As we have already indicated, investors will allocate only a small proportion of their funds to infrastructure. So, when presented with two different opportunities, how do they decide which one to invest in? Their analysis would need to take into account the value created, the alternative opportunities, the market dynamics, the risk-reward proposition, and the scale of the opportunity.
First, any investment should be value creating. So whether NPV or IRR is used, the results should be positive.
Second, the return should be in line with, or better than, the returns offered by an equivalent-risk investment. Investors may analyze comparable-risk investments to provide a benchmark. However, it is challenging to identify equivalent-risk investments because the risk-reward spectrum is not always easily observable. They may also use complex models such as the Capital Asset Pricing Model (CAPM), which can calculate the theoretical required return of an asset.
Third, any investor must compete with others and so may need to adjust the desired return to make investments. For example, if an investor overstates the return he requires for taking the opportunity risk, another investor will beat him to the investment.
In this way, as in any other market, required return levels are likely to emerge where the market prices each point on the risk spectrum. All parts of the market, including infrastructure, show that pricing can be cyclical, with periods of high prices or asset bubbles. Infrastructure funds also target a range of returns, and evidence suggests that for unlisted funds this ranges from 10 to 30 percent on an IRR basis, as seen in Figure 15.
Different investors will seek different levels of return and have different aspirations for where their return should come from. Sources of return include regular income, yield from the investment, and capital appreciation through future sale of their stake in the asset. Such differences will affect the choice of investment. For example, if a regular income is important, then investment in existing and established assets is going to be favored. If capital growth is the aim, developing new infrastructure may be preferable and once the investment reaches an established level of performance it can be sold.
Table 3: Net present value (NPV) characteristics
| • The basic premise of the NPV calculation is to accept investments with a positive NPV when cash flows are discounted at the opportunity cost of capital. • Underpinning this premise are three principles: - A unit of value today is better to have than a unit of value tomorrow because the future is uncertain - Some opportunities will be safer or less risky than others - The market is competitive • The NPV approach allows someone to give an uncertain future cash flow a value today The calculation discounts the investment's expected future cash flows at the opportunity cost of capital (the discount rate). The opportunity cost is the return an investor forfeits by investing in this opportunity instead of another opportunity of equivalent or comparable risk. | |
| Advantages of approach | Disadvantages or common pitfalls |
| Market competition should mean that return levels are likely to emerge for different risk propositions. | Need to understand the forecast cash flows and the risks to which these cash flows are exposed. |
| NPV calculation gives a value for the whole period of the investment and so will not fluctuate over time. | Deciding the discount rate is complex and assumes there are efficient capital markets and all investors assess risks and returns the same way. |
| NPV calculation can be used to measure a return when capital is rationed. | NPV calculation assumes that the risk to the cash flows is steady over the period being measured. |
| Need to ensure both the forecast cash flows and discount rate approach other factors such as inflation and tax on a consistent basis. | |
| Table 4: Internal rate of return (IRR) characteristics | |
| • The basis premise of the IRR calculation is to accept the investment if the opportunity cost of capital of the relevant investment is less than the investment's IRR. • The calculation finds the annual discount rate that, when applied to a cash flow, calculates an NPV of zero. | |
| Advantages of approach | Disadvantages or common pitfalls |
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| IRR can be used where cash flows are irregular and the single discount rate approach used in an NPV analysis is not appropriate. | Because this is an annual measure, opportunities that have higher cash flows in early years may appear to be a better proposition. However, this assumes the money can be reinvested at the same rate in later years, thus it can be unreliable if capital is rationed. |
| The result of the IRR calculation can be difficult to interpret if there are fluctuations between positive and negative cash flows other than the original investment | |
| TAKE-AWAYS | |
| Corporate equity | Returns |
| • Corporate equity has historically been a significant source of private finance for infrastructure. • Corporate equity is an important source of capital for the early development of a market, and is likely to be so in the future. • The drivers for an investment and a target return can vary significantly between corporate investors. • Effective management of conflicts between the deliverer and investor roles must be carefully considered. | • It is necessary to fully understand the method used to measure return in order to ensure that this preferred method is in line with investment performance indicators. • Comparing investment opportunities is as much an art as a science, and competition to invest can drive up prices, thereby driving down returns. • Investors will have different return expectations, ranging from regular income to capital growth. |
| Institutional equity | |
| • There is a wide range of institutional investors that consider infrastructure-such as public and private pension funds and insurance companies-offer portfolio diversification; potentially returns on these investments match their liabilities. • The majority of institutional equity is invested through list ed or unlisted funds. • There has been a significant increase in funds raised over the past 10 years, and fundraising has continued despite the recent global economic crisis. • There are many routes for institutional equity to invest in infrastructure. These routes offer a range of risks and rewards, and the selected route depends on the investment profile sought. | |