There are two key measures of financial performance - NPV and IRR. Each measure can be calculated from the perspective of the overall project and the equity holder. The private investor will assess the potential returns to equity, and the project's ability to support a financial structure that provides an acceptable balance of financial risk and reward.
The financial model calculates the net present value (NPV) and internal rate of return (IRR) of the project by expressing all future cash flows related to the project as present values. This takes account the time value of money, or the fact that it is more valuable to have, say, 1 million pesos today rather than the same amount at the end of one year. The NPV calculation applies a discount rate to the future cash flows to convert them to present values. The IRR, on the other hand, calculates the return on investment of the project.
These two concepts are discussed below.
Net present value. The net present value (NPV) of a project is defined as the sum of its net cash flows (revenues from all sources net of all selected expenses) over time at some defined discount factor.
This is a very concise performance indicator for an investment project. It is the total value of net cash flows generated by the investment over time, discounted by a predetermined discount factor. It is important to note that the net cash flows realized over the first years of a project (i.e., during construction and, possibly, the early years of operation) are usually negative and become positive after sometime. The use of a discount factor means that the negative values in the early years will be given more weight than the positive ones in the latter years. Hence, the time horizon is crucial for the determination of the NPV. Likewise, the choice of the discount factor is also a key variable in the calculation of the NPV. The larger the discount factor, the smaller the NPV.
The NPV, as an indicator, is a very simple but precise evaluation criterion for an investment. NPV > 0 means that the project, at the predetermined discount rate, generates a net benefit because the sum of the weighted net cash flows realized during the construction and operation period of a project is positive and is generally desirable. In other words, NPV can be a good measure of the project benefit in monetary terms with the use of an appropriate discount rate. Projects can also be prioritized on the basis of their ranking in terms of their NPVs either in absolute terms (i.e., on the basis of NPV to be realized) or in relative terms (i.e., on the basis of the relationship between NPV and the level of investment).
The internal rate of return (IRR) of a particular project is defined as the discount rate at which the net present value of the costs equals the net present value of the benefits.
Most commonly used data management softwares automatically calculate the value of these indicators. The analyst mainly uses the financial internal rate of return in order to determine the future performance of an investment. If i is the approximate cost of equity in the marketplace, a project is viable if financial IRR > i. This means that a project is financially viable if the net sum of its annual revenues and expenses over its construction and operating period results in a positive NPV, when discounted at the interest rate i, where i represents the yield normally required for a similar project, at a given time.
There are different points of view regarding the definition of the discount rate to be considered in the financial analysis of investment projects but it may be generally defined as the opportunity cost of capital. Opportunity cost means that when we use capital in one project, we relinquish the right to earn a return from this capital on another project. Thus, we have an implicit cost when we sink capital in an investment project resulting in the loss of income from an alternative project. An investor is generally knowledgeable about the opportunity cost of capital and will not invest in any undertaking unless it can generate a return at least similar to the opportunity cost of capital. Indeed, the professional investor will search for investments that generate the maximum IRR.
The most commonly used discount rate i - the opportunity cost of equity, for a project that is similar to that being developed - is applied to the net financial cash flows of a project, including all its gross inflows (revenues from all sources) net of all outflows (operating expenses, maintenance, interest payments and principal repayments). A larger financial NPV is more desirable than a smaller NPV and projects can be generally prioritized in this manner.
There are two different discount rates used in the financial NPV calculation. When the return to the project investor is being calculated, the appropriate discount rate is i, the opportunity cost of equity. On the other hand, when the return on the entire project is being considered, including the portion of the project revenues that flow to debt holders, the appropriate discount rate is the weighted average cost of capital (WACC). It is important to understand that i and WACC are applied to different cash flows, and result in different values that are not comparable. The overall project value, calculated using WACC, is equal to the value received by debt holders plus the value of the equity calculated, using i.
How then is i determined? The simplest way is to ask knowledgeable institutions, such as commercial banks or the Public Private Partnership (PPP) Center on the current equity return of certain projects, such as water supply, commercial buildings, etc.
WACC, on the other hand and as its name implies, is a weighted average of the cost of equity capital and the cost of debt. The weights are determined by the proportions of debt and equity in the capital structure of the project company. The formula for the calculation of WACC is as follows:
WACC = i x (E/(D + E)) + Cd x (1 - T) x (D/(D + E))
Where: Cd is the cost of debt
E is the amount of equity contributed
D is the amount of debt raised
T is the corporate tax rate
As mentioned earlier, WACC is the discount rate used to calculate the NPV of the project, as WACC represents the cost of the total financing package used to fund the project; while i is the discount rate used to calculate the NPV to equity.
WACC is higher for the 60/40 debt/equity ratio because that capital structure uses a higher percentage of expensive equity. However, the additional cost is somewhat offset by the lower financial risk (loan interest rate volatility) of the 60/40 capital structure.
We note that the methodology used to arrive at a financial discount rate differs from that used to calculate economic viability. To test for economic viability, one needs to use the 15% social discount rate prescribed by NEDA. Economic analysis (or social cost benefit analysis SCBA), applies the 15% predetermined discount rate to the project's gross economic benefits over the construction and operating period net of its financial costs, to determine the degree of desirability of the project. A project with a larger economic net present value (ENPV) is more desirable, from an economic perspective, than one with a smaller ENPV. As was true with financial indicators, projects can also be prioritized from the perspective of their economic desirability, in absolute as well as relative terms through the determination of their ENPVs.
Either NPV or IRR could be used as evaluation criteria for ranking projects. Nevertheless, it is useful to always consider NPV and IRR together to avoid confusion.
Risk and investor's required return are directly related in the sense that the lower the risk, the lower is the private sector's target return on a project. Therefore, in assessing a 'fair' return to the private sector, it is crucial that government understand this risk/profit relationship in general and in particular as it relates the subject project. The more the risks of a project can be allocated to the best party able to bear and mitigate them the lower will be the private sector's demands for a specific return and the cheaper will be the cost of the services provided under the project.
The LGU may request the PPP Center is to ensure that the hurdle rate for a specific project is the correct one and is not excessive. It is important to be clear, however, that in trying to avoid excessive returns, it is not itself taking on unreasonable risks, nor negating legitimate commercial interest in the project. The LGU must therefore be sufficiently flexible and agree to higher returns if the project or other relevant circumstances demand. This balance should be appreciated as a delicate issue on which adequate consideration should be included in the pre-feasibility study.
The payback period. The payback period is a measure frequently calculated to assess the financial performance of an investment. Payback period measures the time that the project needs to operate until all of the initial investment costs have been recovered out of project cash flows. It is thus an indirect measure of risk - a shorter payback period is preferred to a longer one. There is no absolute standard as to what is an acceptable payback period, but clearly a project that has a payback period of less than 10 years is preferable, from an investor's perspective, to one which has a payback period greater than that. Microsoft excel provides predefined formulas to calculate NPV and IRR, but payback period has to be manually calculated as it is the reciprocal of IRR.