Why IRR is an inadequate indicator of costs and returns in relation to PFI schemes

Measuring the inadequacy of IRR in PFI schemes using profitability index and AIRR

“…As pointed out in Cuthbert and Cuthbert (2012) Consider, for example, a typical PFI project (like the building and running of a hospital) from the point of view of the public sector client. During the construction phase, the public sector client makes no payments to the private sector consortium which is undertaking the project: but when the facility becomes operational, the public sector starts making regular unitary charge payments, which will go on during the 30 or so year life of the project.…”

“…These unitary charge payments can be separated into two elements. The first of these, denoted in Cuthbert and Cuthbert (2012) as the "service element", covers the cost of ongoing activities relating to the operation and upkeep of the facility -like provision of contracted services, maintenance, and lifecycle costs. The second element, which Cuthbert and Cuthbert denoted the "non-service element" (NSE) covers loan charges, and pre-tax profits on equity.…”

“…As guidance issued by the UK Treasury recognises, however, use of IRR is potentially misleading, unless the relevant payment streams are of a flat, annuity, type (Treasury, 2004). In Cuthbert and Cuthbert (2012) an appropriate indicator was developed for assessing how significant the departure from a flat payment stream might be in any particular case. In this section, we recapitulate on the approach developed in that paper.…”

“…In section 2 we introduce the problem of IRR in relation with PFI schemes and summarise Cuthbert and Cuthbert's (2012) results; in particular, we decompose the profitability index into interest component and scheduling component. In section 3 we describe the AIRR approach and introduce the new notion of blended AIRR (BEAIRR).…”

“…3 In a recent paper, Cuthbert and Cuthbert (2012) both gave empirical evidence showing that the assumption of flat payment profiles was commonly violated in PFI schemes and developed an approach, based on the definition of what the authors called interest and scheduling effects, which allowed measuring the distortion caused by the IRR. Separately, Magni (2010Magni ( , 2013, developed a generalisation of the concept of IRR, denoted as average internal rate of return (AIRR).…”