The underlying basis of the economic value of a toll road concession, regardless of venue, is the projected annual cash flow generated by the road over the concession period. (The cash flow in a particular year is equal to the gross toll revenue minus operating costs and capital expenditures.) The inputs used to develop the projected cash flows are: (1) The term of the concession; (2) A projection of gross toll revenue which is a function of future traffic and future tolls; (3) Operating costs; and (4) Capital expenditures.
To determine the price an investor would be willing to pay for this cash flow, we need to discount the cash flow over the term of the concession. The appropriate discount rate is the weighted cost of capital used by the concessionaire to finance the concession payment, or rent.
In both the French and U.S. cases, each bidder was provided certain bid parameters; the term of the concession, the toll regulation (for example, the formula by which tolls can be adjusted annually), and the minimum capital investments to be made over the term of the concession. The Chicago and Indiana concession agreements, in addition to setting forth operating and legal requirements, established minimum standards for the physical upkeep of the roads. It was left to each bidder, however, to determine the level of investment to maintain these standards. This is contrasted with the French concessions where the actual investments are monitored by the government.
The bidders, armed with the bidding parameters, were then in a position to construct financial models of the toll roads' future cash flows. These models require making assumptions about (a) the relevant economic indices (for example CPI, GDP) that form the basis of the toll setting formula; (b) traffic (for example, usage) growth that reflects the elasticity of demand as a function of increases in tolls, among other factors; (c) operating costs (reflecting usage, efficiencies and inflation; and (d) capital expenditures.
To understand the differences in the multiples paid for the US and French concessions it is useful to determine the sensitivity of the discounted cash flows to each of the bid parameters and assumptions. To do this, we have used the Chicago Skyway as the example.6 The parameters and assumptions used by the winning bidder to arrive at the $1.83 billion concession price for Skyway were: Concession term (99 years); toll increases (stated increases through 2017 and 3.6% per annum thereafter); compound annual growth in traffic (1.23%); and annual net growth in operating expenses (3.45%).
These parameters and assumptions constitute the base case (Case 1) in Table 5. Cases 2, 3, 4, and 5 each show a change in a single variable to illustrate the effect of each variable on the size of the concession price.
(Insert table 5 around here)
Changes in the length of the concession term (Case 2), toll rates (Case 3) and growth in traffic (Case 4) have a significant impact on the discounted value of the resulting cash flows. Case 5 indicates that the discounted value is less insensitive to operating (and capital) costs. With respect to the relative importance of these variables on the discounted value, Enright (2006) found that the toll schedule was the primary driver in establishing the value of the Skyway concession.
Case 6 shows the effect of shortening the length of the concession term and moderating the annual increases in the toll rate, both consistent with the French concession agreements, and moderating the assumed growth in traffic. (With respect to the last, see text associated with Table 10.) The resulting discounted value, expressed as a multiple of EBITDA, is close to the multiples of the French concessions (15 vs. 12). In other words, if the French concession parameters with respect to term and toll regulation were applied to the Skyway, the concession price for the Skyway, expressed as a multiple of EBITDA, would have been similar to the prices paid for the French concessions.
There were certain other parameters included in the French concession documents that were absent in the US concession agreements. These parameters do not affect the projected cash flows, but impact the cost of capital and therefore the discount rate, which in turn affects price. One of these parameters was an upper bound placed by the French government on the amount of leverage the concessionaire could use to finance the concession payment. The French government mandated that the concessionaire comply with two leverage ratios; Net Debt/EBITDA≤ 7.0, and EBITDA/Financial charges> 2.2. These constraints have the effect of increasing the amount of equity relative to debt the concessionaire must use to finance the concession rent. Given equity has a higher cost than debt, the overall (weighted) cost of capital will be higher. The consequence of a higher cost of capital, all other things being equal, is a higher discount rate that results in a lower valuation.
To illustrate the magnitude of the effect of the cost of capital on valuation, we can apply one of the leverage constraints imposed by the French government to the Skyway transaction. This constraint is Net Debt/EBITDA≤ 7.0. Immediately following the refinancing of the Skyway concession (approximately six months after the closing of the original transaction), the ratio of net debt to EBITDA was 35 ($1.4 billion divided by $40 million). Reducing the amount of debt (by increasing the amount of invested equity) in order to be in compliance with the French leverage ratio would have caused the Skyway's concessionaire's cost of capital to increase by approximately 2.3 percentage points, as illustrated in Table 6. The impact of this increase on the Skyway valuation using the Case 1 and Case 6 assumptions (see Table 5) is shown below. The concession price in Case 6a, expressed as a multiple of EBITDA, is virtually the same as the multiples realized for the French concessions as shown in Table 1.
(Insert table 6 around here)
To summarize, the lower price-earnings multiples observed in the French concessions are due in large part to the shorter terms of the concessions and the more moderate toll increases allowed under the French concession agreements, as well as the less aggressive assumptions regarding growth in traffic. Further, the more conservative capital structure imposed by the French Government has the effect of lowering the price a concessionaire is willing to pay.
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6 The reason for choosing the Skyway is that we have access to the assumptions made by the winning bidder through the Preliminary Offering Memorandum dated July 28, 2005 for bonds issued by the Skyway Concession Company LLC. These bonds refinanced the bank loans used to fund the upfront concession payment.