Internal Rate of Return on Infrastructure Reinvestment

Phil Kenkel

Bill Fitzwater Cooperative Chair

The old saying is “You have to spend money to make money!”  In terms of our discussion of growth, the cooperative has to reinvest in equipment and infrastructure to maintain and grow.  Every investment should be evaluated to determine if is forecast to generate an acceptable return.    Many boards and CEOs skip that step concluding that if they committed to replacing the asset the return is ill relevant.  However that return is very relevant for the future return on equity of the cooperative.  If the return on a capital expenditure is low it pulls down the future profitability of the cooperative. One of the best measures of return on investment is the internal rate of return.

In the old days a description of internal rate of return always led to a discussion of the formulas involved.  Nowadays with an IRR function on every spreadsheet we can easily find out what time it is without having to explore how the watch was made.  All we need to calculate internal rate of return is a series of cash flows with the outflows, like the initial investment entered as a negative number and the annual cash flows entered as positive numbers.  The cash flows should include the associated margins less expenses but do not include interest expense, depreciation or loan principle payments.  Those elements are implicit in the calculated return.  (If we wanted to be precise we would include the tax benefit of the depreciation.)  Cash flows for a fertilizer applicator would basically be the annual application income less the fuel, maintenance and labor costs associated with the applicator.

There are many benchmarks for an “adequate internal rate of return” but a simple threshold suggested by our growth rate formula is the desired return on equity.  If capital investments meet that threshold the future profitability and return on equity of the cooperative should be adequate.  If a fertilizer applicator doesn’t generate an internal rate of return higher that our ROE target we know that we need to increase our application fee or expect a lower return on equity in the future..  If we are examining a long term investment like a grain structure we might want to begin with our existing handling margin and storage fees and include a reasonable growth rate in revenues.

The old saving should really be “you have to invest money to make money”.  Internal rate of return forecasts if we are investing wisely.