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Have you ever wondered why not many finance guys have featured on the top list of genius

people in this world? The answer is simple; I call them Super Genius. They are super natural people who don t have any respect for the crown, always bend rules, thinks extra differently, define new theories to suit their needs and finally can do anything which nobody could ever imagine. In a nutshell, they can easily defeat Mr. Albert Einstein in his own game of intelligence. Anyways, even though we know that we are Super Genius, we always shy away from too much of publicity and Eulogize. Thank you from the bottom of my heart for praising our finance community. Now, let s focus on our main topic of discussion: IRR. The story starts some few days ago, me and some of my finance friends were working on a project related to IRR calculation. For those who do not understand what IRR is, then for their reference, IRR means Internal Rate of Return. It is a rate of return which a company generates internally from the project undertaken or investment decision taken. While working on IRR calculation, everybody started to give different definitions and theories. Some said, cash flows are Profit After Tax (PAT) plus Depreciation, while some said it s a Net cash outflow, which we calculate from cash flow, some were of the opinion that cash outflow will include whole project cost, while some voiced only equity for contribution and so on. One IRR calculation and so many definitions and opinions, this can only happen in finance. But like Mr. Sherlock Holmes, a finance guy will never sleep until and unless he reaches at the depth of the answer. And that s what makes us stand apart from the rest of the world. If you read through many books, IRR is one of the capital budgeting tools. Capital budgeting is the process of evaluating and selecting long-term investments, like buying new plant & machinery, land & building, real estate project etc those are consistent with the firms goal of maximizing owners wealth. Hence, from the above definition it is quite clear that IRR calculation will work best mostly in sale model rather than operating model. The reason highlighted is; in sale model cash flows are for a fixed tenure, which is not the case in operating model. This however do not make operating model leper to IRR calculation. We can calculate IRR in operating model as well but, with some assumptions which every finance guy regularly do. IRR calculation has three basic components; Initial investment, Operating cash inflows and Terminal cash flow. A) Initial Investment

Initial investment is an investment which we incur at time Zero. It is calculated using following formula: Installed Cost of New Asset: a. Cost of new asset b. Installation cost Subtracted by after tax proceed from sale of old asset* *(Proceed from sale of old asset minus Tax on sale of old asset) Plus or subtract change in net working capital This will give Initial investments Assumption No.1: The abovementioned formula is for installation of new asset. Incase of a new project Initial investment will include total project cost. However, while calculating Equity IRR, initial investment will be only equity contribution made by the shareholders. B) Operating Cash Inflow Cash inflows represent rupees that can be spent, not merely accounting profits . Operating cash inflows are calculated as follows: Revenue Subtracted by Expenses (excluding depreciation and interest) = Earning before depreciation, interest & taxes (EBDIT) Less depreciation = Earning before interest & taxes (EBIT) Less tax =Net operating profit after taxes (NOPAT= EBIT X (1-t) Plus depreciation & non cash items Operating cash inflows (OCF) Note: In the abovementioned formula, interest cost is excluded as the focus is purely on investment decision. Assumption No. 2: We can less interest if our focus is on making financing decision. C) Terminal Cash Flow Terminal cash flow is the cash flow resulting from termination and liquidation of a project at the end of its economic life. Terminal cash flow is calculated as follows: After Tax proceeds from sale of new assets* *(Proceeds from sale of new asset minus tax on sale of new asset) Less After-tax proceeds from sale of old asset** **(Proceeds from sale of old asset minus tax on sale of old asset) Plus or Minus Change in net working capital This will give Terminal Cash Flow Assumption No. 3: In Operating model, assume all net fixed assets and net working capital available at the end of the assumed tenure as a Terminal Cash Flow. Assumption No. 4: Select the IRR tenure as per the requirement of the user of IRR. Like for example, for

shareholder tenure can vary from 5 years to 10 years or 15 years or so. But, from bankers/ lenders point of view tenure will be restricted to the loan period. Finally, it s very difficult to calculated IRR manually and requires frenzied permutations and combinations. As IRR is defined as a discount rate, that equates the NPV (Net Present Value) of an Investment with Rs. 0. Mathematically, the IRR is the value of K in equation below for NPV calculation. NPV = NPV = Where, CF = Present Value of Cash inflows, and CFo = Initial Investments But, finance guys are very smart and never solve any math s equations manually. We make optimum utilization of resource and always hooked upon MS Excel. Why unnecessary make use of mind for irrelevant things, when it can be used for other constructive work like many assumptions, designing new theories, and doing things which no body understand