4.1 It is important that the Authority bears the following principles in mind when using IRRs in the Contract:
4.2 All the cash flows used to compute the relevant IRR should relate exclusively to the investor in respect of whom the IRR is being computed. For instance, if an IRR is being computed to reflect the measure of return on the project as a whole, a Project IRR should be used whereas if it is being computed to reflect the return earned by investors in equity and Junior Debt, a Blended Equity IRR should be used.
4.3 The timing of underlying cash flows used to compute IRRs (or cash flows which IRRs are used to discount) should always reflect the dates on which cash payments are made from the investors' account to the Contractor or vice versa for all historical cash flows, and should always reflect the dates when cash is available for Distributions to investors for all projected cash flows. All cash flows used to calculate IRRs in the Financial Model should be assumed to occur at the end of each relevant period.3
4.4 Inflation should be treated consistently. Real IRRs can be calculated if the underlying cash flows are expressed in constant prices, while Nominal IRRs can be computed if the underlying cash flows are expressed in current prices. Similarly, when using discount rates, cash flows in constant prices should be discounted using real discount rates, and cash flows in current prices should be discounted using nominal discount rates. Many PFI projects have Unitary Charges which are partially indexed to inflation. In such cases it is preferable to use the Nominal IRR, but if the Real IRR calculation is used the future cash flows which are not indexed or subject to inflation (i.e. are in current prices) should be decreased by the rate of inflation.
4.5 In SoPC4, IRRs are used as discount rates to compute compensation and termination payments or refinancing shares. The table below summarises the type of IRR and the Section of SoPC4 in which it is recommended for use:
| Section of SoPC4 | Relating to | Type of IRR | Usage |
| | Compensation on termination for Authority Default / Voluntary Termination | Real Post-tax Blended Equity IRR | To calculate compensation amount for junior debt and equity holders |
| Estimated Fair Value of Contract | Nominal Pre-tax Project IRR* | To discount future Unitary Charges less | |
| Refinancing | Nominal Post-tax Blended Equity IRR ** | To compute Refinancing Gains for sharing |
* This should be adjusted for movements in underlying market interest rates as discussed in 21.2.9.9
** The base case (Financial Close) calculation of this is used as the "Threshold Equity IRR" in the Refinancing provisions.
____________________________________________________________________________________
3 Most spreadsheet programs use this methodology in the algorithms they use to compute IRRs.