How is IDFC Calculating “Tax Adjusted Yield on Buyback” of 17.85%?

This part is easy to understand. The method used by IDFC to reach the misleading figure of 17.85% is as under.

1. Assume you are investing Rs 20,000 – Principle Amount P = 20,000

2. Since infrastructure bonds investments are exempt from tax the investor will save 30.9% of Rs 20,000. This amount is equal to Rs 6180.

3. IDFC is now incorrectly saying that since the investor invested Rs 20,000 and saved Rs 6180 this is the same as investing Rs 20,000- Rs 6,180 or Rs 13, 820. So principle amount P is not Rs 20,000 as in step 1 but Rs 13,820. This assumption is not only illogical but also misleading and we strongly feel SEBI should look into this matter.

4. Investor will receive Rs 1600 as interest at the end of every year. The duration of investment is assumed to be 5 years. Total number of interest payments will be 5 of Rs 1,600 each at the end of every year. Now IDFC is assuming that each interest can be invested at the rate of 8% per annum compound interest for the remainder time period. This statement is elaborated below

1. First interest of Rs 1,600 invested @ 8% compound interest for 4 years will give Rs 2,177
2. Second interest of Rs 1,600 invested @ 8% compound interest for 3 years will give Rs 2016
3. Third interest of Rs 1,600 invested @ 8% compound interest for 2 years will give Rs 1,866
4. Fourth interest of Rs 1,600 invested @ 8% compound interest for 1 year will give Rs 1,728
5. Fifth interest of Rs 1,600 comes at the end of 5 years at the time when the investor redeems the bond so no interest on this amount

Interest and interest on interest (at rate of 8% per annum) will give the investor Rs 9,387 at the end of 5 years. But there is a major flow with this assumption. No one can predict interest rates 5 years in future like IDFC has done. What if interest rate comes down or goes up?

5. At the end of 5 years the investor gets Rs 20,000 he/she invested. Add to this the wild assumption of interest on interest. Total amount received by the investor at the end of 5 years is Rs  29,387 – as per “fairy tale” assumptions of IDFC.

6. Now IDFC has assumed that the interest amount and interest on interest will not be added to your taxed at 30.9% (Remember we are doing this calculation for investor who is in 30% tax slab). Why? because IDFC assumes that after investing the investor lost his/ her job or business and is below all tax slabs.

7. Now as IDFC has assumed that investor invested Rs 20,000 and got tax exemption of Rs 6,180 on this amount he/ she actually invested Rs 13, 820 only. (See points 2 & 3).

8. Keeping these points 5, 6, and 7 in mind and logic out of mind answer the question -“What is the Internal Rate of Return of this type of cash flow”? To find IRR solve the following equation for x. Where x is the “Tax Adjusted Yield on Buyback”.

-13820 + 1600/(1+x/100)power4 + 1600/(1+x/100)power3 + 1600/(1+x/100)power3 + 1600/(1+x/100)power2 + 1600/(1+x/100)power1 + 1600/(1+x/100) = 0

The answer is 17.85%. IDFC Infrastructure Bond – Jai Ho!