One component that is important to the assessment of the total costs of services and projects is the determination of the discount factor. Since the project is over several years, a Net Present Value (NPV) must be determined to perform a proper and accurate PCC.26 The NPV is the best method to use when analyzing the time value of money of the cash flow over the life of a project. 27 It is an evaluative measure that is able to distinguish high and low risk projects and their correlation to the rate of return.28 Theoretically, the discount rate for the public sector evaluation will be smaller than the one used by the private sector, otherwise the present value of the private cost stream will be overestimated.28 This is due to the fact that the private sector will base their discount rate on the cost of capitol, private borrowing costs, and the costs of equity, while public sector will use their cost of borrowing rate or interest rate, which is inherently lower for the public sector or government entity. 26 This will remain the case even under a completely free market with zero taxes. If the same discount rate is used for both the public and private sector, it is assumed there are two, similar, cost cash flows being compared. However, when incorporating the private sector cost benefit analysis, benefits and revenues must also be taken into account. 29
One way to determine the discount rate for both the public and private sector is to use the Capital Asset Pricing Model (CAPM). Several countries use this calculation to determine the discount rate used for the NPV of the private bids. As applied in Australia, the variables are defined differently for a PPP to include systematic risk. When this method is used there is no reason to adjust the cash flows for systematic risk.: if only the risk free rate is used then the cash flows should reflect the risk of return involved in the project. This discount rate should be used to rank the different options and not on a stand alone analysis.30 The basic CAPM formula is:
Ra=Rf+Ba(Rm-Rf)
Ra is the the required return, which factors in systemic risk
Rf is the risk free rate
Ba is the variation of asset returns in the market (this can be adjusted to reflect the project's risk
(Rm-Rf) is the return expected over the risk free rate
The risks transferred to the private sector will be added to the risk free rate resulting in choosing a higher discount rate to be applied to the private sector bid.31
Another more accurate equation to calculate the discount factor is the Weighted Average Cost of Capital (WACC). This does not only include the cost of equity (CAPM), but it will also take into account the cost of debt. The formula is as follows:
WACC=(E/V *Re) +(D/V*Rd*(1-Tc))
Re=Cost of Equity (CAPM as described above)
Rd=Cost of Debt (market value)
E=market value of firm's equity
D=market value of firm's debt
V=D+E
E/V=% of financing that is equity
D/V=% of financing that is debt
_________________________________________________________________________________________
26 Buxbaum, J. & Ortiz, I. (2009).
27 Guidelines for the Appraisal and Management of Capital Expenditure Projects in the Public Sector (2005). Department of Finance. Dublin, Ireland.
28 The National Public Private Partnerships Policy Framework and National PPP Guidelines (2009). Financial Circular. Australian Government, Department of Finance and Regulation
29 Grout, P.A. (2002). Public and Private Sector Discount Rates in Public-Private Partnerships. CMPO: University of Bristol.
30 Shugart, C. (2008). PPPs, the Public Sector Comparator, and Discount Rates: Key Issues. John Deutsch Institute: Canada.
31 Summary of Discount Rate Changes (2009). Partnership Victoria Requirements. Retrieved from www.partnerships.vic.gov.au.