Difference between IRR and ROI in Cost-Benefit Analysis

1. Difference between IRR and ROI in Cost-Benefit Analysis A cost-benefit analysis is used to evaluate investment alternatives' profitability and analyzes the course of action that has to be taken in a particular business decision. This technique weighs the cost and benefits of different project alternatives over an individually defined time horizon. Two of the metrics used to support the cost-benefit analysis are the internal rate of return (IRR) and return on investment (ROI). In this context, we will narrow down the difference between IRR and ROI. What is the Purpose of Cost-Benefit Analysis? The purpose of cost-benefit analysis is to have a systematic approach to evaluate the list of projects. It is used to determine the expected financial gains of a project or investment. Additionally, different options can be compared against each other, which would support an unbiased decision towards the project. Internal Rate of Return (IRR) IRR is one of the common metrics used in the cost-benefit analysis along with other metrics. It is a way to calculate return on investment over a specified period and typically forward-looking. IRR is the discount rate which leads to zero Net Present Value (NPV) and takes into consideration the cost of a project and the annual net cash flows. Often, the internal rate of return is the best way to compare an investment opportunity with different cash flow structures and holding periods to determine which project could maximize your return over a specified period of time. Ideally, the project's IRR should exceed the business's required return rate for it to be accepted. The company's hurdle rate is the minimum or required return, usually set higher for larger profits. Any project with an IRR higher than the minimum return is deemed to be a profitable one. Still, businesses or companies should not rely on this basis alone as it also has some weak points, which does not apply to all. What is ROI? Return on Investment (ROI) is quite a popular metric applicable to the most investment project. While IRR is a forward-looking metric, ROI, on the other hand, can be used to analyze the projected or actual return of a project using a historical period. Though ROI is pretty straightforward to compute, it is best used for short-term projects. Conclusion: IRR and ROI can be both used in cost-benefit analysis The purpose of cost-benefit analysis is to help decision-makers make an informed business decision towards a particular project. While IRR and ROI would help analyze and assess different project options, you should also be aware of its limitation. Differences between IRR and ROI have to be pointed out to avoid misinterpretation. Keep in mind where these both metrics could be of best use so you won't be misguided. eFinancial Models Zurich, Switzerland 8000 info@efinancialmodels.com https://www.efinancialmodels.com/