2 minute read

Using Rate of Return or IRR alone can be misleading

  • When discussing investment, most people tend to focus only on rate of return (or internal rate of return, IRR) – this is fine as long as the options are very similar
    • The common investing options most people are exposed to, like ETFs or commodities, are somewhat standardised and closely regulated – thus the risk are not too diverse
    • Those investments would have similar initial capital (or at least we can make it so) and risk factor that are not too significantly different
  • In engineering business and thus its economics, comparing IRR alone is not only insufficient but also can be misleading
    • Investment in engineering business can vary from a small project needing only few millions dollar to a mega project requiring close to a billion dollar
    • On top of that, one project may carry more risk than the other – consider building a road on flat plane vs on mountainous area, where you have to account for unforeseen circumstances
  • To better understand the arguments above, let’s consider an example below
    • Consider that we only have $1000 of available and disposable cash to invest in a project. Yet we’re being presented with two options per Table A
      • One require only $450 of capital and will give us 20% p.a. return, while another require $1000 of capital but will only give 15% p.a. return.
    • Which one would we choose? Better yet, would we decide based on this alone?

Table A

Project . Y1 Y2 Y3 Y4 Y5 Y6 . IRR
Project 1   -450 150 150 150 150 150   20%
Project 2   -1000 300 300 300 300 300   15%

NPV and IRR are complementing metrics

  • The previous table and metric (IRR) isn’t sufficient for us to make an informed decision – we would need further information
    • We would need at least the net present value (NPV) so that we can gauge how much value (return in dollar amount) the project will give
    • If we apply a discount rate of 10% (in fact, it doesn’t matter what discount rate we use since we’ll be doing direct comparative analysis) we would get the results per Table B
    • When we do this, we can see that despite Project 1 giving 20% IRR, the NPV is only $118.6. But Project 2 will give us $137.2 with only 15% IRR
  • NPV represents the additional value the project gives after recovering the initial investment and exceeding my possible alternative investment
    • The discount rate applied for calculation of NPV normally to counter for possible alternative investment and thus my expected minimum return
    • Due to scale, a 15% IRR for $1000 investment would give us more return in absolute dollar. To put it in the extreme, a 10% of a million dollar would worth more than 50% of a thousand dollar.
  • Both IRR and NPV need to be used together would tell us the rate of return of our investment
    • IRR should be used to compare against our minimum expectation (normally represented by discount rate) – to ensure it meets or exceed it. Beyond that, we should go back to NPV
    • NPV should be the primary metric for you to anchor your business investment decision, but it has a requirement – to know what is our acceptable discount rate (minimum expected IRR)

Table B - expanded to include NPV results

Project . Y1 Y2 Y3 Y4 Y5 Y6 . IRR NPV@10
Project 1   -450 150 150 150 150 150   20% 118.6
Project 2   -1000 300 300 300 300 300   15% 137.2