An investment insider has given us this explanation of why ASIC has recently taken Macquarie Infrastructure Group to task over its dodgy internal rate of return calculations.

According to The Australian (4/4/2002) the use of the internal rate of return (IRR) concept is the subject of a dispute between the Australian Securities and Investment Commission (ASIC) and the Macquarie Infrastructure Group (MIG).

This dispute has led to the withdrawal of claims by MIG of a specific IRR for investors, who will now no longer have any basis for long term investment decisions even though the original basis will be shown to be suspect.

It is unfortunate that some superannuation funds have been induced to invest considerable amounts in these infrastructure schemes.

What is the IRR?

Broadly, ‘internal rate of return’ is defined as the discount rate that sets the net present value of the stream of future benefits equal to zero.

In the case of the disputed MIG statements, the IRR is the discount rate that is applied to the series of equity dividends claimed to be payable up to that year in order to account for the fact that the present value of these dividends is less then their future value.

The sum of all these discounted dividends taken over the entire concession period is equal to the original equity invested. The original equity minus the sum of the discounted dividends is the net present value, which is thus zero.

From the above description “IRR” is not the same concept as “interest rate” or “return on equity” and other measures commonly used to specify return on investment or funds employed.

IRR promotes the perception of large gains to the investor in the long term

The promise of an internal rate of return of, say, 12.2% for MIG at the end of a notional investment period may lead to the perception that long term investors such as superannuation funds will eventually receive a very large payback for retaining the investment over the concession period.

But this payback can be demonstrated to be illusory.

The same use of IRR also appears in the prospectuses of individual components of the MIG, such as the M2 Motorway and similar projects.

The Base Case financial model for the M2 Motorway and other parts of the project deed were released by order of the NSW Parliament in October 1999. The model in particular provides a detailed numerical insight into how the IRR was derived.

Why the IRR as used by the MIG corresponds to fictional amounts of money

The numerical example given below which is taken from the Base Case financial model for the M2 raises questions about the magnitudes of the equity dividends and the corresponding values of IRR. Consider the reality of the following financial outcomes.

The initial equity invested in the M2 was $155m with an initial debt of $311m.

The financial model shows that in the year 2042, the equity dividend pre-tax is $342.4m and the IRR = 16.96%, and a return of 221% pa for that year.

The toll revenue in that year is forecast to be $453.83m.

The original construction cost of the road was $436m (Prospectus, p67, 1994) so that the equity dividend alone is 78% of the construction cost, the toll revenue alone is 104% of that cost.

All these fictitious figures are the result of a failure to discount future cash flows.

For example, if the toll revenue is discounted at, say, 6% pa, it would have a present value of $77.7m, or about one sixth of the undiscounted value which MIG is relying on.

Put another way, the value of money received or disbursed in the future is assumed by the Macquarie Bank directors who developed the model to be the same as at present.

In effect they deny the existence of positive interest rates over a concession period of 45 years!

The use of present value analysis in assessing infrastructure projects was recommended by the Private Infrastructure Task Force of the Economic Planning Advisory Commission (EPAC) in 1995.

In summary, IRR is derived by discounting future dividends, but the dividends themselves are on the other hand, the result of a failure to discount the cash flows giving rise to them.

This tactic leads to a highly misleading view of the value of these infrastructure investments.

In the case of the M2 Motorway, the nature of this deception has so far been disguised first by a revaluation of property, plant and equipment, which is then used to boost the profits using a loophole in the AASB standards.

Second, the shortfall has been partly covered up by inflation of the actual toll revenue using infrastructure bond interest.

Third, the misleading value placed on the investments has also been partly obscured by the avoidance of rental payments for the tollway corridor to the NSW state government.

The second and third items constitute a burden to the taxpayer as do initial subsidies given by the government.