3.5.3.1. The financial viability of a project to an entity is indicated by

its FIRR and its financial net present value (FNPV). The FIRR is
the discount rate at which the FNPV of the project’s net cash flows
become zero. The FIRR and FNPV should be computed for all revenue
generating projects.

3.5.3.2. The FNPV is first calculated
by discounting the project’s net cash flows (or “free cash
flows”) by the WACC. The FIRR is then
calculated as that discount rate at which the FNPV becomes zero.

  • The free cash flows of a project
    include all the cash flows for the project-operational, capital
    expenditure, and working capital related. Operational cash flows
    derive from operating revenues and expenses after removing all
    noncash items such as depreciation and also excluding any financing
    flows such as interest on debt and other financing charges during
    construction. A standard formula for calculating free cash flows:
  • Operating
    Revenues
    Less: Operating
    expenses (including depreciation)
    Taxation
    add: Depreciation
    Less: Capital expenditure
    on fixed assets
    Investment
    in working capital
    = Free Cash
    Flow

     

  • The FNPV and FIRR are calculated
    on an after-tax basis in real terms (i.e., nominal financial cash
    flow is converted to real terms by removing the impacts of inflation
    and potential currency fluctuation).
  • Calculations should be over a
    realistic useful life of the assets not necessarily over the ADB
    loan term. Generally, a computation over 15 years after project
    completion is considered reasonable.
  • Should the assets have an estimated
    residual value at the end of the computation period, that should
    be included as a financial benefit in the computation.
  • The FIRR and EIRR should be calculated
    over the same period of time.
  • FNPV and FIRR calculations and
    assumptions should be provided in the
    financial evaluation
    appendix to the RRP.

3.5.3.3.The
following table provides an example of FNPV and FIRR calculations.
The table presents the calculation of project free cash flows over
the project’s full 20-year period (5-year construction period plus
15 years operations). In this example, it has been assumed that
there are no effects from working capital changes.

Example of FIRR and NPV Estimation (2001 prices: Rs’000s)

Year
Capital Expenditure
OperatingInflows
Operating Outflows
Operating
Cash Adjustments (add
back depreciation less
taxation)
Net (free
cash flows)
0
(32,410)
-
-
-
(32,410)
1
(659,150)
-
-
-
(659,150)
2
(799,140)
-
-
-
(799,140)
3
(365,600)
-
-
-
(365,600)
4
(216,390)
-
-
-
(216,390)
5
a
716,279
(435,303)
(56,557)
224,419
6
a
719,202
(392,813)
(51,038)
275,351
7
a
719,202
(403,277)
(45,520)
270,405
8
a
719,202
(410,874)
(40,001)
268,327
9
a
719,202
(418,369)
(34,482)
266,351
10
a
719,202
(425,764)
(28,963)
264,475
11
a
719,202
(433,066)
(23,445)
262,691
12
a
719,202
(440,278)
(17,926)
260,998
13
a
719,202
(447,406)
(12,407)
259,389
14
a
719,202
(454,454)
(6,889)
257,859
15
a
719,202
(461,424)
(2,075)
255,703
16
a
719,202
(467,617)
-
251,585
17
a
719,202
(471,003)
-
248,199
18
a
719,202
(472,248)
-
246,954
19
a
719,202
(473,432)
-
245,770
a a Net Present Value (NPV) @ WACC 3.55%
618,819
a a Financial
Internal Rate of Return (FIRR)
6.89%
WACC
= weighted average cost of capital

3.5.3.4.
The discount rate at which the present
value of the net benefits becomes zero works out to be 6.89%. This
is the FIRR, which should be compared with the WACC. If the FIRR
equals or exceeds the WACC, the project is considered to be financially
viable. If the FIRR were below the WACC, the project would only
be financially viable if subsidized, or further subsidized, by the
government. In the example, the FIRR of 6.89% is above the WACC
of 3.55%, and hence the project is financially viable.

3.5.3.5. The FNPV shows the present
value of the net cash flows, or the project’s worth today. The discount
rate to be used here is the WACC. A positive FNPV indicates a profitable
project; (i.e., the project generates sufficient funds to cover
its cost, including loan repayments and interest payments). If the
FNPV, discounted at the WACC of 3.55%, turns out to be positive,
the project is earning an interest of at least the required 3.55%.
In the example, as the FIRR is 6.89%, the project is forecast to
earn a rate of return of 6.89%. The project, thus, earns more than
the required 3.55% interest, recovers all investment and recurrent
costs, and yields a profit.

3.5.3.6. A negative FNPV points to
a project that does not generate sufficient returns to recover its
costs, to repay its loan and to pay interest. Note that, as a general
principle of discounting cash flows for the purpose of FIRR calculations,
loan repayments, and interest payments are not considered part of
the economic cost.

3.5.3.7.Discounted at the WACC of
3.55%, the FNPV of the project is 618,819. The project is thus financially
viable. If a discount rate of 6.89% is used (equal to the FIRR),
the FNPV (by definition) equals zero.

3.5.3.8. The example shows that if
the discount rate used, i.e. WACC, (3.55%) is below the FIRR (6.89%),
the FNPV is positive; vice versa, if the discount rate used (say
12%) were above the FIRR (6.89%), the FNPV would be negative.