Notes on Managing: Investing without IRR
Most CEOs and senior executives are familiar with making most or all investment decisions based strictly on the internal rate of return (IRR) of the project or investment. IRR is the annual rate of return on an investment considering its original cash outflow and its ultimate outcomes (in terms of cash inflow) over time. Such an analysis allows an investor to compare any investment to other similar investments or to a market-based standard. This is a common method used to make investment decisions of all types. IRR is a common part of the executive’s lexicon and tool box.
IRR has a tendency in some companies or situations to be used as a rigorous test for any and all investment decisions. Further, if the future return outcomes cannot be easily or reliably quantified, an investment may not even be considered. As a result, many investments are never made nor considered. Uncertainty becomes a disqualifier—and aren’t all financial outcomes uncertain, in reality? I once worked in a company where $100 wasn’t invested without a 2-inch thick (single-spaced) analysis being properly completed and approved by Corporate Finance. You had better “show” an IRR of a zillion %, or forget it.
While rigor is important when making an investment, we believe that as one gets higher in the organization the executive is expected to make some investments—of both small and large scale—without the benefit of a reliable outcomes’ analysis and forecast. Let me give some (recently-heard) examples of such investments and opportunity—
- “Let’s start a new marketing & advertising initiative that we think will give us increasing client mindshare. The cost is $25,000 per year but we may never know if it gives us a single new sale or project. But, it feels like the right thing to do.”
- “Our competitor is having quality (and ultimately financial) difficulty. Consequently, they are very vulnerable in New England. If we hire 2 new sales representatives and go after 20 of their biggest accounts we could (possibly?!) take a few away. The cost may be $250,000 per year and it may take 2 years to get a $1 back. It’s just too good an opportunity to pass up.”
The examples are numerous but you get the idea.
A CEO or senior executive is expected to make such decisions or judgments each year—with or without the information required for an IRR analysis. The ability to make such abstract decisions is part of what qualifies one for the job and title. Are you using your intuition when faced with such a decision, or are you relying too heavily on the Controller’s spreadsheets?
One way to find out is to take a little 1-year test. Budget a pool of annual investment—say $100,000 (clearly an arbitrary amount) at the beginning of the coming year. [I usually tell CEOs to put it in cash in a coffee can and place it in their lower desk drawer.] If by the end of the year, you have not spent most of your fund on non-IRR supported projects something is wrong. Most likely: 1.) not enough good and intuitive projects are making it to your office, or 2.) you or your staff may have too little tolerance for the inherent uncertainty within your business. Either possibility should allow you to take pause.
While no one is advocating reckless decision making, intuition does have its place. So begin 2012 with that coffee can full of cash in your desk drawer. How much to put in it is up to you. I know mine has less than $100,000 in it, but it will be there.