investment costs
Uses:- Measure investment efficiency
- Assess investment profitability
- Make capital allocation decisions
When NOT to Use:- When time value of money (TVM), cash flow timing, and risk are critical factors in decision-making
Key Differences Between IRR and ROI:- IRR accounts for the time value of money (TVM), while ROI does not.
- IRR considers cash flow fluctuations over time, whereas ROI only provides a static percentage.
- ROI is easier to calculate but less accurate for long-term investments.
- IRR is used for comparing different projects, while ROI is a quick efficiency metric.
Conclusion:- Use
ROI for quick comparisons of investment profitability.
- Use
IRR for detailed financial analysis when time value and cash flow variations matter.