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					                                        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


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 project’s 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 project’s 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 company’s 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 project’s 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

  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 IFC’s Independent Evaluation Group’s internal website contains a standard
methodology on calculating FRR for real sector projects, from an XPSR perspective.
  A company’s WACC is especially important when it is deciding among competing investments. In general, if the FRR of a project is > a Company’s
WACC, the project is creating value for the Company. However, there is internal debate within IFC as to whether a Company’s WACC should be a
threshold for IFC to invest in a project. Also see para 20.
  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 project’s 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 project’s 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.


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

  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 project’s 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

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
Company’s 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

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

 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).


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 short-term
              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
  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).
   T (t) = the Company’s 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.)
  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 year’s 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 project’s incremental impacts. To calculate the project’s FRR,
first estimate the Company’s “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 IFC’s 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 company’s “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.

   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.
   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 Company’s 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 Company’s
                                           E                    D r
                          WACC =          E+D r E +                  (1 – T )
                                                               E+D D       C
WACC, the formula is:                                                                       where E is the market value of the
firm’s equity, D is the market value of the firm’s 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 CRV’s 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).
   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 Company’s WACC.

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Attachment #1: GDP Deflator Series

                              GDP-Deflator: Base Year
Year        2000     2001      2002     2003      2004     2005      2006     2007    Inflation
 1992        86.4     84.4      82.9     81.2      78.9     76.6      74.4      1.0   2.3%
 1993        88.4     86.3      84.8     83.1      80.8     78.4      76.2     74.6   2.3%
 1994        90.3     88.1      86.6     84.8      82.5     80.1      77.8     76.2   2.1%
 1995        92.1     89.9      88.4     86.6      84.2     81.7      79.4     77.8   2.0%
 1996        93.9     91.7      90.1     88.2      85.8     83.2      80.9     79.3   1.9%
 1997        95.4     93.2      91.6     89.7      87.2     84.6      82.2     80.6   1.7%
 1998        96.5     94.2      92.6     90.7      88.2     85.6      83.1     81.5   1.1%
 1999        97.9     95.6      93.9     92.0      89.4     86.8      84.3     82.6   1.4%
 2000      100.0      97.7      96.0     94.0      91.4     88.7      86.2     84.4   2.2%
 2001      102.4    100.0       98.3     96.2      93.6     90.8      88.2     86.5   2.4%
 2002      104.2    101.7     100.0      97.9      95.2     92.4      89.8     88.0   1.7%
 2003      106.4    103.9     102.1    100.0       97.2     94.4      91.7     89.9   2.1%
 2004      109.4    106.9     105.0    102.8     100.0      97.1      94.3     92.4   2.8%
 2005      112.7    110.1     108.2    106.0     103.0    100.0       97.1     95.2   3.0%
 2006      116.0    113.3     111.4    109.1     106.1    102.9     100.0      98.0   2.9%
 2007      118.4    115.6     113.7    111.3     108.2    105.0     102.0    100.0    2.0%

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

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                            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

Annual Return on Invested Capital (ROIC) = Net operating profits less adjusted taxes
                                                    Invested Capital

Net operating profits less adjusted taxes (NOPLAT) represents the profits generated from the
company’s core operations after subtracting the income taxes related to the core operations:

NOPLAT = (Earnings before interest and taxes14 + amortization] – cash taxes
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 end-
of-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 life-
of-project ROIC (see below).

Invested capital = Total funds invested in the operations of the business

   This draft note was prepared by the Development Effectiveness Unit, led by Roland Michelitsch. Comments are
welcome and should be sent directly to him.
   However, depreciation should be subtracted.
   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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                   = Operating working capital + net property, plant & equipment
                     + net other assets (net of noncurrent, non-interest bearing liabilities)
Operating working capital = operating current assets - non-interest-bearing current liabilities
Net PP&E = book value of the company’s 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.

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                                      1 to T                         T
      - Initial invested capital             + NOPLAT                       + Final invested capital
                                             - Change in invested capital18

   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).
   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
   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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