Is the ROI a Good Indicator of the IRR?

ABSTRACT

The relationship between the internal rate of return (IRR) and the return on investment (ROI) as criteria for evaluating the profitability of investment is presented in this paper. The relative behavior of the ROI under several definitions is analyzed. While certain simplifying assumptions are made, the model is comprehensive, flexible and useful for examining the impact of changes in policy and environmental variables on the ROI. Under a certainty framework, the ROI is determined by company's policies (dividends and leverage) business environment (interest rate, IRR, and taxes); and the investment horizon and depreciation. Mainly due to the reinvestment rate assumption implicit in the ROI, the most pervasive of all these factors is the dividend policy,φ. Given the reinvestment rate assumption and different revenue and investment measures, the ROI is not a good indicator of the IRR. The introduction of uncertainty in cash flows which need to be analyzed under a probabilistic framework, perhaps using numerical analysis or simulation methods, is suggested for extending this model and to develop further research in this area.

Notes

The views expressed in this paper are soley of the author and do not necessarily represent those of the World Bank Group.