Internal Rate of Return for Law Firm Financial Executives: A Simple, Non-Technical Explanation

How can law firm Chief Financial Officers compare returns on the firm's different investments when the amounts invested, the timing of those investments, the returns, and the timing of those returns are all different? The tool investors use can be used by law firm CFO's to compare the rates of return on each investment on an "apples-to-apples" basis - that tool is the internal rate of return (also known as the compound annual growth rate or CAGR).

A typical law firm investment involves several investments made at various stages of the project. From an investment perspective, those investments are considered negative cash flow; that is, cash going out from the law firm. Of course, the cash goes out from the firm at different times. Investing $100 today is more expensive to the firm than investing $100 in the project three years from today because the firm would only have to put aside, say, $80 today to grow into the $ 1OO needed in three years for the investment at that time. This $80 is known as the discounted value or the value in "today's dollars" of the $100 investment that would be made in three years. Accordingly, any "apple-to-apples" comparison of investments would have to compare investments based on today's dollars.

Similarly, when the investment yields returns to the law firm, cash is then returned to the law firm. This is positive cash flow for the law firm. Obviously, it would be better for the law firm to receive the positive cash flow earlier rather than later for the same reason the law firm would prefer to have the negative cash flow later rather than earlier. Receiving dollars today is more valuable than receiving the same number of dollars in the future, because if the firm receives the dollars today, it can invest those funds and earn a return on them. Accordingly, an "apples-to-apples" comparison of investments would have to compare investments not just on when the dollars are invested and how much those dollars are, but also on when the returning cash is received and how much it is. Thus, if a law firm were to compare one investment to another, the firm will want to compare those investments based on outflows of cash in today's dollars and inflows of cash in today's dollars.

If a law firm projected its investments into a project, say for instance a branch office, and projected how much positive cash flow that office would generate over what period of time, and also took into consideration when it made the investments and when it would receive the returns, then the law firm could determine what rate of return it would earn in today's dollars. Thus, this calculation would reflect all of the investments and all of the returns in today's dollars, and show the law firm what rate of return it would earn in that investment. This rate of return calculation is called the internal rate of return, also known as the compound annual growth rate.

Accordingly, the Chief Financial Officer or analyst would use the above information to solve for the rate of return, rather than knowing the rate of return and solving for the value of the investment in today's dollars. Thus, the cash outflows and inflows, in today's dollars, would determine the rate of return. With this in mind, it is easy to see that in order to calculate the internal rate of return, all that the Chief Financial Officer need know or assume is the amount of money to be invested and when (and it might be lumpy; that is, different amounts invested at different times), and the amount of money assumed to be returned and when (and this too may be lumpy).

Timing Is Crucial

Accordingly, the timing of the firm's outlays and the timing of the receipt of the returns of cash are crucial determinants of whether the investment should be made. If the law firm must invest a lot today and a small amount later (for example, when leasing and remodeling a facility), then the firm will have its money in the project at risk longer and therefore will not have the opportunity to use those funds to earn a return elsewhere. It is not the same to the law firm if it makes its entire investment in the project right away instead of staging its investments over time. Therefore, even if the total investment amount would be equal and the final payments back to the law firm would be equal in each case, the timing of the investments would be important in determining whether the investment was a good one or not compared to other investments available to the firm.

Timing is also important with regard to the ultimate funds received when the investment begins to generate cash flow or is liquidated. The law firm would definitely prefer to receive its returns earlier rather than later, and depending on the circumstances, would accept a smaller return if it is received earlier. Thus, the internal rate of return informs the law firm, that the smaller the early investments and the earlier the returns are generated (assuming the early returns are equal in amount to the later returns), the better the internal rate of return. That is fairly intuitive.

For example an investment of $100 that returns $100 in earnings plus the $100 capital invested in one year is a much better investment than if the returns are received in fifty years. The question is how much better of an investment is it - and the internal rate of return can answer that question.

The Internal Rate of Return: Putting Dollars and Timing Together

The internal rate of return informs the law firm of the rate of return of the investments made based on how much was invested, when it was invested, how much was returned, and when the return was received. Thus, if several outlays of cash are made at different times into one investment, like law firm capital investments, the internal rate of return informs the Chief Financial Officer of the rate of return for the total of the investments based upon when those investments were made and when the returns were, or are expected to be, received. It even works if the returns are spread over time as well. Therefore, for complicated staged or lumpy investments, or for those that return periodic payments or returns (like a bond), calculating the internal rate of return can allow a law firm to compare that investment to other similar staged or lumpy investments to see which one actually offers the highest compound annual growth rate, the internal rate of return.

For example, if a law firm makes an investment in a new building, remodels part of the building immediately and leases out part of the space, then one year later remodels the rest of the space, and makes a final investment improving the building's technology infrastructure, and the firm is receiving cash from the attorneys in the building and using cash for operating expenses of the building, the law firm can compare that investment to others alternatives for generating revenue, such as using the cash for laptop computers for the attorneys to allow the attorneys to work from home, by using the internal rate of return.

Rather than just compute the difference between the proceeds from the investments and the sum of the amounts invested, which would be the total profit, and then divide the profit by the total amount invested (which would provide a total percentage return), the internal rate of return uses time to determine the rate of return needed for the investments to equal returns generated. That is why the internal rate of return is sometimes referred to as the compound annual growth rate - the rate at which lumpy investments grow to equal the final returns.

So What?

The power of the internal rate of return is that it allows the law firm to compare different investments, because the internal rates of return incorporate timing - when the investments are to be made and when the returns are expected to be received. That is, the magic of the internal rate of return is that it allows any investor to compare the rate of return on different investments in today's dollars. Taking the example above about a $100 investment returning $100 plus the capital invested in either one year or fifty years, the only difference was when the returns were received. In both cases, the total percentage return is 100% ($100 profit on $100 invested), but the internal rates of return are much different. For the investment returning all capital and profit in one year, the internal rate of return is 100%; for the investment returning capital and profit in fifty years, the internal rate of return is 1.4%.

Advantages

The main advantage to computing the internal rate of return on investments is to compare investments that have uneven investments or uneven cash flows. The Chief Financial Officer can then determine, from a purely financial perspective, if the capital investment should be made.

Disadvantages

The main disadvantage to relying too heavily on the internal rate of return as a guidepost for investing is that it does not account for the relative risk of the investment. Although the calculation can allow the law firm to compare a variety of investments on a strict returns analysis, the internal rate of return does not address the relative risk, and that must be done with other tools.

Accordingly, a new branch office in new city may have greater risk than investing in hiring a new group of attorneys for a new practice area to service existing clients. The risk of the two investments may be quite different.

Furthermore, because of the structure of law firms, the calculation may be complicated, but not made infeasible, by tax considerations. In many capital investments, there may be valuable depreciation allowances, or borrowing the funds may provide interest deductions. In addition, retaining cash in a law firm partnership for a capital investment may mean that the partners are taxed on the cash retained even though they will not receive the cash to pay those taxes. Thus, the affect on the owners of the capital may complicate, but not defeat, the internal rate of return analysis.

Conclusion

The internal rate of return is one of the most useful metrics for evaluating investments, but it does not account for risk. In any enterprise there is a large universe of risk: risks in development, competition, and recruiting and retaining key employees, to name a few. Although the internal rate of return is useful in making a "go - no go" decision on an investment, it is not a substitute for the experience of the law firm Chief Financial Officer.

By Thomas C. Klein, Esq.

Tom Klein is a partner at the law firm of Wilson Sonsini Goodrich & Rosati in PaIo Alto, California. He is also a California registered investment advisor and accredited asset management specialist as certified by the College for Financial Planning.

A version of this article appeared in Accounting and Financial Planning for Law Firms, published by Law Journal Newsletters.

Copyright American Association of Attorney-Certified Public Accountants Winter 2005
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