The Tweaked IRR ©Dr. Bradley C. Paul 2002 Note – The procedures in these slides can be found in numerous books and papers on engineering economics, none.

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Presentation transcript:

The Tweaked IRR ©Dr. Bradley C. Paul 2002 Note – The procedures in these slides can be found in numerous books and papers on engineering economics, none of which was used as a template for these slides. The author considers the information in these slides to be common knowledge to those schooled in the field.

The Tweeked IRR  Problem is that committing to the project means committing not only money now but money in the future  I will have to cover that future commitment by taking some of my earnings and setting them aside to meet that expense (probably in lower earnings - low risk short term fluid investments)  Its kind of like a sinking fund  I’m certainly not going to set all my earnings in

How to Tweek Take Just Enough of Your Future Earnings to offset the future negative cash flow

How do I do that?  Determine what rate you can get on secure, fluid, short-term investments  For Hanna and Herby it was 4%  Create a temporary pot at the beginning of the negative cash flow

Tweeking Procedures  Discount the future negative cash flows back into the temporary pot at the chosen rate.

Discounting Back -$

Next Step -$ Now discount part of your positive cash flow forward into the pot at 4% to balance the red ink.

How much and when?  Part of the project earnings are to be discounted forward to cover the red ink  Because the rate of return on this sort of “sinking fund” money is less than the project itself we want to use as little as late as possible  The simple approach is to use the last so many savings flows to cover the red ink  In practice one may not want to turn in zero earnings quarters  They spend more for a good investor smoke screen

I’ll Use the Simple Approach I will sweep enough future earnings forward at an available external rate to cover the future red ink commitment.

My New Cash Flow Future Negative Cash Flow is cancelled by positive cash flows swept forward. Now sweep the rest of the cash back into the main pot.

The Sanitized IRR Note that I now have a classic cash flow problem - invest and make money there after. I can get a regular trick free IRR on this thing. IRR on this cash flow is 39.01%

Three Answers - 1 Problem  Regular IRR was over 39.51%  but to get it - Herby had to invest his savings at over 40% (I don’t think so)  ERR was 34.37%  If Herby diverts funds into a money market to cover the payments after he graduates he will get 39.01%