u/A.AJ - 3L DRAFT/PGarg:gas December 8, 1982 RATES OF RETURN IN BANK'S PROJECT WORK 1. Broadly speaking, the Rites of Return used in the Bank's project analyses can be classified into two groups: the Internal Rates of Return and the Rates of Return on Assets. Internal Rate of Return 2. The Internal Rate of Return (IRR) of a project is the discount rate which equalizes. the present value of the cost stream associated with the project to the present value of the project's benefit stream. The cost stream includes all costs required to construct, operate and maintain the project facilities over the project's useful life and the benefits are the gross revenues derived from the project outputs.l/ Stated alternatively, the IRR is the maximum interest rate that a project could pay for the resources used while recovering its investment and O&M costs. 3. In principle, several variants of the general concept underlying IRR are possible depending upon: 0 (a) whether the cost and benefit streams are expressed in nominal or real (net of any general inflation) prices; the resulting rate being Nominal IRR in the first case and the Real IRR in the second.2/ In Bank analyses all IRRs are expressed in real terms. 1/ Mathematically, the internal rate of return is the discount rate i such that: t =n Bt - Ct t t 1 (1+ i) where Bt - expected gross benefits in year t. Ct - expected costs in year t (including capital and O&M costs as well as any salvage value at the end of the project). n - useful life of the project in number of years. 2/ As a first approximation the real IRR equals the nominal IRR less the average annual inflation rate expected during the project period. -2- (b) whether the cost and benefit streams are expres3ed in financial terms (i.e., from the viewpoint of the individual investor/enterprise) or economic terms (i.e., from the viewpoint of the entire economy); the resulting IRRs being referred to in the Bank reports as the Financial Rate of Return (FRR) and the Economic Rate of Return (ERR) respectively. Both formulations are extensively used in Bank analyses.3/ (c) whether the benefit streams are net or gross of taxes on profit. This distinction is relevant only for the FRR since the tax liabilities, being transfer payments, are omitted in the economic analysis in any cose. Normally, both pre- and post-tax FRRs are included in Bank reports. (d) whether or not the financing arrangements for the project are taken into account. Thus, if the cost an'd Benefit streams are net of any borrowings and debt service liabilities, the IRR is on equity rather than on the total investment. Generally, this distinction is relevant only for the FRR. Typically, all Bank projects involving non-governmental equity participation include a FRR on equity besides the more commonly used FRR on the entire investment. 4. The ERRs and FRRs provide convenient summary measures of the overall project profitability from different perspectives. Through comparisonz with the relevant cost of capital they provide a useful device for weeding out the non-viable investments. Generally, they can also assist in ranking the alternative investment opportunities. Finally, a comparative analysi.s of the project profitability from different perspectives can help identify any serious distortions in the prevailing economic environment for redressal at the sectoral/macro level. For example, a large difference between the ERR and FRR of a project may be indicative of serious distortions on the pricing of project inputs and outputs. 5. The main limitations of the above measures are as follows: (a) the ERRs are not very helpful for comparing projects from different sectors/sub-sectors since the reliability and the completeness with which the benefits can be estimated varies greatly for such projects. In public utilities projects, for example, it is difficult to quantify fully all the benefits (particularly, the "consumer surplus") and hence the ERRs tend to be significantly underestimated; 3/ The ERRs are estimated for all Bank projects for which the costs and benefits can be quantified and valued with a reasonable degree of confidence. In addition, normally the FRRs are estimated for all projects involving financially autonomous entities producing marketable outputs. Typically, about two-thirds of all Bank projects include an ERR estimate and about one-half of all Bank projects include a FRR estimate. (b) the use of ERRs & FRRs for selecting the best among the mutually exclusive options (e.g. a hydropower project and thermal project) involves significant complexity and can potentially lead to sub-optimal choices; (c) the FRRs are not particularly useful for moitoring the year-to-year financial performance of a project or an enterprise since, by definition, they reflect the profitability of the project over the entire project period; and (d) because of the relatively large data requirements and the need for long range forecasts of a variety of parameters (e.g. prices for key project inputs/outputs), it is often impractical to use ER_Rs/FRRs in early stages of the project cycle. L tes of Return on Assets 6. In simple terms, the Rate of Return on Assets is the ratio of an enterprise's earnings to the average capital invested. Several variants are possible, depending upon: (a) the specific definitions employed for the "earnings" and the 'capital invested". The "earnings" for example, may be taken as income before or after interest charges, and before or aftey tax liablities. Similarly, the "capital invested" may or may not exclude work in progress and/or working capital. Alternatively, the "capital invested" may represent only the shareholder equity or the total assets. (b) whether or not the asset base and the depreciation charges are adjusted to reflect changes in price levels. Under the inflationary conditions which have prevailed in recent years, the sound practice requires that the asset base and depreciation practices reflect current prices. 7. The most comtwn form used in Bank's project work is the Rate of Return on Revalued Net Fixed Assets in Operation.4/ This is defined as the Net 4/ Alternative formulations used occasionally include: Rate of Return on Equity where the "earnings" are taken as the net operating income after taxes and interst charges and the "capital" as the shareholder equity; and Rate of Return on Total Assets with "earnings" defined as the net operating income after taxes and the "capital" being the total assets net of accumulated depreciation. -4- Operating Income 5/ after taxes expressed as a percentage of the revalued Net Fixed Assets in Operation 6/. The revaluation of assets is, however, not a universal practice since some borrowers' legal restrictions preclude the use of other than historical costs. B. The Rates of Return on Assets are simple and objective measures of year-to-year financial performance of an enterprise. They provide a useful tool for sound financial management including guidance on appropriate tariff/price levels for goods and services which are not subject to the discipline of the competitive mark2ts. 9. The main limitations of the above ratios are: (a) where resistance to the principle of as!et revaluation exists, only nominal ratios are availc -e which normally are of very limited use; (b) they do not measure the liqvidity status of an enterprise and accordingly despite earning a "reasonable" rate the enterprise may not have adequate cash to sustain operations; (c) in monopolistic conditions, a criteria based on earning adequate return on assets can lead to inefficiency and overpricing unless separate criteria are established to ensure efficient use of resource; and (d) being short-term meacures, they tend to be rather volatile necessitating, in practice, careful targetting for meaningful performance monitoring over time. 5/ Net Operating Income means gross revenues from all sources less all expenses related to operation, maintenance and depreciation provisions. Interest on debt is not deducted. 6/ Net Fixed Assets in Operation means the gross value of fixed assets lees accumulated depreciation. Work in progress and working capital are excluded.