Question

a projects internal rate of return is independent of its level of risk. True or False

Answer 1

TRUE

*Note

The rationale behind IRR in an independent project is:

If IRR is greater than WACC (IRR>WACC), the project’s rate of return will exceed its costs and as a result the project should be accepted.

If IRR is less than WACC (IRR<WACC), the project’s rate of return will not exceed its costs and as a result the project should be rejected.

There are two scenarios where IRR is the more representative and relevant measure of performance: a) the manager controls the external cash flows (making these discretionary cash flows part of the investment process and b) the cash flows are part of the client’s financial goals (such as an endowment which needs to make contributions to its beneficiary organization each quarter.) This second scenario is very common for non-profit organizations such as foundations and endowments, and for pension plans. Equally important is its relevance for individual investors, especially high net worth investors who have a series of planned expenditures as the purpose of the portfolio. So, if we need a single measure of return for these investors, it’s the return of the portfolio through IRR.

That said, what is the set of relevant risk measure(s) for these investors? Since their financial goals are related to the adequacy of the cash outflows and the preservation of portfolio value relative to targets, then I suggest that the risk around meeting these goals is the right risk measure. For example, funding ratio is the key risk metric for pensions – it doesn’t matter if your portfolio beat its asset benchmark if its funding ratio declined. That would be a failure, not a success. The volatility of return around an asset benchmark might be interesting to a performance analyst, but it is almost completely irrelevant to the client’s financial goal. Why measure the wrong thing with great precision? That would be precisely wrong. Similarly, a foundation portfolio needs to meet its grant making targets for its beneficiary organizations while preserving the value of the portfolio so that it can continue making these grants. The volatility of this cash flow relative to target is a relevant risk measure for this first client goal. The median portfolio value relative to its target value with a minimum and maximum value over the performance period are adequate measures of meeting this second client goal.

You’ll note that these measures of risk have more to do with the adequacy of money rather than with return. This may sound like heresy to the fundamentalists of the performance world, but these illustrate the simplicity and clarity which emerge when we first consider the question we are answering, rather then simply rushing to calculate returns simply because that’s the comfort zone for people who like math and who work for fund managers. Can we create somewhat comparable risk measures around the money rather than the returns? I think we can. Tracking error? We can measure the tracking of the withdrawals supported by the portfolio compared with the planned withdrawals. Downside risk? We can evaluate the funding ratio of the portfolio relative to its minimum acceptable money value. Standard deviation? How about the standard deviation of both funding and portfolio value relative to their average values over a long time period? These all work from the money that is most relevant to the clients who own these portfolios.

An IRR is a return that is defined by its consideration of money over the performance period. The risk inherent in an IRR should be calculated with an equal emphasis on money.