Internal Rate of Return: variation on the theme of “Net Present Value”, with no improvements, when used in “Company based scenarios”

Posted on September 8, 2010 by CEO

I will not describe the theory of IRR, as I assume that you already are familiar with it, and if not, you can easily get. To begin with, it is not really another method, but simply a variation on the theme of the “Net Present Value” method. So, everything that has already been said about NPV applies equally to IRR.

What I would like to point out is that on a cerebral level, IRR acts as a surrogate to the notion that we only invest in projects that deliver huge sales, coupled with enormous margins, as the existence of that pair of circumstances, tends to have a forgiving effect on errors and miscalculations.

For example, a project with forecasted sales of 1,000 mil USD and a forecasted margin of 50%, even if in reality it manages to make actual sales of 800 mil USD and an actual margin of 40%, it’s still going to create earnings of 320 mil USD (instead of the forecasted 500 mil USD), and thus still yield a very good return.

If anyone lives in a world in which that magical couple of huge sales and enormous margins exists in abundance, I would like to ask that person to send me an invitation to visit that fantasy world. In the world that I live in, the norm is for razor thin margins and cutthroat competition for every penny. Ask anyone who has worked in a super market chain to tell you stories on that.

This is the business reality, and the only serious way to go about it, is by accurate Financial Analysis work. Now you might wonder how is it possible to create serious and accurate work, when the currently existing Financial Analysis methods have so many built-in flaws and inaccuracies. Well, as you have probably guessed by now, the answer is: You can’t. At least, not with those methods which are currently being employed.

Stick around, and we are going to see the problems in the way “Sensitivity Analysis” is currently being performed.

Posted in Financial Analysis, Financial Analysis Method, Investment Plan Evaluation, NPV, Net Present Value, Problems of Net Present Value | Tagged , , , , , | Leave a comment

A Financial Analysis paradox Part 2: Why the “Monthly Average method” delivers a better result than “Net Present Value”, when used in “Company based scenarios”?

Posted on September 8, 2010 by CEO

The “Monthly Average“ method might be the currently prevailing method to conduct “Investment Plan Evaluation”, Budgeting and CashBudgeting, but that doesn’t mean that it is trouble free.

Let’s not stand a lot on the fact that thru this method, Interest during a month can only be either Income or Expense, but not both. For me, the most important thing to notice is that we create a simulation in which everything is assumed to happen on the first day of each month, from that day on nothing happens, and so there is a constant daily Bank account balance, on which to calculate Interest. Anyone can see that this has no connection to reality.

The biggest consequence of that is that thru the “Monthly Average method”, a collection that takes place on May 5th has the same impact with another one that takes place on May 15th, or May 25th, because they are all herded under the title of “Collections of May”. The problem can be summarized under the title of “Time Value of Money”, or in other words, the ability of money to create new money (a.k.a. Interest). The more time that money spends in the Bank account, the more money (Interest) it creates.

Ironically enough, the recipe that was meant to cure that problem was the “Net Present Value” method. Even though that specific problem is actually taken care of in a satisfactory way (but only in “Bond Based scenarios” – never in “Company based scenarios”), as we have previously seen, new problems of greater importance were created by the solution. This is a case where the medicine creates new and more lethal problems than the sickness that it cures.

Another consequence of the “Monthly Average method” is that any subsequent “What if” scenario can only be examined in time increments of whole months. For example: a scenario where days of credit to the customer (from sales) from 30 days become 60 or 90, it has meaning. If the change is from 30 days to 40 or 45 or 50, then that cannot be calculated.

So we see that by using a method that is a step back to NPV in the evolution of Financial Analysis calculation methods, the Accounting & Finance professionals are conducting “Investment Plan Evaluation”, Budgeting and CashBudgeting, in a manner less problematic, but one that still leaves a lot to be desired.

Stick around, and we are going to see the problems in the “Internal Rate of Return” method, which in reality is just a variation on the theme of the “Net Present Value” method.

Posted in Budget, Budgeting, CashFlow, Financial Analysis, Financial Analysis Method, Investment Plan Evaluation, NPV, Net Present Value | Tagged , , , , , , , | Leave a comment

A Financial Analysis paradox Part 1: Which is the method that lays one step behind in evolution from “Net Present Value”, and yet delivers a better result when used in “Company based scenarios”?

Posted on September 8, 2010 by CEO

The problems and the inaccuracies of the “Net Present Value” method are not really much of a secret among Accounting & Finance professionals, but that knowledge by itself doesn’t solve the situation. At the end of the day, those professionals still need to have their work done. So, in practice, the prevailing method to do “Investment Plan Evaluation” and Budgeting is the following:

Thru a spreadsheet, numbers for forecasted income and for forecasted expenses are being registered in distinct columns. The obvious action is to say that:

Income – Expenses = Profit

That equation is fundamentally correct from an Accounting point of view. Let’s not linger a lot on the need to calculate the “valuation of residual stocks of goods at Fiscal Year end” and other things, as these are considerations that eventually (one way or another) can be done. However, there are two missing numbers from that equation that need to be calculated and then incorporated into the result. They are the values for “Interest Income” and “Interest Expense”.

In order to calculate those two last numbers, we must create the simulation of the Bank account, or to call it thru other names the “Cash Budget” or the CashFlow. For that purpose, all sales, purchases, expenses etc are being turned into CashFlow projections.

For example: Forecasted Sales of March 2011 of 10 mil EUR plus VAT 23% and 60 days of credit to the customer, result in Bank collections on May 2011 of 12.3 mil EUR.

In that way, the Bank simulation gets populated by the forecasts. The result of this is that in the end we can say:

+ Collections of May

– Payments of May

+ Average Bank Account balance of April

=================================

= Average Bank Account Balance of May”

Interest is being calculated on a monthly total figure, on the basis of the monthly average balance of the Bank account.

Stick around, and we are going to see the problems that this method has, and why the “Net Present Value” method, even though it is one step in front of it in evolution terms, it delivers an inferior result.

Posted in Budget, Budgeting, CashFlow, Financial Analysis, Financial Analysis Method, Investment Plan Evaluation, NPV, Net Present Value, Problems of Net Present Value | Tagged , , , , , , , , | 5 Comments