Every well-run company that is considering making an investment in new equipment, a new facility, upgraded technology, or a new product or development project, considers at some level what return it will earn on that investment. Accountants and analysts will often calculate Return on Investment (ROI), Discounted Cash Flow (DCF), Payback Period, or Internal Rate of Return (IRR).
Oops! Wait! Most of them get that last one wrong! Often a well-intentioned analyst will calculate ROI and call it IRR, maybe because it sounds more technical or more elegant or whatever. But the calculation and the information conveyed are very different. Look at these definitions:
Return on Investment – a comparison of the total amount an investment will earn over its effective useful life compared to the total cost of that investment, expressed as a percent of that total cost. A simple enough calculation if you have the correct numbers.
Internal Rate of Return – that rate of return, stated as a percent, at which the return on the investment and the cost of capital to make the investment are equal, with both at present value. Put another way, it’s the discount rate that makes the net present value of all cash flows (in and out) from a particular project equal to zero.
Big difference, huh? ROI does not consider the cost of the capital used to make the investment, other than to include it in the calculation of the earnings from it. And, there is no comparison to the cost of the money, or the significance of the time value of money. So, some lessons you can draw from this: First, never invest in a project with a net present value less than zero or a negative IRR. Second, you can’t decide on the first until you actually do the math.
So, which one should you use in making your company’s investment decisions, when the return from the investment is a factor, for example, in choosing between competing projects when there isn’t sufficient capital to do both?
- Obviously if the project at hand is critical to your company’s growth or survival it must be done, and the only choice may be to do it at the lowest possible upfront cost. In this case both metrics are effectively irrelevant to the decision process.
- In today’s interest rate environment, the project to go ahead might be the one that can be done without borrowing additional money, or borrowing as little as possible, unless the additional capital can materially increase the return. Now we’d consider IRR the metric to use.
- If the project is an acquisition that must be consummated now or it will be lost, consider whether the sellers would value more money down the road rather than less money at closing, if the difference must be borrowed money. This may be especially valuable if your acquisition will produce more value than the sellers have been able to produce with the same assets. In this case your future returns as measured by ROI might help decide how to structure the deal, whereas an IRR calculation would help you evaluate where to tweak the deal. We’d use both.
As in every great recipe, the quality of the meal is decided by the careful selection of ingredients. In this arena, we are excellent cooks to consult with, because…
We are Your CFO for Rent.
