THE FINANCIAL RATE OF RETURN (FRR) (Work in progress) 01.

The purpose of this note is to clarify the calculation of the Financial Rate of Return (FRR, also referred to as internal rate of return or IRR) for real sector projects. This note is a revision of the relevant portion of the old IFC Project Policy Guideline 1.01 issued on January 7, 1985.1 Context 02. The FRR of a project is a summary measure of overall project profitability from the viewpoint of the enterprise as a whole (rather than from the viewpoint of a particular type of financier). IFC can only expect to have a lasting impact if projects earn a rate of return on investment, i.e. if they are financially successful. Although other metrics and ratios (such as DSCR, margin analysis, profitability, etc) need to be used to evaluate a projects ability to meet its obligations to various stakeholders, many of these metrics are more relevant for a particular category of financiers, and they do not take into account the time value of money. As such, taken in isolation, they do not offer sufficient information about whether an investment is attractive irrespective of the financing plan (i.e. the split of debt/equity), and given the projects timeframe and opportunity cost of capital. 03. The FRR is an IRR calculation and is measured as the discount rate that equalizes the present value of the cost stream (the Cost Stream or Outflows) associated with the project (normally the value of the initial (and subsequent) investment, such as capital expenditures, pre-operating expenses and working capital) and the present value of its financial benefits stream (the Benefit Stream or Inflow). It is thus a Return on Operating Assets measure that takes into account: (i) returns over a period of time and not just for one year; and (ii) the time value of money. The FRR, then, is a useful metric to quantify and evaluate the attractiveness of a particular project over a period of time. It is also a useful metric to compare the potential returns of different/alternative projects, thereby allowing decision makers to prioritize the allocation of resources. The FRR of a project can thus be compared against the companys weighted average cost of capital (WACC) and against the FRR of other similar or competing projects (which represent the opportunity cost of capital) in making an informed evaluation of a projects attractiveness.2 Like any analytical tool, FRR has its advantages and disadvantages which need to be understood.3 04. Calculation of FRR in US$ and in constant value or real terms rather than inflated terms is considered more meaningful since only relative changes in real terms are included and the
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This note was revised by Robin Glantz in Feb. 2007 with input from numerous staff: Manuel Nunez, Roland Michelitsch, Clive Armstrong, Sanjay Puri, Nomaan Mirza, Kalim Shah, and Cecilia Rabassa. Please note that IFCs Independent Evaluation Groups internal website contains a standard methodology on calculating FRR for real sector projects, from an XPSR perspective. 2 A companys WACC is especially important when it is deciding among competing investments. In general, if the FRR of a project is > a Companys WACC, the project is creating value for the Company. However, there is internal debate within IFC as to whether a Companys WACC should be a threshold for IFC to invest in a project. Also see para 20. 3 Care must be taken in the use and calculation of FRRs, and the related tool net present value (NPV). Under certain conditions, NPV and IRR can rank projects differently, i.e. i) if the cost of one project is larger than the other; or ii) if the timing of the projects cash flows differs. The FRR is a measure of the rate of return for a particular investment, and does not account for the scale of the investment. As such, although Project A may have a higher rate of return than Project B, its overall NPV may nevertheless still be lower if Project B is of a larger scale. One also needs to look at the relative volatility of cash flows vs. the differential in FRRs. For projects with large costs later in time, when choosing among projects, the better projects will actually have lower IRRs. Also, if, a projects future cash flows are volatile and fluctuate between positive and negative values, it is possible for the project to have multiple FRR values. Finally, a high FRR (e.g. > 30%) should be viewed with caution because the IRR calculation reinvests the yearly cash generation at the FRR interest rate; this is especially an issue if there are high positive cash flows in the early years. In those cases, the MIRR function in Excel (in which the user can determine at what rate cash flow is reinvested) is a better way to calculate and compare project returns. (NPV and IRR make different assumptions about the opportunity cost of capital. IRR assumes the opportunity cost is the IRR rate. NPV assumes it is the cost of capital.)

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magnifying effects of inflation are avoided. Thus, the comparison of costs and benefits of a project is not affected by changes in the general price level or by the different rates of inflation among countries. For this reason, FRR is generally calculated in real terms. The date or period may relate to the time the projections are prepared, usually the date of the project cost estimates, or the project completion date; the measuring unit used for both outflows and inflows is expressed in terms of a monetary unit as of the given base date or period. Calculating returns in US$ allows us to have comparability across projects. 05. After tax FRR - The basic FRR calculation should be after tax, to indicate whether a project is expected to earn an acceptable return on capital invested for all the financiers, irrespective of the source/mix of financing, but taking into account all subsidies, taxes and other transfer payments. It also shows how the investment decision compares with other investment alternatives available to project financiers. You may also wish to calculate a pre-tax FRR, to put projects on a comparable basis by showing their intrinsic earning potential before project benefits have been distributed among beneficiaries (government and financiers). The two computations, pre and after taxes, should be appropriately labeled. 06. FRR vs. ERR - The after tax FRR should be compared to the Economic Rate of Return (ERR), which is a return to the country as a whole. While there will usually be some difference between the two, a large difference is a red flag (especially if the FRR is greater than the ERR) and needs to be understood very carefully. If the FRR is less than the ERR, this indicates there are benefits generated by the project that are not captured by the projects investors (e.g. taxes). If the FRR is greater than the ERR, other constituency(ies) in society are incurring costs that are not picked up by the project, i.e. the project benefits from direct or indirect subsidies.4 07. The following is a brief description of the more important items comprising the cash outflows (cost stream or negatives) and cash inflows (financial benefits stream or positives) of a project. COST STREAM 08. Project Cost - This consists of the cash outflows, year by year, for the capital expenditures (fixed assets), pre-operating expenses and working capital of the project. 09. Restate project costs in real terms - For purposes of determining how much money is needed in the financial plan of a project, estimates of project cost include expected changes in real prices as well as changes in the general price levels from the time the estimates are made until the expenditures are expected to be incurred. To modify the project cost for use in calculating FRR, the outflows over the project implementation period which are expressed in currency units of the year in which the expenditures are to be made, need to be placed on a common basis: i.e., in terms of a single unit of measurement. To make this adjustment, the expenditures must be deflated back or inflated forward, as the case may be, to the general price level as of the base date used. If the base date is the date the projections are prepared, adjustments should be made to the project costs expressed in current terms, including escalation allowances, to deflate these costs back to the base date (i.e., eliminating the
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For example, if FRR<ERR, there may be duties and taxes paid to the government or other benefits that accrue to parties external to the project. A project that has no economic distortions or externalities would normally have an FRR<ERR due solely to income taxes. If FRR>ERR, there may be tariffs on imports, whereby consumers end up paying more than they should to the projects benefit. IFC looks very carefully at projects where the FRR>ERR, to understand who are the winners and losers, and to ensure that there is a national benefit. For more details on ERR, please talk to your Dept. Economist.

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escalation allowances). Likewise, if the base date is the date of project completion, the project costs and any project revenues and expenses in current terms, inclusive of escalation, should be inflated from the date these are projected to be incurred up through the date of project completion. For purposes of deflating or inflating project costs to the base date, project cost estimates and any project revenues and expenses prepared in local currency should be adjusted by the estimated local inflation index; project costs and any project revenues and expenses prepared in US$ should be adjusted by using the appropriate GDP deflator series (see Attachment 1). Interest during Construction 10. Interest expenses and all costs incurred as a result of lenders during the implementation period are excluded from project costs for the purpose of calculating the FRR, since interest is itself part of the return on the capital invested in the project (i.e., the IRR calculation assumes reinvestment of cash at the IRR rate). The FRR computation refers to the rate of return on the entire investment in the project. (See also paragraph 16 on the treatment of interest expenses in calculating cash inflows.) Additional Capital Expenditures after Start-up 11. Additional capital expenditures during operations, for purchases of new equipment or major replacements of equipment or other capital expenditures needed for the project being financed, form part of the costs stream and should be included in the year or years in which they are expected to be paid. Operating Working Capital5 12. This refers to the changes in the minimum Operating Working Capital needed for operations. Operating Working Capital equals Operating Current Assets minus Operating Current Liabilities. 13. Operating Current Assets refers to all current assets used in or necessary for the operations of the business, and would generally include minimum cash, trade receivables and inventories. Excess cash, marketable securities, and temporary investments of excess cash are not necessary for the Companys core operations and therefore are not included in Operating Current Assets. 14. Operating Current Liabilities would include payables to suppliers, accrued expenses, and other operational payables related to the physical operation of the business. Short Term Debt and the Current Portion (of Long-Term Debt) relate to financing, rather than operations, and therefore are excluded. Note that, as a rule, Operating Current Liabilities equal non-interest bearing current liabilities. 15. Changes in Operating Working Capital in FRR calculations should be included in the cost stream (or outflows6) at the start and in every year of operations. The ending value of Operating Working Capital in the last year of calculations should be deducted from the cost stream (i.e. as a negative cost, or an inflow). Please note that if the terminal value for fixed assets is based on a

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Sometimes this is referred to as Net Non-financial Working Capital. Some industries such as retail may have negative working capital needs, i.e. working capital operations add cash to the business and therefore need to be added.

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going concern, the ending value of Operating Working Capital in the last year of calculations is not recuperated in the final year7 (see para 18 on Terminal Value). CASH INFLOWS OR BENEFIT STREAM 16. Cash inflows from operations after tax are calculated from profit projections estimated in terms of currency values as of the same base date or period used for the cash outflows for the project. To determine cash inflows from operations after tax, the following adjustments are made to net income shown in the financial projections: Add back non-cash expenses and subtract non-cash income, such as depreciation and amortization, provisions and other non-cash gains and losses; Add back the after tax interest expenses and other finance charges on long and shortterm debt by multiplying these expenses * (1-t)8 and adding back the resulting number. Subtract the after tax interest income (if any) by multiplying the interest income * (1-t) and subtracting the resulting number. Adjust for changes (if any) in long-term deferred taxes9. (ST deferred taxes should have been captured in changes in working capital.) 17. To calculate the FRR pre-tax: Start with Net Income before tax Add back non-cash expenses and subtract non-cash income (as above) Add back interest expense (and subtract interest income, if any) Adjust for any changes in long-term deferred taxes (as above).

Terminal Value of Fixed Assets 18. The calculation of FRR is normally prepared for 10, 15, 20 years of operating life, depending on the expected commercial life of the assets. In the last year of calculations, the terminal value of fixed assets, taking into account how they have been affected by the additions/replacement referred to in paragraph 11, are recognized as a cash inflow. There are numerous ways of estimating this terminal value. The estimate of an appropriate terminal value should be based on knowledge of the industry and is normally derived with the assistance of the Technical Specialist and economist. The terminal value may be the estimated salvage value of the plant and equipment, or the price which may be expected to be paid by a buyer of the assets who sees an opportunity to derive future benefits from them (a going concern value). With respect to salvage value, land often is worth more in real terms than its original purchase price, but the latter is more conservative and may be preferable as the terminal value. With respect to a going concern value, the terminal value could be computed as a
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I.e. Another way to think about Operating Working Capital is that it is part of the recoverable terminal value (TV) of a company, provided that the TV of fixed assets is based on a method other than a going concern (e.g. salvage value, Invested Capital). 8 T (t) = the Companys marginal tax rate. Interest expenses and other finance charges are excluded (i.e. backed out) in the calculation of cash inflows for the same reason that these are excluded from the determinations of project cost. As explained in para 09, the rationale for excluding interest income earned on short and long-term liquid investments is that the FRR formula assumes that cash generation is reinvested at the IRR/FRR rate. (In general, IFC prefers not to calculate any interest on short-term investments in its projections.) 9 If the deferred tax liability increased, then add the change back; if it decreased, then subtract the change. If deferred tax asset increased, then subtract the change; if it decreased, then add back the change.

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perpetuity value (the final cash flow of the FRR table divided by an appropriate expected return number) or a price/final cash flow number (such as an EBITDA multiple or a Price/Earnings ratio). If you use a going concern valuation, make sure it also bears a sensible relation to the project cost. Another approach, gaining wider use within IFC, is to use the final years Invested Capital of the Company (net Fixed Assets plus Operating Working Capital), which is a book value concept. In any event, the terminal value is a residual value concept and should not make a material difference in the rate of return calculation; otherwise it is normally preferable to extend the projection timeframe.

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Calculating FRR in Expansion Projects 19. To calculate the FRR in an expansion project, you must be clear what would have happened without the project, and what are the projects incremental impacts. To calculate the projects FRR, first estimate the Companys with and without project anticipated cash flows and terminal value. Then take the difference between the with and without forecasts to obtain the net cash flows and the net terminal value, and estimate the FRR of the expansion.10 What is an Acceptable FRR? 20. Whether an FRR meets IFCs standards for an investment depends on the industry, the level of risk of the project and the basis of the financial projections (e.g. price assumptions). Because an expansion project uses existing infrastructure of the company, the FRR of an expansion project is generally higher than that of a greenfield project.11 Calculating ROIC in Corporate Loans 21. The ability to perform a with and without project analysis hinges on knowledge of the investment program and its impact on the company. In some cases the investment program is not clearly defined or the program might constitute a small proportion of the companys with project operations, making it challenging to create with and without project scenarios. Under such circumstances, it would not be possible to apply the methodologies for greenfield or expansion projects described above to compute the FRR for the investment program. Since the investment program and its effects can neither be well-articulated nor enumerated in these circumstances, an alternative solution is to consider the new investment as part of the overall corporate investment program; thus, instead of attempting to analyze the FRR for the particular investment program, compute the return on invested capital (ROIC) for the entire company. The corporate ROIC is the proxy for the investment FRR. The initial value of the company (i.e. cash outflow) is approximated by using Invested Capital (net Fixed Assets plus Operating Working Capital). The corporate cash flow stream is obtained through adjustments to net income as described above. Invested Capital in the final year of projections is also a proxy to be used for the terminal value.12 See Attachment 2 for a draft note on ROIC methodology.
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Be realistic as to what would have happened without the project. If the without project cash flow is consistently negative, then it is probably best to assume that the project would have been shut down. 11 There are different views within IFC as to whether there is an absolute threshold for FRRs. The Development Effectiveness Unit and IEG feel strongly that any project with an FRR below the Companys WACC (Weighted Average Cost of Capital) indicates that the Company is destroying value. In any event, the Investment Officer should understand whether a Company is investing in assets that return below its cost of capital. If you want to calculate a Companys

WACC, the formula is: where E is the market value of the firms equity, D is the market value of the firms debt, rD is the weighted interest rate on LTD and TC is the corporate tax rate. The suggested method to calculate the equity hurdle rate (rE) is: 5-year US treasury rate + equity premium (2.5%) + IFC country macro spread + IFC project risk spread. CRV much prefers to judge the adequacy of the FRR by the factors stated in para 19 above. From CRVs viewpoint, a projected FRR lower than 10% (in real terms) will require careful explanation (and 10% is considered quite low on an ex-ante basis). 12 Typically, given the overall averaging impacts of the size of various activities of a company, including a reasonable period of historical data, it is not surprising that estimates of ROIC are generally lower than FRRs of individual projects. Also, the Investment Officer should be aware of how the ROIC compares to the Companys WACC.

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Attachment #1: GDP Deflator Series

Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

2000 86.4 88.4 90.3 92.1 93.9 95.4 96.5 97.9 100.0 102.4 104.2 106.4 109.4 112.7 116.0 118.4

2001 84.4 86.3 88.1 89.9 91.7 93.2 94.2 95.6 97.7 100.0 101.7 103.9 106.9 110.1 113.3 115.6

GDP-Deflator: Base Year 1) 2002 2003 2004 2005 82.9 84.8 86.6 88.4 90.1 91.6 92.6 93.9 96.0 98.3 100.0 102.1 105.0 108.2 111.4 113.7 81.2 83.1 84.8 86.6 88.2 89.7 90.7 92.0 94.0 96.2 97.9 100.0 102.8 106.0 109.1 111.3 78.9 80.8 82.5 84.2 85.8 87.2 88.2 89.4 91.4 93.6 95.2 97.2 100.0 103.0 106.1 108.2 76.6 78.4 80.1 81.7 83.2 84.6 85.6 86.8 88.7 90.8 92.4 94.4 97.1 100.0 102.9 105.0

2006 74.4 76.2 77.8 79.4 80.9 82.2 83.1 84.3 86.2 88.2 89.8 91.7 94.3 97.1 100.0 102.0

2007 1.0 74.6 76.2 77.8 79.3 80.6 81.5 82.6 84.4 86.5 88.0 89.9 92.4 95.2 98.0 100.0

Inflation 2.3 % 2.3 % 2.1 % 2.0 % 1.9 % 1.7 % 1.1 % 1.4 % 2.2 % 2.4 % 1.7 % 2.1 % 2.8 % 3.0 % 2.9 % 2.0 %

1)

Source: International Monetary Fund, World Economic Outlook Database, September 2006, and IEG's calculations

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ATTACHMENT #2 - DRAFT13

GUIDANCE FOR CALCULATING RETURN ON INVESTED CAPITAL (ROIC) FOR REAL SECTOR OPERATIONS (DRAFT)
Earning a return on invested capital (ROIC) greater than weighted average cost of capital (WACC), and growth are the two primary value drivers for companies. High returns and growth create value by driving high cash flows. ROIC is the return earned on the total capital invested in the business whether it is debt or equity. The most important principle to calculating ROIC is to define the numerator and denominator consistently - if an asset is included in invested capital, the income related to that asset should be included in NOPLAT. Annual Return on Invested Capital (ROIC) = Net operating profits less adjusted taxes Invested Capital NOPLAT: Net operating profits less adjusted taxes (NOPLAT) represents the profits generated from the companys core operations after subtracting the income taxes related to the core operations: NOPLAT = (Earnings before interest and taxes14 + amortization] cash taxes Where: Cash taxes = operating taxes increase in deferred taxes = (reported taxes paid + tax shield from interest expense taxes paid on non-operating income) increase in deferred taxes NOPLAT can also be calculated starting with net income: NOPLAT = Net income + increase in deferred taxes + goodwill amortization + after-tax interest expense after-tax non-operating income after-tax interest income15 Invested capital: Invested capital should typically be calculated as the average of the beginning-of-period and the endof-period invested capital. It is also permissible to use only the beginning-of-period invested capital, in which case the calculation is closer to a discounted-cash-flow (DCF) calculation used for the lifeof-project ROIC (see below). Invested capital = Total funds invested in the operations of the business = Operating working capital + net property, plant & equipment
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This draft note was prepared by the Development Effectiveness Unit, led by Roland Michelitsch. Comments are welcome and should be sent directly to him. 14 However, depreciation should be subtracted. 15 Deferred taxes stem from the difference between financial accounting and tax accounting. Investors expect to also receive a return on them. Goodwill does not really "depreciate"; it is mainly a tax treatment. After-tax non-operating income usually does not come from the operating performance of the company, and is thus excluded to better gauge the company's operating performance. After-tax interest income usually does not come from the operating performance of the company either, and is thus excluded.

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+ net other assets (net of noncurrent, non-interest bearing liabilities) Where: Operating working capital = operating current assets - non-interest-bearing current liabilities Net PP&E = book value of the companys fixed assets16 Invested capital can also be calculated starting with total assets: Invested capital = Total assets - non-interest bearing current liabilities - goodwill non-operating investments, excess cash and marketable securities other liabilities17 In cases where all the adjustments are small, it is permissible to use the following simplified proxy for ROIC: proxy: ROIC = Net income + after-tax interest expenses Total assets - non-interest bearing liabilities More advanced adjustments to consider: - Operating leases: If material, they should be treated as if they were capitalized. First, reclassify the implied interest expense portion of the lease payments from operating expense to interest expense and add it back to EBITA. Second, add the implied principal amount of operating leases to invested capital. Calculation of WACC will need to be adjusted too by treating the operating leases as additional debt. - Pensions: For unfunded or under-funded pension plans where the liability is recorded in the financial statements, treat the liability the same as interest-bearing debt in calculating invested capital and the cost of capital. For NOPLAT, estimate the implied interest expense on the liability for the year and reclassify a portion of operating expenses equal to this amount as interest expense. - Inflation effects: ROIC can be distorted by inflation especially in high inflation environments, therefore adjustments may be necessary. LIFE-OF-PROJECT ROIC: ROIC is typically an annual measure (i.e. the "annual ROIC"). However, it is also possible to calculate a "life-of-project" ROIC, which amounts essentially to an FRR calculated on the company as a whole. This measure can be used to assess company performance over a defined period (e.g. as projection at appraisal, and as a re-assessment prior to closure). The recommended life-of-project RIOC measure is the internal rate of return for the following cash flow stream: Years 0 - Initial invested capital 1 to T T + NOPLAT + Final invested capital 18 - Change in invested capital

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Where the book value does not appropriately reflect the value of the underlying assets (e.g. in high inflationary environments) and the assets could be sold for other uses, market values may be used. However, in such cases NOPLAT should also be adjusted to reflect the appreciation of the assets (e.g. the depreciation charge). 17 ROIC excluding goodwill is a better indicator of operating performance and should be standard practice. However, ROIC including goodwill can provide an additional measure assessing how well the company is using investors' funds (e.g. in particular following an acquisition). Non-operating investments, excess cash and marketable securities are not directly related to the company's operations, and returns are also not taken into account in NOPLAT. Other liabilities are those liabilities that are not directly related to the company's operations; their costs are also not taken into account in NOPLAT. 18 Change in invested capital is also equal to change in working capital minus gross investment in PP&E.

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NOPLAT minus change in invested capital (also called "net investment") is also called free cash flow, and is equivalent to gross cash flow minus gross investment. Non-operating cash flows are explicitly excluded from this calculation. However, note that they do affect the value of the company and one should therefore exercise extreme caution in excluding cash flows as "non-operating". Other adjustments: Further refinements of the calculation may be needed (e.g. for foreign exchange gains or losses, for pension plan funding, etc.). Please consult a standard finance textbook for additional guidance (e.g. Koller, Goedhart, and Wessels: Valuation - Measuring and Managing the Value of Companies, or its earlier versions by Copeland, M.

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