The cash flow streams differ between the PSC (e.g. progress payments through construction) and the ASB (e.g. lump sum payment at substantial completion or through post-construction payments during the maintenance period). In order to numerically compare the cash flow streams, the respective cash flows must be expressed in dollars as at a single date in time, known as the base date, by the technique of discounting cash flows.
Bringing cash flows forward in time (future valuing) or back in time (present valuing) is known as discounting and follows the concept of time value of money - the premise that a dollar today is worth more than a dollar in the future. This reflects the opportunity cost of capital: funds available earlier can earn a return, or be used for other capital expenditures and therefore reduce the associated cost of borrowing.
Discounting hinges on the rate used to estimate the value of a future dollar in today's terms. Since the project costs are in future dollars, and are estimated costs that may turn out to be different (e.g. higher) than projected, the discount rate chosen should match the uncertainty inherent in these cash flows. Since higher risks require higher returns, one could argue for a higher discount rate (i.e. risk-free rate plus risk premium) to capture the uncertainty in the project costs. However, this leads to the counterintuitive result of future uncertain costs being heavily discounted leading to a project appearing less costly in present-day dollars as a result of this increased risk. An appropriate method to avoid this result is to quantify the embedded uncertainty in costs through a comprehensive risk assessment. The quantified risks (i.e. cost of risk) can be added to the estimated project costs resulting in virtually "risk-free" costs. This "risk-free" cash flow stream can then be discounted back and expressed in dollars as at bid submission date at a "risk-free" rate. As the public sector financing rate reflects the virtually unlimited taxing power of the crown to repay its debts, crown borrowings are viewed as being risk-free.
Since crown borrowings are viewed as risk-free, the appropriate rate to use for discounting project costs is the public sector financing rate. |
Infrastructure Ontario has chosen to be conservative and transparent by accounting for risks exclusively through risk quantification workshops, rather than adding a risk premium to the discount rate. |
The public sector financing rate simply reflects the Province's most current weighted average cost of capital (WACC). In consultations with the Ontario Financing Authority (OFA), IO has determined that the best proxy for the Province's most current WACC is the simple average of the long-term Provincial debt (bonds with terms of one to 30 years). To neutralize the effects of daily fluctuations on the discount rate, a ten-day rolling average of this simple bond yield average is used as the standard discount rate.
The advantages of computing the discount rate this way can be summarized by the following:
• Readily available, as market rates are public and easily accessible when required;
• Reflects the market cost of funds as opposed to static historical costs; and
• Recognizes the OFA's general borrowing practices rather than being purely based on every project's duration.
The choice of the discount rate has a significant impact on results. Generally speaking, the higher the discount rate, the higher the calculated VFM. IO's choice of the lowest reasonable risk-free discount rate ensures a conservative estimate of VFM.