Internal Rate of Return Revisited: Economic Analysis

Ray Martin

Editor’s Note: Management consultant Ray Martin notes the concerns that the Presidential/Congressional Commission on Risk Assessment and Risk Management has identified about the use of economic analyses in regulatory decision making. He contends that if economic analyses as practiced by the government were carried out with all tools available, the Commission’s concerns would be greatly mitigated and possibly resolved.

In discussing the strengths and limitations of economic analysis and its role in regulatory decision-making the Presidential/Congressional Commission on Risk Assessment and Risk Management identified three common concerns: *

• Economic analysis places too much emphasis on assigning dollar values to aspects of health and the environment that are difficult, if not impossible, to quantify in monetary terms.
• Regulatory decisions about health and environmental protection might be based strictly on whether the estimated monetized, quantifiable benefits outweigh the estimated quantifiable costs.
• The results of economic analyses are often conveyed in a manner that ignores assumptions and uncertainties, giving the impression of far greater precision than is generally possible or appropriate.

The first concern is perhaps the fatal flaw: it necessitates placing a monetary value on health and human life. The second concern is that an economic analysis requires two difficult-to-calculate numbers: quantifiable costs and benefits. The third concern is likewise valid. For example, small changes in the discount rate or unit costs can make extraordinary changes in the results. All three concerns are related to the way economic analyses are conducted. All three concerns can be mitigated, if not resolved, by simply using both measures of discounted cash flow rather than only one.

Economic analysis (EA) as practiced in government uses discounted cash flow (DCF) to normalize cost and benefit streams. DCF includes the present value (PV) (or net present value (NPV)) and the internal rate of return (IRR) methods of analyzing cash flows. DCF provides insight into financial management not possible using other techniques. The NPV of the time-phased costs over the economic life of an investment project is the best single-number measure of its life-cycle cost. NPV is used in government EAs. IRR is not used.

IRR is used in the private sector, but only with considerable (unwarranted) caution. The major reason for IRR not being used in government and with caution in the private sector centers around the extensive criticism of IRR found in financial management textbooks. These criticisms overstate the minor difficulties associated with IRR and understate the coexistent difficulties with NPV.

IRR is used cautiously despite the textbook criticism. It is often favored by business people. For one thing, IRR is very good for screening projects--especially important in government. NPV is highly sensitive to the discount rate, causing near continuous controversy in government analyses. IRR, on the other hand, bypasses the problem of deciding the "correct" one. Because IRR is a rate or ratio, not an absolute amount, it is more useful for comparing unlike investments, say government projects. IRR is also more useful for making comparisons between different periods, between different sized projects and in making international comparisons. The intention here is not to argue for either case, but instead to put the two measures into balance. The aim is to show:

• NPV and IRR have essentially equivalent utility;
• they are complementary ways of looking at a problem or opportunity;
• IRR and NPV together gives a better economic analysis than either alone;
• if properly viewed, NPV and IRR give identical signals, including EAs;
• IRR is particularly useful for comparing different sized projects, where it receives some of its greatest criticism; and
• IRR is useful alone.

The professed reasons for the superiority of NPV over IRR in financial decision making--the primary reason IRR is not used in government analyses--are examined in a paper entitled "Internal Rate of Return Revisited."

*Framework for Environmental Health Risk Management, The Presidential/ Congressional Commission on Risk Assessment and Risk Management Final Report, Volume 1, 1997, p. 36.

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Posted in RiskWorld on June 27, 1997.