INCREASE IN COSTS OF FINANCE

2. Table 1 shows how the component costs of the deal changed between preferred bidder stage and financial close. It is clear that £54 million, that is almost all, of the £60 million increase was due to increases in the net discounted cost of debt finance.

TABLE 1: HOW THE COSTS HAVE CHANGED

	Cost at selection of preferred bidder (£ million)	Cost at financial close (£ million)	Change in financing costs (£ million)	Increase (£ million)
Project capital and operating costs Financing costs	665	704		39
-Equity	29	32	3
-Debt	-63	-9	54
-Cash	16	19	3
Total change in financing costs				60
Total	647	746		99

3. In costing projects that involve expenditure spread over many years, it is standard practice to use a technique known as discounted cash flow analysis. This technique puts costs or revenues arising in future years on a common basis that takes account of the time value of money (that is the fact that £100 available for spending today is more valuable than £100 made available in one year's time). Accordingly, all the costs shown in Table 1 have been discounted in accordance with the principles laid down by the Treasury for use in public sector projects.

4. When discounted cash flow analysis is used, attention needs to be paid to the discount rate. The discount rate is supposed to be a measure of the time value of money and is akin to a rate of interest. During the negotiation of the PFI deal for Main Building the standard discount rate prescribed by the Treasury was 6% per annum in real terms.

5. Because the costings in Table 1 are discounted, the financing costs shown are a measure of the difference between the interest rate Modus expected to pay and the Treasury discount rate. So the figure of minus £63 million at preferred bidder stage indicates that at that stage Modus was expecting to obtain debt finance at a markedly lower cost than 6% in real terms; and the figure of minus £9 million at financial close indicates that at that stage the cost of debt finance was only slightly lower than the 6% rate.

6. We have examined why the cost of debt finance changed from minus £63 million to minus £9 million-an increase of £54 million. There are three factors:

(a) £27 million from an increase in long term borrowing rates;

(b) £25 million from a decrease in short term lending rates