Internal rate of return: Good and bad features, and a new way of interpreting the historic measure
Introduction
The Internal Rate of Return (IRR) has been used for years by economists and engineers to estimate the profitability (or potential profitability) of projects. Its definition is rooted in procedures of Discounted Cash Flow (DCF), a methodology that is utilized to “weight” cash flows occurring at the “present time” in some rational way so as to represent their value relative to “future” cash flows in later years. When coupled with Net Present Value (NPV), IRR forms the necessary second measure of profitability. NPV is scaled, i.e., with units of dollars, while IRR is un-scaled or normalized, with units of % or %/time. Two such measures are required to distinguish between projects that may appear to be about equal in terms of profitability but are of different size or scope. Whether the designer prefers a higher profitability or a lower scale of investment can then be considered.
Process Engineers interested in plant design/costing (Douglas, 1988, Edgar et al., 2001, Peters et al., 2003, Ross et al., 2005, Seider et al., 2008, Towler and Sinnott, 2007, Turton et al., 2003, Wells and Rose, 1986) have long used a variation of the IRR, now generally referred to as the “hurdle criterion.” In this approach, a company will impose a significantly high hurdle rate before approving any conceptual design, in other words, will require that a potential process possess a minimum value of IRR as its discount rate, then choose the conceptual process alternative that yields the highest value of NPV above this hurdle.
Process engineers are generally satisfied with this approach; and economists view IRR/NPV as a mature area, another way of saying that the field is “dead” as far as need for additional research. Still, the reexamination of the use of NPV methods made earlier by the author (Mellichamp, 2013) and (Mellichamp, 2016) indicated that much more could be accomplished by defining/using a different normalized profitability measure (the normalized NPV, referred to as NPV%). It is useful to look at the IRR concept again in light of the NPV% measure, to see what it does and does not provide as an alternative.
First, it is important to note that IRR is strictly defined and used only to determine whether a plant or project will be profitable enough to a company (the Enterprise) to build it. The definition specifically does not involve the concept of financing. Thus, for companies large enough to have a group that focuses on financing plants/projects, it is only after a design engineer or group evaluates that it is potentially profitable enough to the company to justify constructing and operating it for its anticipated lifetime that the “finance group” considers what alternative to use— to take on an outside financier, borrow money, sell a bond issue, sell shares of stock—and then how much of any of these is required.
Section snippets
The good features underlying IRR
Apparently, the original idea of IRR was to calculate the annual return on a purchase made with a single-payment of cash, then sold n years later for cash, for example, the acquisition of a fine painting. How much it appreciated or depreciated each year that it was owned, the so-called IRR, was simply the nth root of the quotient of sales and purchase values, thus
Notice that no cash flows occur except at times “going in” and “coming out” of the purchase.
The so-called Modified IRR (MIRR): an incorrectly defined related measure
Many business applications have utilized a modification to the IRR that presumptively deals with the issue of having all cash flows originate or terminate in an account paying/charging at the IRR rate to maintain physical reality and mathematical rigor. The Modified IRR (MIRR, Kierulff, 2008) is an attempt to return to a situation more like the original defining relationship for IRR (in which a single payment is made to purchase the investment and a single payment is returned to the buyer
A new way of interpreting IRR, providing a constructive path to broader use
At this juncture, having questioned several fundamental issues with the IRR metric, one might ask whether it is possible to take advantage of new knowledge available from the author’s earlier NPV% developments, to make better use of an obviously flawed but still widely applied metric.
Note that in this and other representations, the Enterprise Rate is defined as the after-tax rate of return, averaged year over year,2 that the company
Conclusions
One can conjecture that IRR has grown up in many different business environments and has been adapted to use in each one. Thus, a company will have established a “Hurdle Rate” that works for its own applications, meaning that it will be set at a value that reflects its particular Enterprise Rate. It also will reflect some sort of standard expectation for the timing of design, construction, and start-up cycles. And it will have included a suitable (even if unidentified value of profitability
Acknowledgments
The always challenging conversations with my colleague, Michael Doherty, have provided the sort of devil’s advocacy for IRR methods that one needs to keep questioning the status quo. These special discussion times are gratefully acknowledged. Also, the mostly written discussions with Christopher Burk, a chemical plant design TEA practitioner who makes his living doing analysis the right way (Burk Engineering LLC, Salt Lake City) have been very helpful, especially in the computational area.
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