Richard Block, CFO.com | US
February 20, 2009

Re IRR methodology

Your cash inflows presumably can be best assumed to occur evenly over each time period.Hence you are overdiscounting by SQRT(1+r) r being the discount rate used. In every company I have worked in we had to change investment models to reflect this. The simple fact is most people do not understand the cash flow timing assumptions and discount assumptions in the Lotus/Excel spreadsheets. And they do not think of matching their models to the real life shape of their own cash flows or to have several periods for each year.
Sectors were underestimating the worth of projects as a result.If target ROR's were 20% then values of net cash inflows were underestimated by 9.54%. On a ?250 million investment project that could be very significant. More importantly in an integrated business with separate project evaluation units one can find units adopting different logic in their investment models so CEO's and Boards are not comparing like with like.This can also be very inportant in an acquisition or sale when such a value difference can mean success or failure.
I would be interested to hear how many large companies/investment banks have still got this wrong.

Regards Bruce G

Posted by Bruce Galley | Feb 23, 2009 7:53 AM ET