5.1 IRRs are normally calculated using standard formulæ which are embedded in the software being used to model the IRR for the Project,4 and most Project Agreements refer to a particular cell in the Financial Model which reflects the relevant IRR. Consequently, it is important to ensure that the underlying cash flows in the Financial Model from which the software calculates the IRR are entirely consistent with the principles intended in the PFI Contract.
5.2 The calculation of equity cash inflows going into an IRR calculation should reflect all actual or projected cash available for distributions to investors, once Senior Debt service and covenant requirements have been satisfied. In the case of the Blended Equity IRR calculation used for calculation of Refinancing Gains, Distributions to investors should include the elements set out in Section 34.7 (Model Refinancing Provisions) of SoPC4.
5.3 The calculation of cash outflows is relatively straightforward in most IRR calculations. It reflects the amounts invested (in cash or kind) by investors into the project, timed according to the date on which the investment amount was transferred into the control of the Contractor. The Authority should ensure that this approach is followed throughout the Contract and in the Financial Model. An IRR calculated on this basis is referred to as an IRR calculated on a "Cash-on-Cash" basis, and is invariably the most accurate measure of return available to the Authority.
5.4 In some instances, particularly in negotiations relating to refinancing, investors may suggest a different method for estimating cash outflows. In this method, outflows are timed not on the date when investment amounts are transferred to the control of the Contractor, but the date on which the investment amounts are committed to (but not necessarily transferred to or drawn down by) the Contractor. The former is usually an earlier date than the latter, and the effect of this is to reduce the IRR compared to the Cash-on-Cash basis. An IRR calculated on this basis is usually referred to as an IRR calculated on a "Cash-on-Commitments" basis.
5.5 The most common justification provided by bidders for the use of Cash-on-Commitment IRRs is that Senior Lenders typically require the investors to commit funding to the project (through a letter of credit or otherwise), which can be accelerated at any time. As a result, investors are required to "lock up" funds to meet this commitment on the date they are committed, and it is argued that they are as good as invested in the project on that date.
5.6 As this is a hybrid measure of return on investment it is not one which can be recognised as providing a meaningful financial measure of return on investment, unless a suitable adjustment is also made for the return which can be earned by investors on capital committed but undrawn. This adjustment is normally effected by crediting a notional deposit rate on the undrawn funds as a distribution to the providers or equity or Junior Debt.5
5.7 A Cash-on-Cash calculation is always preferable, but if the Authority agrees to a Cash-on-Commitment IRR methodology, it must ensure that the methodology is applied consistently, and its limitations recognised. This is especially relevant should a refinancing occur.
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4 The software used in the calculation of an IRR in the Financial Model should be specified in the Contract as different spreadsheet programs may generate different values an IRR because of the differences in the algorithms used in different software.
5 More correctly, it is the opportunity cost of capital rather than a deposit rate which should be credited back in this way, but this is difficult to assess, so market practice has been to credit the deposit rate.