Thread by @IAmOanaLabes

IRR vs. ROI

They’re both financial metrics used to evaluate investment profitability and to compare the profitability of different investments.

🎯 Definition:

⚫ IRR (Internal Rate of Return): The discount rate making the net present value (NPV) of investment cash flows zero.

🟢 ROI (Return on Investment): A financial ratio measuring the profitability of an investment as a percentage of the initial investment.

🎯 How do you calculate them?

⚫ IRR: NPV = ∑(Cash Flow_t / (1 + IRR)^t) = 0

🟢 ROI: (Investment cash flow - cost of investment) / cost of investment

🎯 What drives IRR & ROI?

⚫ IRR: Time value of money, cash flow timing, cash flow amounts, discount rate, project duration, risk.

🟢 ROI: Investment cash flow, cost of investment, project duration, risk.

🎯 How should you use them?

⚫ IRR: Evaluates investment profitability, compares different investments, determines break-even discount rate.

🟢 ROI: Measures investment efficiency, compares different investments, decides where to allocate funds.

🎯 How should you NOT use them?

⚫ IRR: Avoid when investment cash flows are expected to be both positive and negative during project

🟢 ROI: Avoid when time value of money, cash flow timing, and risk are crucial in investment decisions.

🎯 How are they different?

⚫ IRR is more complex, considering the time value of money.

⚫ IRR accounts for cash flow timing and amounts, providing a more accurate profitability picture

⚫ IRR may produce multiple solutions or none, making it difficult to interpret

⚫ IRR considers risk by accounting for the required discount rate to achieve a positive NPV

🟢 ROI is easier to calculate and understand

🟢 ROI ignores the time value of money

🟢 ROI doesn't consider risk

What do you think?

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