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## Financial Structuring and Assessment for Public-Private Partnerships: A Primer

October 1, 2012

DRAFT
FOR REVIEW BY P3 EVALUATION TOOLKIT BETA-TESTERS

### Chapter 8 - Financial Metrics Used by Equity Investors

The consortium bidding on the project and its investors expect to receive returns on the equity invested in the project and lenders expect to receive interest on the money lent to the concessionaire’s shareholders. Each party may have its own specific tools to analyze the robustness of a project and the best way of structuring the financing. This Chapter discusses the indicators that are most commonly used by equity investors, and Chapter 9 discusses indicators used by lenders.

The Weighted Average Cost of Capital

In corporate finance, weighted average cost of capital (WACC) is used by companies (e.g., members of a P3 consortium) to determine the feasibility of investment opportunities. The WACC calculates a firm’s cost of capital, which is equal to the average return expected from all sources of financing. Each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in the calculation.

WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing. WACC is thus the average of the costs of these sources of financing, and represents the annual amount the company needs to pay for every dollar it receives in financing. Net cash flows from new investments must at least match this rate of return to preserve the company’s value. The WACC, used as a discount rate to discount future net cash flows expected, will produce a Net Present Value (NPV) estimate of the current value of the company. (Discounting of cash flows to calculate present value is discussed in Chapter 7).

As its name implies, the WACC is an average cost of capital calculated based on market value of equity (E) and market value of debt (D) to finance and operate the company.  Simply stated, it is the percentage of the financing that is equity times the return on equity (Re) plus the percentage of the financing that is debt times the return on debt (Rd). The WACC calculation also recognizes the benefit obtained from the tax-deductibility of interest payments. The weighted average cost of capital is calculated using the formula:

WACC = [E/V  x Re] + [D/V x Rd (1 – Tc)]

where:

Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Thus, if a company is financed 50 percent by equity whose cost (Re) is 10 percent per year and 50 percent by debt costing 5 percent per year, and the corporate tax rate is 35 percent, the WACC calculation would be:

WACC = (50/100 x 10%) + [50/100 x 5% (1 – 35%)]  =  6.625%

WACC is higher for a higher equity-to-debt ratio because that capital structure uses a higher percentage of expensive equity. In the case of a P3 consortium, the required WACC for the project may be that of the company with the highest WACC.

The cost of debt may be readily established from debt markets or debt providers. The cost of equity requires a much more detailed assessment, since risk is largely supported by the equity of investors. This measurement has to take into account both the general risk premium applied to any company compared to investment in government debt, as well as the particular risk premium that the stock market attributes to the company’s business (which in the case of a concessionaire is the project risk premium).

Project Equity Internal Rate of Return (or Equity IRR)

This represents the yield of the project for the shareholders through the remuneration of their investment with dividends. The Internal Rate of Return (r) on equity is calculated on the basis r of the following equation:

∑    Di – Ii   = 0

(1 + r)i

where:

Di is the dividend at year i
Ii is the amount invested by the shareholders at year i

The equity IRR is commonly used as a "hurdle" rate for investments. In order for an investment to be justified, the equity IRR must be above the hurdle rate. The standard approach used by bidders for pricing P3 projects is to determine the leverage and cost of debt, and then to apply the required equity return to the balance of funding needed.

The required equity IRR may be used by bidders to calculate the required annual availability payment. It may also be used to calculate refinancing gains (when refinancing gains are to be shared with the public agency), or for compensation for contractual changes required by the public agency during the life of the P3 contract, including early termination of the P3 contract.

Rates of return required by equity investors in a P3 project are likely to be driven mostly by project-specific risks, until the project has been successfully operating for some time. Table 8-1 shows how the required equity return may vary depending on project phase. Investors may come into projects at different stages, and price their required return depending on when they come into the project.

In Table 8-1, the "risk-free rate" is the WACC of the consortium bidding on a project.  Project risk is the risk that applies throughout the project’s life.  A toll-based concession with high traffic risk would be at the high end of the scale.  The phase risk relates to the point at which the investor comes into the project. In the U.S., the consortium providing equity prior to construction expects roughly a 12–14 percent rate of return on equity.

Table 8-1. Project Phases and Required Equity Return
Phase Risk-free Rate Project Risk Phase Risk Equity Return
Construction 6% 2-4% 4% 12-14%
Ramp-up 6% 2-4% 2% 10-12%
Long-term operation 6% 2-4% -  8-10%
Source:  E.R. Yescombe, Public-Private Partnerships: Principles of Policy and Finance

Project Internal Rate of Return (or Project IRR)

The project IRR may be used to assess the general financial viability of a project without taking account of its financial structure (i.e., ratio of debt to equity).  It represents the financial return or yield of the project regardless of the financing structure. The project Internal Rate of Return (r) is calculated on the basis of the following equation:

∑   Ri – Ii – Ci   =  0

(1 + r)i

where:

Ri is the operating revenue at year i (after operating costs and taxes)
Ii is the amount invested at year i
Ci is the operating cost at year i
r is the project IRR

The project is considered to be financially viable when r is above a benchmark rate of return with respect to the project characteristics.  For example, if the required return on equity is 12 percent, the required return on debt is 6 percent, and the ratio of debt to equity is 80/20, the required project IRR would be calculated as follows:

Project IRR = (12% x 0.20) + (6% x 0.80) = 7.2%