When you are in business you sometimes need to determine the value of a capital infusion into a project based on its projected cash flows. Two useful measures available to you are the Return on Investment (ROI) and Internal Rate of Return (IRR). Both measures provide an expected return for a capital infusion and its corresponding projected cash flows, but they differ in the way they account for investment costs.
Internal Rate of Return (IRR)
The internal rate of return measures the break even investment return required on a capital infusion in comparison to projected annual cash flows. If your capital infusion today is $X and you expected future cash flows of $CF(n) for each of years n = 1, 2, 3 and 4, then the IRR is the interest rate at which the sum of the discounted present values of the cash flows equals your capital infusion of $X. Suppose you needed $300,000 to finance a project and expected cash flows of $125,000 in each of the next four years. The present value of those cash flows at a discount rate of 24.1 percent would equal $300,000, making your IRR 24.1 percent.
Return on Investment (ROI)
The return on investment measure takes a similar approach to IRR but also accounts for investment cost, and therefore becomes more a measure of the return of profit generated rather than simply cash flow. The measure is also more simple as it is equal to annual projected profit divided by the capital outlay. If your $300,000 capital infusion was projected to yield cash flows of $125,000 annually, but ongoing investment costs of $25,000, your expected profit would be $100,000. The ROI would then be calculated as $100,000 / $300,000 or 33.3 percent.
Both measures are used to determine the efficiency of an investment in a project. By evaluating each project's costs and cash flows based on a return matrix, you come up with a measure that is easily comparable to measures from other projects you are considering. IRR allows you to evaluate how a capital investment will perform without considering the effects of additional costs, which could be beneficial where costs are static across each project considered. ROI does take costs into consideration, and can be useful when various projects are expected to have different ongoing costs and you wish to evaluate which project can most justify the cost.
According to CFO.com, the use of IRR can make bad projects look good by building in reinvestment assumptions and ignoring cost factors. When the decision comes down to solely which project has the highest IRR, hidden factors such as potential negative cash flows or unaccounted future costs do not factor in the calculation. Furthermore, IRR does not take into account the size of the project and may result in making a smaller project look like the better investment.
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