| The cost of capital for a project is a weighted sum of the cost of debt and the cost of equity. Risk is an important element which is factored in to determine the cost of debt and equity. 32 Lenders determine risk premiums to take into account the assessed levels of risks from various sources (see chapter VI) and are added to risk-free rate of borrowing to determine the required return on debt finance. The risk-free rate of borrowing is practically the rate at which government can borrow money from the market. | Definition |
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| Similarly, the cost of equity is defined as the risk-weighted projected return required by investors. However, unlike debt, equity does not pay a set return to its investors. The cost of equity is therefore established by comparing the investment to other investments with similar risk profiles.33 | Cost of equity |
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Once these rates of return on debt and equity are established, the cost of capital can be determined as follows:
Cost of capital = Return on debt x % of debt + Return on equity x % of equity
| A higher proportion of debt would therefore mean higher rate of interest to off-set the higher risk of loan default. This in turn can make the project more expensive compared with a lower debt/equity ratio. As higher debt/equity ratio transfers a large part of the commercial risk to lenders, the project operator may also lose incentives to improve economic performance of the project. | Why debt - equity ratio matters |
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| The cost of capital of may be lowered through refinancing of PPP projects after their construction phase. Sponsors may be required to provide a significant amount of equity capital at the beginning of a project during the construction phase when the risk is high. Once the construction is complete, the construction risks associated with it have been overcome, and the cash flow begins to materialize, the expensive equity or debt capital can be refinanced using cheaper debt capital thus lowering the total cost of capital. | How cost of capital can be lowered |
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| The relationship between risk and return of a project changes over different phases. The highest level of risk exists during the construction phase of a project when construction delays and cost overruns can have serious consequences to a project’s success. It is during this phase that investors require the highest return on their capital to compensate for the risk, thus the higher cost of capital. Once construction is over and the cash flow from operations has begun, project risks drop off substantially and it is possible for sponsors to refinance at a lower cost. | How refinancing helps |
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32 The cost of capital is often used as the discount rate, the rate at which projected cash flow is discounted to find the present value or net present value of a project.
It is also important to mention here that consideration of the cost of capital is required to determine an appropriate tariff level by government or by a regulator. Ideally, the Internal Rate of Return of a project should be equal to its cost of capital. If IRR is greater than cost of capital, the concessionaire/investor makes excess profit, and if IRR is less than cost of capital, the concessionaire/investor loses money and may even go bankrupt.
33 There are methodologies to establish the expected rates of return on debt and equity. For example, the capital assets pricing model or CAPM is used to determine the expected return on equity for a particular type of asset. Governments (through the Treasury or Ministry of Finance) may also establish the expected rates of return considering alternative investment opportunities and the level of risks involved in different types of infrastructure projects in their countries.