Misinterpreting the Internal Rate of Return in Sustainable Forest Management Planning and Economic Analysis

Abstract

Sustainable forest management planning includes accounting for revenues and costs that accrue throughout time. While debate continues as to the how to account for these cash flows, the most used techniques are net present value, benefit cost ratios, and internal rate of return (irr). Managing forests sustainably depends critically on interpreting the results and management implications of these techniques accurately. It is appealing to equate the irr with a market-derived rate of return given its definition. Unfortunately, its mathematical derivation does not support this interpretation and past use of irr often illustrates this confusion and misinterpretation. The irr only reflects the amount and timing of the net cash flows for a given venture and does not include any social, economic, or other external factors found in market-derived discount rates. Therefore, the irr does not reflect an appropriate rate of return or opportunity cost of capital for sustainable forest management. My purpose is to provide a theoretical argument that can be used to help correct this misinterpretation and stimulate discussions on the economics of sustainable forest management.