Provincial Local Economic Development Support Programme
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Calculation of NPV and IRR

Posted: 14 November 2008 | Source: PCU

NOTE ON PREPARATION OF NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR) CALCULATION

The LCF CAP Implementation applicants are required to calculate Net Present Value (NPV) and Internal Rate of Return (IRR) of their income generating projects. For clarity reasons, we firstly need to delineate what the word “project” means. A project is an economically indivisible series of tasks related to specific technical functions of the action (for which funding is being sought) and with identifiable objectives and results to be achieved within a defined time frame and budget. Project financial analysis must clearly delimit the results and activities to be carried out within the specific time allocated for the implementation of the proposed action and its lifespan (time horizon).

Important factors to be considered:

1. Time horizon: this is the maximum number of years for which forecasts are provided, including the implementation period – e.g. 24 months and a period appropriate to its economically useful life and long enough to encompass its mid/long term impact. The lifespan will normally be equal to the depreciation period of the investment concerned, but it may be shorter or longer, depending on the specifics of the action.

2. Residual value: if the time horizon is shorter than the depreciation period, the applicant should consider the residual value of the project at year end as an inflow, but only when the investment is really liquidated (e.g. sale of vehicle in year 4 before is it fully depreciated in year 5).

3. Inflation factor: it is highly recommended to use constant prices and fixed for the base year (year 1 when the project commences). If justified, corrections for changes in the relative (real) prices can be entered if significant for the project (e.g. oil, electricity). Alternatively, applicants may use current prices (adjusted for inflation).

4. Income (revenue) generated by the project: all sales should be accounted for on accrual terms. The level of sales must be realistic.

5. Costs: all realistic and probable running costs (including maintenance) to be accrued must be considered but financial costs (interest to be paid on loans) must be excluded from the calculation.

6. Discount rate: it is recommended that a 5% real rate is considered when abstracting from inflation or the current prime rate (currently 15.50%, as published by the South African Reserve Bank) when current prices are applied and adjusted for inflation.

The financial analysis (NPV and IRR) should result in the drawing up of tables summarising the forecasted net worth of cash flows for investment returns (capacity of operating net revenues/income to sustain the operating costs and the investment costs) in line with the following requirements:

1. Table 1 (see table templates) should be drawn up regardless of the way in which the investment is financed. This table will present NPV and IRR in relation to the entire investment. If the NPV is negative, Table 2 should be drawn up subsequently.

2. Table 2 must add a separate row to account for the requested Thina Sinako grant that should be considered as inflow in years when it is expected to be paid to the applicant. Table 2 should be drawn only if the NPV in Table 1 is negative.

3. Table 3 must point to the effectiveness of the local (South African) capital secured so far and to be engaged in financing the project. This table must indicate:

a. as inflows: all revenues (income) to be generated by the project and residual value (if any);

b. as outflows:
1) operating costs,
2) the equity invested by the applicant (including in-kind contribution like land, etc.),
3) all grant and in-kind contributions by all spheres of the government,
4) loan repayment (if any),
5) interest on the loan finance. Table 3 must be drawn up notwithstanding the calculations made in Table 1 and/or Table 2 and abstract from Thina Sinako grant.

The table templates can be found in our LED Resource Centre - look under the sub-heading Templates, which can be found under the main heading Other useful documents. Please make sure that you use the spreadsheet that discounts your forecasts at 5% when using fixed prices, or the one that discounts your forecasts at 15.50% when using current prices. When adding rows or columns, please make sure that Excel formulas have not changed.
 
Please, note that the supporting spreadsheets are designed for your convenience only. It is allowed to use dedicated software or other custom-made spreadsheets as long as the basic rules of the calculation of NPV and IRR referred to above have been respected.
 
If you struggle to make sense of these notes or find it difficult to use the table templates, please contact your nearest Thina Sinako Regional Office: