ROI, NPV and IRR
Difference between IRR and ROI
When securing funding, prioritising and/or scheduling the delivery of a series of requirements, a Product Owner or Product Manager must consider a number of factors.
Some of these factors might include:
- Business Case – including NPV, ROI and IRR
The first question you need to ask is – Why do I want to do make this investment?
These questions and answers will more often than not be raised and answered by the Product Owner, however the Product Manager will play an active role in contributing to this investigation.
This may be for a number of reasons e.g.
- Return on Investment (“ROI”) – it will deliver a financial return
- Strategic investment - it will help to protect your market position
- Compliance - it will ensure you stay within the law
Although ROI can be measured in terms of financial gain, a Strategic/Compliance – lead investment may be justified and/or measured through Opportunity Cost i.e. the cost of not making this investment (v.s. an alternative course of action that may include doing nothing at all).
There may also be intangible benefits delivered through ma Nking an investment – e.g. stakeholder satisfaction. In these cases it’s best to use proxy measurements to provide some indication of return e.g. if my stakeholder is satisfied, he/she will purchase more, which will in turn lead to a financial Return on Investment.
Return on Investment and Internal Rate of Return
In the event you need to secure investment to fund this development – you may be asked to model the return using an ROI/IRR model.
IRR stands for Internal Rate of Return. The IRR, measured in % return p/a, is essentially equal to the (annualized) interest rate a bank would have to pay you to match the performance of your portfolio – so if the bank interest rate is 2% and you’re forecasting a 12% return, you’re doing well.
Net Present Value and Cost
With that said, you can’t look at IRR alone – you also need to consider Net Present Value i.e. the value of the investment once you’ve taken all of the costs (including opportunity cost) into consideration. NPV is measured as a number (hopefully) between 0 and 1.
If NPV > 0, it means the investment would add value to the firm then the project may be accepted If NPV < 0, the investment would subtract value from the firm then the project should be rejected If NPV = 0, the investment would neither gain nor lose value for the firm then we should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation
Return on Investment Model
Here’s a sample ROI model and it’s totally fictitious!
You will notice that there are three distinct input areas:
- What are the costs associated with delivering the asset?
- What are the benefits (revenue) that will be realised as a direct result of making this investment?
- What are the additional costs associated with realising this return e.g. maintenance/support/cost of sale
The outputs are:
- Payback years - the number of years it will take to break even
- IRR 5 years - in this example, we’re interested in the percentage return over 5 years
- NPV – the value of the investment
Risk – Risk vs. Value Matrix
Once you’ve calculated the potential Net value that could/would be created by proceeding with this investment, we need to consider the Risk involved in delivering the value.
The golden ticked is clearly a High Value, Low Cost, Low Risk opportunity.
One good way to represent the relative relationships between NPV and Risk is via a Risk vs. Value Matrix.
NPV vs ROI
The Net Present Value (or NPV) is an investment term that represents the difference between the present (and/or discounted) value of cash flow in the future and the present value of the investment and any cash flow that may accumulate in the future. Basically, it represents the net result of a multiyear investment (expressed in USD).
The Return on Investment (or the ROI) is an equation that measures the efficiency of an investment. Basically, it’s the quotient of the difference between the gain from an investment and the cost of investment, and the cost of investment
The summary is:
- NPV measures the cash flow of an investment; ROI measures the efficiency of an investment.
- NPV calculates future cash flow; ROI simply calculates the return that the investment produces.
- NPV cannot determine the dedicated investment; ROI can be easily manipulated to the point of inaccuracy.
ROI vs IRR
Compared to the ROI, the IRR is a more complex metric, because it not only takes into consideration the increase of the investment value, but also the timing of the cash flow. This is perhaps why some business minded individuals are discouraged in regards to the tedious solving for the IRR value. Nevertheless, modern tools like Google docs and MS Excel have enabled the automatic function of calculating IRRs. Thus, the IRR has become the most trusted, and most accurate metric for assessing investment stats, even if you incorporate many other variables, such as dividends and taxes.
- ROI is a simple finance metric for investments, whereas IRR is a more complex metric.
- ROI is and was a more commonly used metric, especially when computers were not yet that popular, compared to the IRR.
- ROI only makes use of two values and two operations (division and subtraction), whereas the IRR uses a more complex mathematical formula and algorithms, and is somewhat unsolvable using a purely analytical means.
- IRR is the more accurate metric compared to the ROI, because it can incorporate multiple variables or values in its equation.
Read more: Difference Between IRR and ROI | Difference Between | IRR vs ROI http://www.differencebetween.net/business/difference-between-irr-and-roi/#ixzz1Zjd6H3lG
Uses of ROI
First, ROI gives a quick assessment of investment performance, and it helps that ROI can be computed mentally.
Second, ROI is useful when comparing two investments over the same time period. If one mutual fund had an annual ROI of 15 percent compared to another that had 10 percent, you could conclude the first performed better.