Learn how to estimate the ROI of your project or proposal using IRR and sensitivity analysis. Find out how to select the appropriate discount rate and cash flow assumptions for your business case.

I have always considered using a discount rate as the methodology to bring cash flows to period zero on a risk-free basis. I don't see an opportunity cost to capital unless you're operating in a tight capital environment; capital is usually available if the business case is there. Since putting risk into a discount rate is difficult, I find it helpful to discount cash flows for time at the risk-free rate and risk-adjust cash flow items.

How do you choose the appropriate discount rate and cash flow assumptions for IRR and sensitivity analysis?

When you prepare a business case, you need to estimate the return on investment (ROI) of your project or proposal. One of the most common methods to do this is to calculate the internal rate of return (IRR), which is the discount rate that makes the net present value (NPV) of your cash flows zero. However, to get a realistic and reliable IRR, you also need to make some assumptions about the future cash flows and how they might vary under different scenarios. This is where sensitivity analysis comes in handy, as it helps you assess the impact of changing key variables on your IRR and NPV. In this article, we will explain how to choose the appropriate discount rate and cash flow assumptions for IRR and sensitivity analysis.

1 Discount rate

The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the opportunity cost of capital, or the rate of return that could be earned by investing in a similar project or asset. The higher the discount rate, the lower the NPV and IRR of your project. There is no one-size-fits-all formula to calculate the discount rate, but some common factors influencing it are the risk-free rate, risk premium, inflation rate, and tax rate. Depending on the type and source of your project's cash flows, you may use different methods to estimate the discount rate, such as WACC, CAPM, or APV.

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Michael Stine

Manager, Mining Economics and Risk | Aggregates and Mining
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I have always considered using a discount rate as the methodology to bring cash flows to period zero on a risk-free basis. I don't see an opportunity cost to capital unless you're operating in a tight capital environment; capital is usually available if the business case is there. Since putting risk into a discount rate is difficult, I find it helpful to discount cash flows for time at the risk-free rate and risk-adjust cash flow items.

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Fred Martins, MBA

Data Weaver – Insight Integrator ~ Modeling Wizard ~ Intellectual Explorer | I weave data into integrated models for strategic decision-making
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In my experience of preparing business cases for industrial investments, the WACC has been the metric of choice. It is fairly straightforward and considers the weighted average costs of equity, debt, and other forms of financing. In summary, the WACC serves as the benchmark for comparing your IRR. The extent to which the IRR needs to exceed the WACC is dependent on your company's risk appetite.

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2 Cash flow assumptions

The cash flow assumptions for your project are projections of future money inflows and outflows, which depend on various factors, such as the market size and growth, demand and supply, pricing and costs, competition and regulation, as well as the timing and duration of your project. To make reliable assumptions, you should use historical data and industry benchmarks to support your estimates. Additionally, it’s important to consider different scenarios and cases to capture the range of possible outcomes. Furthermore, you should apply conservative and realistic assumptions instead of optimistic or pessimistic ones to avoid bias or overconfidence. Lastly, you need to update and revise your assumptions regularly as new information becomes available.

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Jim Ward

Accounting Manager
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You may be asked to provide a proforma for a new division you want to start. It would be a good idea to master this concept in a way not to sell it to a board or shareholders but to be thinking very somber and conservative thoughts. Hint: Do not talk to marketing too much before drawing your assumptions!

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3 Sensitivity analysis

Sensitivity analysis is a technique that allows you to assess how sensitive your IRR and NPV are to changes in your discount rate and cash flow assumptions. This helps you recognize the key drivers and risks of your project, and evaluate the robustness and feasibility of your business case. To conduct sensitivity analysis, select the variables you want to analyze such as revenue, cost, growth rate, or discount rate. Then define the range and increment of values that you want to apply to each variable, such as +/- 10%, 20%, or 30%. After calculating the new IRR and NPV for each combination of values, compare them with your base-case values. Finally, plot the results in a table or graph like a tornado chart or spider chart to visualize the impact of each variable on your IRR and NPV. Performing sensitivity analysis with an appropriate discount rate and cash flow assumptions can improve the quality and credibility of your business case, enabling you to make more informed decisions about your project or proposal.

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Fred Martins, MBA

Data Weaver – Insight Integrator ~ Modeling Wizard ~ Intellectual Explorer | I weave data into integrated models for strategic decision-making
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The method selected for performing sensitivity analysis depends on the required depth of the analysis. I primarily rely on two methods: - "Ceteris paribus" (meaning "all other things being equal") to analyze the impacts of changes in individual variables. This approach is direct and straightforward to explain. - For more complex projects, a Monte Carlo Analysis is preferable. This structured approach allows several factors to vary simultaneously according to statistical distributions. By randomly sampling thousands of scenarios, it is possible to generate a probability distribution of positive outcomes for the business project and to identify the main influencing factors.

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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you choose the appropriate discount rate and cash flow assumptions for IRR and sensitivity analysis?

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1 Discount rate

2 Cash flow assumptions

3 Sensitivity analysis

4 Here’s what else to consider

Business Case Preparation

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