Return on Investment – Internal Rate of Return

By R. S. Miolla

Agenda

• 1) What is return on investment (ROI)?• 2) Internal Rate of Return• 3) Net Present Value Method (NPV) compared

to Internal Rate of Return (IRR).

1) ROI or Capital Budgeting

• Answers: Is this a good financial investment?• Simple ROI computed as (Returns –

Investment)/Investment– Assume 10k investment, 3k return for 4 years– (12,000-10000)/10,000 = 20%

• A long-term investment – Example: buying equipment, opening a plant

• Simple ROI may use cash or profit as return.

2) Internal Rate of Return (IRR)

• Gives the % rate of return on the investment. Computed based on the cash inflows and time value of money.

• Can be called the yield on the investment.• Contrast to Simple Return on Investment =

{(return-investment)/investment}/# years.– Note simple ROI can be annualized.

2) IRR - Calculation

• Can be done in Excel• Financial calculator• Online calculator• Phone Apps• Financial tables

2) IRR - Example

• Investment of $50,000• Return or cash inflow of $20,000 a year for 3

years.• IRR = 9.7%

Strengths of IRR vs. NPV

• 1) Projects of different initial investments are easily compared.

• 2) A firm can set a hurdle rate for IRR (maybe its cost of capital plus 5%) and all projects are easily compared to the hurdle rate.

Summary

• 1) Return on investment.• 2) Internal rate of return.• 3) NPV and IRR compared.