Each analyzes the cash flow of project including the costs (investments) and benefits over time. Each metric has strengths and weaknesses hence one measure is typically not enough to base a significant decision upon. The main difference between ROI and IRR is depicted in the formulas below and explained.
To calculate ROI, the benefit(s) of an investment(s) is divided by the cost of the investment(s) and the result is equal to a percentage or ratio.
ROI = (benefits – investments) / investments * 100%
An ROI of 200% means that every dollar spent on project nets two dollars in return (original + two).
The benefit to using ROI is that it can clearly describe the ratio of the returns from a project versus the costs. However it does not take into account the time value of money.
IRR is often used in capital budgeting. It is the interest rate that makes NPV of all cash flow equal zero. It is primarily the value another investment would need to generate in order to be equivalent to the cash flows of the investment being considered.
The discount rate (r) is necessary to drive the NPV formula to zero:
The benefit to IRR is that illiterates overall returns in clear percentage terms and its great for comparing project returns head to head. However it does not indicate the level of investment required up-front or the overall dollar value of returns.
This was first published in November 2007