Calculating the Financial Internal Rate of Return and Net Present Value
Posted on February 9, 2012, in Economics, Environment, FInance, Various, with 0 Comments3.5.3.1. 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 projectoperational, 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:  The FNPV and FIRR are calculated
on an aftertax 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.
Operating Revenues 

Less:  Operating expenses (including depreciation) 
Taxation  
add:  Depreciation 
Less:  Capital expenditure on fixed assets 
Investment in working capital 

= Free Cash Flow 
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 20year period (5year 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.