2.25 In the run up to finalising the refinancing in March 2003 the Trust and THC Dartford focused primarily on calculations which had been based on a 6 per cent real discount rate when negotiating the terms of the contract extension and assessing its expected financial effect on the Trust. At this time it was widely known, however, that the Treasury was developing new guidance which would require authorities to use a lower discount rate of 3.5 per cent real.16 The Treasury guidance effective when this refinancing was completed in March 2003 was, however that 6 per cent real should be the principal discount rate for evaluating new investment decisions until the end of March 2003.
2.26 Although the negotiations surrounding the contract extension were based on calculations using a 6 per cent real discount rate the Trust's financial advisers Ernst & Young had evaluated for the Trust, in March 2003 shortly before the refinancing was completed, the comparative financial effect on the Trust of the contract extension using a 3.5 per cent real discount rate. These calculations summarised in Figure 15 show that the financial benefit to the contract payments for availability in net present value terms which the Trust had anticipated from extending the contract, and taking the refinancing gain over time would reduce to £1.4 million if the 3.5 per cent real discount rate is used. This reletively small benefit depended on an assumption that the Trust would have incurred higher maintenance and management costs of £3.9 million, in present value terms at a discount rate of 3.5 per cent real, without the contract extension. These calculations, whichever discount rate is used, are only a partial analysis of the effect of extending the contract period. They do not
15 | Comparison of financial costs and benefits of the contract extension to the payments for availability using alternative discount rates |
| At 6 per cent | At 3.5 per cent |
Reduction/(increase) to net present value of the contract price relating to availability before taking account of the refinancing benefit1 (based on contract payments for a further seven years less benefit of a reduced annual contract charge for the original 28 year contract period) | Nil | (8.5) |
Increase to the net present value of the Trust's share of the refinancing gain as a result of the contract extension on the basis of the gain being taken as a lump sum2 | 4.6 | 4.6 |
Maintenance and management savings assumed by the Trust | 2.1 | 3.9 |
Net financial benefit arising from the contract extension arrangements assuming Trust takes gain as an upfront lump sum amount | 6.7 | Nil |
Increase/(decrease) to the net present value of the Trust's share of the refinancing gain as a result of taking its share of the refinancing gain as a reduction in the PFI contract availability payments | (0.4) | 1.4 |
Net financial benefit arising from the contract extension arrangements with Trust receiving gain over time | 6.3 | 1.4 |
Source Derived from financial analysis of the refinancing by Ernst & Young, the Trust's financial advisers | ||
NOTES 1 In cash terms the extra seven years of payments for availability, before taking account of the refinancing benefit and inflation, would cost the Trust £64 million. The lower contract charge for the original contract period would reduce the same part of the Trust's cash payments by £24 million. The net increase to these payments is therefore £40 million. Taking account of all aspects of cash payments (including the refinancing benefit, inflation and facilities management costs) the Trust's expected cash payments increased by £165 million (from £625 million to £790 million) following the refinancing and contract extension (Appendix 3). The NAO estimates that £11 million of the £46 million increase in THC's borrowings depended on the Trust's agreement to make these additional payments over the extended minimum contract period. 2 The evaluation of the refinancing gain by Ernst & Young is the same under each discount rate because the evaluation assumed that the refinancing gain would be taken as a lump sum at the time of the refinancing. It is not therefore subject to the discounting process which is applied to future cash flows. 3 THC notes that in the negotiations over the amount the Trust should receive when receiving its share of the refinancing gains as a reduction to the annual PFI contract price THC granted the Trust an additional £1 million gain based on calculations using a 6 per cent discount rate. THC would not have expected to make this amount available to the Trust if the calculations had been based on a 3.5 per cent real discount rate. 4 The implicit interest rate on the deferral of the Trust's gain was 6 per cent real. As this was above the cost of capital the refinancing gain, calculated at a 6 per cent real discount rate, was reduced as THC could not raise as much debt as if the Trust had taken a lump sum gain. Evaluating the Trust's savings at a 3.5 per cent real discount rate increased the gain. | ||
reflect the additional risks to the Trust from the contract extension such as higher termination liabilities17 and the requirement to remain committed to the contractual service for a further seven years.
2.27 The case for extending the contract period was, therefore, much less clear cut than the Trust believed. On the issue of the discount rate used to assess the contract extension, the Trust was not formally required by Treasury guidance to use a 3.5 per cent discount rate as the main basis for evaluating the contract extension proposals as this requirement only became effective from the beginning of April 2003 for new investment decisions. This refinancing was completed at the end of March 2003 based on an investment decision taken in September 2002. In addition, the Trust and its financial advisers Ernst & Young consider that the refinancing would have had to be completely renegotiated with a 3.5 per cent discount rate, as the negotiations around extending the contract period, and the effect this had on the refinancing gains, had been based on the calculations using a 6 per cent discount rate. They also note that they were able to secure a further £1.2 million from THC in the refinancing negotiations (Figure 13) specifically arising from the use of the 6 per cent real discount rate. They would not have expected THC to make this amount available if the calculations had been based on a 3.5 per cent real discount rate.
___________________________________________________________________________
16 Draft guidance had been issued to departments in the latter half of 2002. The final guidance was published in 2003 in the new Treasury Green Book effective from 1 April 2003. As well as introducing a lower discount rate the new guidance required separate calculations showing the effect of optimism bias and taxation.
17 The higher termination liabilities arise from the additional borrowings which THC Dartford were able to take on as a result of the contract period being extended.