Once the quantitative elements outlined in Sections 2, 3 and 4 have been determined, decision makers considering a PPP will typically make a comparison of the financial impact of the procurement methods under consideration. The most common and effective way to make this comparison is to determine the NPC of the cash flow streams associated with each approach, based on the estimated value of the quantitative elements described above.
The NPC calculation depends primarily on two main inputs: the estimated cash flows of a project, and the rate at which these cash flows are discounted (the discount rate), from future periods to a common base period, usually present day. Discounting future cash flows to the present takes into account the time value of money so that cash flows that occur in different periods can be added together into one total amount: their net present cost. The NPC of two or more projects can then be compared to determine which one provided better value9.
In carrying out NPC analysis, the choice of discount rate is important and must be carefully determined as it can have a significant impact on the outcome. If an inappropriate discount rate is selected there is a significant risk that it will result in a suboptimal choice of procurement method.
Partnerships BC's approach to determining an appropriate discount rate involves basing the discount rate on the cost of capital for a particular project, as well as considering the discount rate used for other Partnerships BC analyses. The rationale for this cost of capital approach is based on two key factors: correctly formulating the problem facing government as an asset portfolio investment problem, rather than as a social investment or cost of funds problem; and standard investment portfolio theory. Setting the discount rate as the cost of capital is the solution that follows from the application of standard investment portfolio theory.
A detailed discussion of the asset portfolio investment and social investment alternatives is presented in Appendix 5.
__________________________________________________________________________________
9 A sample discounted cash flow calculation is provided in Appendix 4.