For those of us who’ve spent some time in MBA school, the investment-evaluation
metrics called "IRR" (Internal Rate of Return) and "NPV" (Net Present
Value) are extremely familiar. Your HP 12C calculates them
faithfully.
Leave it to McKinsey to
lay out in pellucid terms all the myriad failings of IRR vs. NPV. The
bottom line: Avoid using IRR entirely.
What are its fallacies? Primarily, it implicitly assumes
that interim cash flows from the investment (if any) can and will
be reinvested at the pre-defined IRR rate, whereas NPV only assumes
that interim cash flows will be reinvested at a rate needed to
recover the firm’s cost of capital. Arcane this may sound,
but IRR ends up making investment projects look attractive on the
false premise that there is an endless supply of equally attractive
interim projects. How serious can this flaw be?
According to McKinsey, they recently reviewed 23 major capital
projects approved over five years at a large industrial company
with an average IRR of 77%. With the return on capital adjusted
to the company’s average rate, the average return fell to 16%. More
important for financial decision-makers, the most-highly rated
project by IRR fell to 10th place on the revised analysis.
Law firms, consciously or otherwise, are "investing" all the time:
- in real estate commitments;
- in associate training programs;
- in lateral acquisitions;
- in IT initiatives;
- in business development.
These investment decisions deserve serious professional scrutiny;
it is, need we remind you, the partners’ money. If the analysis
is based on IRR, come back to this post and take another look at
what McKinsey has to say.
