Project IRR Vs. Equity IRR

A good principle to follow is to separate the project decision from the financing decision i.e.the project should be viable on a standalone basis, independent of the financing mix.

Therefore, initially IRR is determined at the project level, without considering cash flows related to financing. In this computation of project IRR, interest and debt-service payments are kept out.

As a separate exercise, debt-­service payments are introduced in the calculations and IRR is re-worked. Since the cash flows after debt-­service payments belong to equity shareholders, this re-worked IRR is essentially the return on equity invested in the project i.e.  Equity IRR.

Suppose that a project entails an investment of Rs. 600 crore. It is expected to generating operating cash flow of Rs. 100 crore in Year 1, going up by 30% each year for the following 3 years. At the end of Year 4, the project will have a salvage value of Rs. 300 crore. It is proposed to finance the project with a 2:1 debt­equity ratio. Given the company’s credit rating, it will be possible to borrow money for the project at 12% p.a., payable annually.

 

PROJECT  IRR Rs. Lakhs
  Year 0 Year 1 Year 2 Year 3 Year 4
Initial Investment

-600

Operating Cash flow

100

130

169

220

Growth

30%

30%

30%

Salvage Value

300

Total

-600

100

130

169

520

IRR

14.6%

 

 

EQITY IRR Rs. Lakhs
  Year 0 Year 1 Year 2 Year 3 Year 4
Cost of the Project

-600

Loan Mobilised

400

Equity Invested

-200

Operating Cash flow

100

130

169

220

Growth

30%

30%

30%

Loan Repayment
Principle Repaid

-100

-100

-100

-100

Interest

-48

-36

-24

-12

Salvage Value

300

Total

-200

-48

-6

45

408

IRR

17.03%

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