PPP financing has a higher cost of capital than traditional public financing because interest on the debt that a PPP issues is taxable. Conversely, interest payments on municipal bonds that public sector entities use to finance projects are exempt from Federal taxation and sometimes from state taxation. Bond purchasers accept lower returns on municipal debt than on private bonds because of the tax exemptions. PPP financing also has a higher cost of capital because PPPs typically incorporate equity financing in which investors own stakes in the projects and share in the profits. Investors generally expect to earn higher rates of return on equity investments than on debt investments. Consequently, the larger the equity component in a PPP's financing structure, the higher the cost of capital compared to public financing. For example, for the 50-year brownfield project in Project Example 2, we calculated the cost of capital of PPP financing to be 7.16 percent and 6.29 percent for public sector financing.3
The disadvantage of the cost of capital in PPP financing has a greater impact on greenfield projects than on brownfield projects, primarily because of the greenfield projects' more uncertain revenue streams. This uncertainty leads equity investors to demand even higher rates of return. For example, using similar market transactions as a guide, we imposed a 16.0 percent cost of equity on the 40-year greenfield project in Project Example 1. This cost was much higher than the 12.5 percent cost of equity we assumed for the 50-year brownfield project in Project Example 2. With the same financing structure, this difference resulted in a cost of capital of 8.21 percent for the greenfield project compared to 7.16 percent for the brownfield project.
The valuations of greenfield projects are also more sensitive to the cost of capital than those of brownfield projects.4 A greenfield project's construction costs occur early on, and consequently are discounted relatively little. The revenue stream, on the other hand, is comparatively small in any given year and stretches out over the life of the project, so its present value is significantly affected by discounting. Increases in the cost of capital translate into increases in the discount rate. Increases in the discount rate reduce the present value of a greenfield project's revenue stream much more than the present value of the project's construction costs. By comparison, a brownfield project's costs, primarily O&M expenditures, are spread out over time, so discounting reduces them in a manner similar to revenues.
The impact of a PPP's cost of capital on its valuation also increases with the length of the project contract. The farther in the future that revenues and costs occur, the more discounting affects their present values. Because of the difference in discount rates, future net revenues are discounted more heavily for PPPs than for public sector financing. As a result, long-term PPP projects face larger disadvantages than short-term PPP projects in providing the value when compared to the value available through traditional public sector financing.
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3 We incorporated multiple factors in our derivations of these estimates. For PPP options, these factors included shares of debt and equity, debt structure, and likely ratings of project bonds. For public sector options, they included availability of junior versus senior debt, presence or cost of bond insurance, and yield on municipal bonds.
4 To see this difference in sensitivity, it is necessary to understand the basis of project valuation. Valuations of multi-year projects are quoted in terms of "present values"-their lump-sum worth today-in order to make them comparable. In financial analyses, the determination of today's value of a revenue or expense occurring in the future is accomplished by discounting the revenue or expense at a rate equal to the cost of capital. Since interest, or the cost of capital, compounds over time, revenues and expenses are discounted more heavily the further in the future they occur. See the Scope and Methodology section for further discussion of present value.