Applying standard investment portfolio theory, a project's cost of capital is based on the weighted average cost of the various project funding sources, and incorporates the following finance principles:
• The cost of obtaining finance is separate from the cost of using finance,
• Risk is inherent in a particular asset, and
• Investors in the marketplace are the best estimators of risk.
The cost of capital is an output of the financial model, rather than an input, with the key determinants being the financial characteristics of a transaction, including the type of financial instruments used, and their relative proportion. In the case of PPPs, projects are typically financed using a combination of debt and equity.
Using this debt and equity combination, and assuming efficient markets, investors will adjust the capital structure of a project (i.e., the mix of debt and equity) based on the optimal amount of equity and loan investment. The mix becomes optimal when equity investors can borrow as much as lenders will allow, in addition to their equity, to finance a project (also known as leveraging their equity). Leveraging by equity investors is limited internally by the potential for an overly-leveraged project to make their investment too risky due to the requirement to make large, fixed debt repayments. Leveraging by equity investors is further balanced by lenders who typically only allow leverage to the point where their risk is just compensated by their expected return. The cost of these combined sources of funds is determined by averaging the weighted return to each source, resulting in the weighted average cost of capital (WACC).
In order to correctly apply the WACC as the discount rate for a project, consideration needs to be given to the manner in which the capital structure and consequently, the WACC, change over the life of the project. To accurately model the project over the term of the partnership, the time weighted cost of capital is used and will be equivalent to the project's internal rate of return (IRR).
In addition to determining the WACC as described above, Partnerships BC monitors financial markets to determine whether market pricing of risk is consistent with historical ranges. This is done to ensure that short term market anomalies don't inappropriately impact the cost of borrowing and resulting calculation of Project IRR. As an additional measure, Partnerships BC considers historical Project IRR to compare current projects with previous transactions where the risk profiles were similar.10
If financial market pricing is determined to be inconsistent with historical ranges relative to the nature and amount of risk in a project, a prescribed rate will be applied. The prescribed rate represents a normalized project IRR which takes into account the industry, project complexity and risk transfer, as well as the historical project IRR used on other BC projects in the same industry, with similar complexity and risk transfer. A rate that differs from historical ranges will continue to be used, however, where it is determined to appropriately reflect a project's specific characteristics. For example, a higher IRR may reflect the fact that a PPP structure is being applied to a new industry in B.C. and is therefore perceived as riskier by proponents.
For transactions based on availability structures, project IRRs have typically ranged from six and a half per cent to eight per cent. Due to the higher cost of debt as a result of broad market uncertainty, project IRRs increased to nine per cent and more.
Determining the appropriate discount rate ensures that the NPC of a project is properly calculated. This, in turn, prevents VFM from being overstated, which would bias the results in favour of the PPP option.
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10 In the fall of 2008, as a result of the global financial crisis, pricing for private sector debt increased substantially from pre-financial crisis levels. The increase in pricing had a number of contributing factors including: a reduced number of financial institutions capable and willing to lend; the need for financial institutions to repair their balance sheets; and a different assessment of risk (i.e. more risk averse). The resulting higher cost of debt increased projects' IRRs.