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.24 Lenders determine risk premiums to take into account the assessed levels of risks from various sources. These 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.
Similarly, the cost of equity is defined as the risk-weighted projected return required by the 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.25
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
Box 1. How subordinate debt helps in debt financing | ||||||||||||
The revenue available for debt service is used first to meet the senior claims. If revenue is still available, it is used to meet the junior claims (subordinate debt and thereafter equity). A simplified example below shows how it works in reducing the burden of debt on a project.
On a combined claim (if the whole amount of loan was of the same type, i.e. senior debt), the coverage ratio is 1.13, which may be considered low and may not qualify for cheaper credits. The coverage ratio, however, is significantly improved if the debt is divided into two parts: a senior debt and a subordinate debt. As the senior debt is only a portion of the total debt and has the first claim on all the revenues available for debt service, its coverage is increased to 1.5 and its credit quality would be enhanced. The credit quality is very important to debt financing. With a good credit rating the project may also be bond financed. As the cost of bond financing is generally lower than commercial borrowing from banks and financial institutions, bond financing can also significantly enhance the financial viability of a project. The availability of subordinate debt helps in reducing the risk to senior debt lenders and allows the project sponsor to borrow at lower interest rates. The subordinate debt provider, however, absorbs a share of the risk if revenues fall short of debt service requirements. Because of this feature of subordinate debt in reducing the monetary cost of debt, some governments provide loans to implementing agencies (under public credit assistance programmes) to improve the credit quality of senior debt. It lowers the risk to lenders and helps the implementing agency to obtain loans at a lower interest rate reducing the debt burden on the project. Source: Based on an example given in a publication of the Federal Highway Administration, US Department of Transportation (undated). Innovative Finance Primer, Publication Number FHWA-AD-02-004, available at http://www.fhwa.dot.gov/innovativeFinance/ifp/ifprimer.pdf |
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24 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 the 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 the cost of capital, the concessionaire/investor makes excess profit, and if IRR is less than the cost of capital, the concessionaire/investor loses money and may even go bankrupt.
25 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.