Pricing a product - NPV and IRR

Hello,

I'm struggling to understand the importance of the net present value when it comes to pricing a product. Consider the example below:

Suppose a new product has been designed and its expected cashflows have been projected out on a best estimate basis (with the premium simply being denoted as P). Also suppose that directors have assessed the riskiness of the product and have arrived at a suitable risk discount rate (RDR). I view the RDR as the rate that the shareholders would desire to achieve having invested in the product - so surely now the next course of action would be to perform a goal seek on P to ensure the IRR is equal to the RDR? (For the sake of argument, assume that the cashflows involve a large outgo initially followed by positive net cashflows at all future time steps, so that the IRR exists and is unique) What I don't understand is why you would set out a certain NPV and then perform a goal seek on P to arrive at that NPV: deriving a P to produce any positive NPV would mean the IRR is actually higher than the one originally decided upon and we have a contradiction. Am I missing something here?

I would appreciate any help on my conundrum!

Thanks,

Graeme

 

NPV / IRR provides two approaches to aid capital budgeting decisions. A major attraction of NPV is that this assigns a £ amount to compare against. If faced with a difficult decision, you’d pick the price, project etc that for a given outlay generated the higher NPV.

The IRR is a special case, which sets NPV = 0. The ‘trouble’ with the IRR is that it says nothing about the hard earned profits to be earned by the price / product. Profits are ultimately what the Directors and shareholders are interested in.

The IRR can also suffer from having a non-unique (or no) solution.

Hope that helps.

 

I don't think the risk discount rate is what the shareholders desire to achieve. It is instead the minimum return they expect from the product.

I think it's all about opportunity cost. Let's say the risk discount rate being used is 6%. I think of that 6% as being the rate of return that the company / shareholders could achieve with the next best alternative investment. E.g. they may feel like they could get a return of 6% if they invested their capital in a portfolio of equities rather than in the life insurance product being priced. (I am assuming that the risk from investing in equities is the same as the risk of investing in the life insurance product, for this example).

Therefore why bother investing in the life insurance product if the IRR is less than 6%? And if the IRR is exactly 6%, I believe the shareholders will be neutral about what to invest in (the life product or the portfolio of equities).

Only if the IRR is greater than the risk discount rate (e.g. 6%) will the shareholders be able to say with conviction that they would prefer to invest the capital in the life insurance product because it is expected to achieve a higher return than the equities investment.

NPV is said to be a better measure than IRR for the reasons listed in the notes. However, assuming the IRR isn't suffering from multiple solutions or whatever, I still think IRR is a sound metric to use.

Having worked in life pricing, I would say that companies don't choose an NPV and perform a goal seek on P, as NPV is an extensive variable. Rather they would target an intensive variable such as profit margin (NPV divided by PV premiums) as this quantity doesn't really vary with volumes of business. E.g. might target a profit margin of 10%.

Hope that helps!

 

Hey Satya,

Thanks for your response, I think your interpretation of the IRR makes more sense. It wouldn't really make sense for someone to say I want a return of x% as any return exceeding x would equally suffice!

And I agree, looking at the NPV without any regard as to the volume of the business wouldn't be very useful.

Graeme

 

Hey Graeme

This is what it says in the ST1 notes about IRR and NPV:

NPV is always the preferred profit measure as when you have a choice between two, you always pick the one that gives higher NPV.

NPV can be divided by initial commissions or PV(premiums) to indicate sales effort or the profit margin relative to cashflows.

Some pattern of cashflows doesn't return an IRR. e.g. initial positive cashflow (however this is arguable IMO as there should always be new business strain).

Hope it helps,
Jian