Improvement project financials – the hurdles

From a discussion in the PEX Network & IQPC – Lean Six Sigma & Process Excellence for… on LinkedIn:

Angelo Fraschilla • I work for an aerospace corporation with 18,000 employees worldwide.
We need a 3 year ROI or better to get a project approved.

Answer: You seem to be using the term ROI for payback period or breakeven time. This is a common indicator for investments but often considered insufficient because the purpose of the investment is not just to get your money back but to make a profit on it. That is why project evaluations often also include the Internal Rate of Return (Excel function IRR).

If the cash outflows of your project were loans and the inflows reimbursements, the IRR would be the interest rate of that loan. The IRR is based on the entire life of the project, not just how long it takes to break even.

Looking at both the payback period or breakeven time and the IRR makes sense. You wouldn’t want to do the project if it took 15 years to break even, even if the IRR were 50% because management is not that patient and because the numbers 15 years into the future are iffy. On the other hand, if the IRR is 0%, the project is financially pointless even if you recover you money in 6 months.

John Macdonald • Michel
Is that the same as NPV?

Answer: Not quite. NPV, or Net Present Value, is the value today of a schedule of future cash flows. To calculate it, you have to assume a Discount Rate, the ratio by which a dollar a year from now is worth less to you than a dollar today, in the absence of inflation. The NPV is a sum of money, not a ratio.

The IRR, or Internal Rate of Return, is the discount rate for which the NPV of a schedule of cash flow is zero. If you lend money at a given interest rate, and use that interest rate as discount rate, the Net Present Value of the borrower’s payments over time will match exactly the amount of the loan, and the interest rate will equal the IRR.

That is why I was saying that the IRR compares your investment with a loan, and, if the outgoing and incoming cash flows of your investment were loans made and repaid, the IRR would be the interest rate. The IRR is not a trivial calculation manually, but no problem with the Excel IRR function. Pocket calculators with financial functions usually do it as well.

Many companies have hurdle rates on both payback period and IRR, and MBAs are trained to use it. Once you get the hang of it, the logic of the IRR is compelling. Its weak point is that it depends on predictions of cash flows far in the future, and this brilliant logic is applied to fuzzy numbers. That is why you complement it with a metric that has a short-term focus.

If you need to learn about this, I recommend Chapter 6 in Eric A. Helfert’s Techniques of Financial Analysis. It provides clear explanations for professionals who are NOT specialists in finance.