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Economics/IRR and Interest Expenses and VAT

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Question
My question may border on minutia, my apologies ahead of time. Firstly, I understand the difference between Accounting Cash Flows vs Economic Cash Flows (I hope).  When calculating a project's Pre-Tax (Income Tax# IRR I know NOT to include any Interest and Capital payments #debt service)as outflows, however, we have a VAT system here and the VAT is applied to the Interest payments.  When I calculate the Economic Cash Flow I usually DO include the VAT's Debit/Credit Year End differential, should I "Back Out" the VAT paid on the Interest expense? Should I even consider the VAT in a Pre-Tax Economic Cash Flow (IRR Calculation)?
Many Thanks.

Answer
Well, Bernhard, you raise some interesting issues. I know the answer to one (but have to raise a question with you), and I know that a second needs to be corrected, but I don't know the answer to the third. Let me take these in sequence.

1. To my knowledge, there is no such thing as "Pretax IRR." I guess it's possible, so, for the sake of this dialogue, let's assume that it is. But why? Why is it Pretax?

2. No IRR analysis includes (a) Interest or (b) debt service. The object of IRR is economics, not how the project is financed. Where the IRR is concerned, financing is moot. That is why taxes are figured on EBIT, not Pretax Income. You want to know the economics of the project . Period. Forget how it's financed. That's irrelevant for the purposes of the project's IRR computation. . .but not, of course, for the purposes of projecting cash needs . Those are two separate and unrelated analyses . Please confirm that you understand what that is. Of course, if you don't understand, please say so, but also say what you don't understand.

3. I've never dealt with a situation where there is a VAT. However, I know a couple of colleagues who might have. Let me query them off-line, and I'll circle back to you. . .after I hear your reply to my question in #1 and my request in #2 above, please, sir.

Take care, and thanks for raising interesting issues.

Warren

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Warren D. Miller, CFA, CPA, ASA

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My expertise in economics is limited to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Questions dealing with macroeconomics and other sub-disciplines of the subject should be submitted to those who have the appropriate expertise. N.B.: I DO NOT ANSWER QUESTIONS MARKED 'PRIVATE' because I believe that knowledge should not be hoarded. I also believe that such questions are likely to come those trying to cheat. Also, as one who was a full-time academic for half a decade, I can recognize test/homework questions several time zones away. Do not demean yourself by submitting such questions to me. Those who do so are cheating; I WILL call you out publicly. I have a zero-tolerance policy for cheating and dishonesty. In addition, please don't emulate the businessman who posted a request for help in August 2008. He expressly denied that he was seeking "investment advice" and said that his query was for, and I quote, "educational and informational purposes." Later, he allowed as how his questions related to the possible purchase of a $500K piece of equipment. I said I thought he had misrepresented himself. Bottom line: high-end business consulting is how I make my living. I am the sole support for my family. Please respect that fact and don't try to get for free what our clients pay for. If your company is big enough to have a sophisticated problem, it can afford to pay for the expert advice we and others provide. Beckmill Research, LLC, is a 95-octane firm. We're small, but we've been at this for nearly 20 years. We know what we're doing. Segue: Early on, some asked me for career advice; I gave it. I now get many such requests. The demand for a valuable good that is free is unlimited, so I now charge for that advice. Email me: cfa2005@gmail.com. Finally, PLEASE DO NOT ASK FOR INVESTMENT ADVICE. I am not licensed to provide such advice. If you want such counsel, talk to your financial planner or other financial adviser.

Experience

I work with Austrian economics (which differs in major respects from the traditional economics), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) every day in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and solutions to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.

Organizations
CFA Institute, Strategic Management Society, American Society of Appraisers, Academy of Management, Culver Legion, National Association of Scholars.

Publications
CFA Magazine, Strategic Finance, Valuation Strategies, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, Business Valuation Review, among others

Education/Credentials
Chartered Financial Analyst designation (2006); Accredited Senior Appraiser in Business Valuation (2006); Certified Public Accountant (1992); MBA - Oklahoma State University (1991); Completed all of my Ph.D. coursework in strategic management - Oklahoma State University (1983-87); BBA in finance and accounting - U. of Oklahoma (1975)

Awards and Honors
Business Valuation Volunteer of the Year (2001) - American Institute of CPAs; Winner - Oklahoma Humorous-Speaking Contest - Toastmasters International (1971)

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Names are confidential. However, the "sweet spot" of our target market is companies that are too big to be small and too small to be big. Usually, those are companies with employees in the 15-to-100 range. At the low end of that range is where companies can first take advantage of the specialization of labor. However, having everyone do everything is a tough habit for many--most, I would argue--small enterprises. That is why they not only remain small, but also fail to survive beyond a second generation. Only 5% (one in twenty) companies make it to the third generation of ownership.

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