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3 issues when using rating bureau's target PM
- Does not consider time value of money
- Does not respond to chg in competitive mkt environment to capture current return expectations
- Uses sales as rate base, which doesn't take into account equity provided by investors
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Key challenges when using IRR model
- How much surplus must be commited up front? → use industrywide surplus level
- When can surplus be released? → in proportion to paid losses, EP, or a combination of the 2
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Pitfalls in IRR Analysis
- IRR vs NPV: not equal when constraints on total resources
- IRR gives no sense of scale
- Difficult to use when multiple reversals (rare)
- Mutually exlusive contracts: can be misleading to focus on IRR
- Presentation of results: not always clear how IRR lower than target impacts the company
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