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

The Internal Rate of Return (IRR) is a commonly used indicator of the performance of Private Finance Initiative (PFI), schemes in the UK. Treasury guidance recognises, however, that IRR is potentially misleading, unless the relevant payment streams are of a flat, annuity, type. This paper uses data on a number of actual PFI schemes to examine whether the payment streams involved are sufficiently flat for IRR to be a reliable indicator. There is clear evidence that the assumption of flat payment profiles in PFI schemes is violated. As a result, quoting IRR alone in the PFI context is liable to understate both the true opportunity cost of PFI finance to the public sector, and the potential scale of private sector profit.Our analysis also indicates that a statistic based on average outstanding debt is a reliable indicator of the extent of departures of the relevant payment profiles from annuity type.

► The Internal Rate of Return is an inadequate indicator of the performance of PFI projects.
► In assessing PFI projects, the public sector in the UK has put too much weight on internal rates of return.
► Internal rates of return should only be quoted in conjunction with a supporting indicator such as the average debt on which the Internal Rate of Return is earned.