Lextree
Simply the best software for managing legal entities and documents.

The Berkman Letter
Practical analysis and commentary for business, law, and more.

# What is the difference between IRR (internal rate of return) and ROI (return on investment)?

Sorry for what is probably a very basic question. Part of my job is participating in a committee that approves projects and I am primarily focused on the human resource aspects but would like to better understand the financial side.

Answers

ROI is a simple way of calculating the profitability of a project. The formula is (Profit-Cost)/Cost. Pros of ROI include simplicity (easy to calculate) and versatility (easily able to adjust calculation for additional costs/income). Cons of ROI include not accounting for the time value of money.IRR also calculates the profitability of project but accounts for the time value of money. However, the formula is a little more complicated: NPV= {Period Cash Flow / (1+R)^T} - Initial Investment where NPV is Net Present Value, R is the discount rate, and T is number of time periods. IRR is the discount rate (R) when NPV equals zero. So while this calculation better allows you to compare projects of differing lengths, it is a little more complex and can get complicated particularly when inflows and outflows of cash are variable over the life of the project.So as a very high level summary, ROI is simple but limited in its ability to account for the time of money; IRR accounts for the time value of money but is more complicated.