Abstract
The internal rate of return (IRR) is widely used in Private Finance Initiative (PFI) schemes in the UK for measuring performance. However, it is well-known that the IRR may be a misleading indicator of economic profitability. Treasury Guidance (2004) recognises that the IRR should not be used and net present value (NPV) should be calculated instead, unless the cash flow pattern is even. The distortion generated by the IRR can be quantified by the notion of scheduling effect, introduced in Cuthbert and Cuthbert (2012). We combine this notion with the notion of average IRR (AIRR), introduced in Magni (2010, 2013) and show that a positive scheduling effect arises if the AIRR, relative to a flat payment stream, exceeds the project's IRR. The scheduling component can be measured in two separate ways, in terms of specific AIRRs, one of which enables the scheduling component to be decomposed into relative capital and relative rate components. We also highlight the role of average capital, whose quotation in the market, in association with IRRs or AIRRs, would deepen the economic analysis of the project.
Highlights
Economic profitability of projects is a major topic in production economics and engineering economy as well as corporate finance
The UK Treasury endorses the use of net present value (NPV) in Private Finance Initiative (PFI) projects and warns against the internal rate of return (IRR), admitting its use only if the relevant payment profiles are of a flat, annuity, type (Treasury, 2004); there is a rationale for this, because in the latter case knowledge of the IRR enables unravelling the cash flows and, if the initial capital investment is known as well, the NPV can be computed
The use of IRRs should be discouraged, as other metrics are available that more properly adhere to the underlying economic referents
Summary
Economic profitability of projects is a major topic in production economics and engineering economy as well as corporate finance. See Percoco and Borgonovo, 2012, on the different ranking of key drivers provided by NPV and IRR). Such difficulties prevent the IRR from being a generally reliable alternative to NPV-based calculations for the measurement of an investment’s economic profitability. In assessing projects undertaken using the Private Finance Initiative (PFI), the IRR is often employed as a convenient measure of different aspects of the project – like the cost of capital formation for the public sector or the return to investors. When the scheduling of payment streams departs from the flat, annuity, assumption, the use of IRR as an indicator may give a seriously misleading impression of actual PFI costs and returns.
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