To further demonstrate the impact of timing delays on long term investment rates of return, Exhibit 5 highlights rates of return on our sample investment project impacted by delays ranging from four one-month (30-day) delays, to four four-month (120-day) delays. Not realizing expected cash savings by as little as 30 days reduces the rate of return of this project by almost a point!
And if the cash savings realization from the project is delayed 16 months (not an unusual or unreasonable situation), the overall rate of return on the project is reduced by almost 2.6 points, from 10 percent, down to 7.4 percent. The conclusion from Exhibit 5 is painfully obvious: Planning for and then managing reasonable timeframes for realized cash savings ought to be a key criterion for any CFO or financial executive when evaluating the viability of long term projects ranked by rates of return.
In CFO.com in October 2004, McKinsey consultants John C. Kelleher and Justin J. MacCormack also tackled this issue in an article titled “Internal Rate of Return: A Cautionary Tale.” The article concluded: “Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions.”
We whole-heartedly concur. It is unfortunate that there is no one rate-of-return function that addresses both the deficiencies at once. If you are about to either prepare or evaluate long-term projects based on expected cash flows ranked by some form of a rate of return, we hope that we have heightened your awareness to the subtle pitfalls buried within these types of financial evaluations and maybe given you some extra ammunition so as to avoid most of them.
Richard Block is an adjunct professor of management accounting at Babson College and a CFO Leadership Partner at Tatum LLC, an executive consulting services firm. Dr. Jan Bell holds the Weiner Family Term Chair and is a professor of accounting at Babson College.
Reference: Management Accounting, Fifth Edition, Atkinson, Kaplan, Matsumura, and Young; 2007, Pearson Prentice Hall, was used as a general reference for this article.
To download an Excel file containing the spreadsheets we reference in this article, click here.