Appendix F:  Frequently Asked Questions

Does government have a low cost of capital?

It is sometimes argued that government faces a low cost of debt, as shown by the rate of interest on government securities compared with the rate on corporate bonds. This might imply that the cost of capital for government should be lower than for the private sector.

The reason government's cost of borrowing is low is that government can use its taxing powers to repay loans. Because of these taxing powers, lenders to government consider that it is unlikely to default, leading to lower interest rates on borrowings.  This does in no way remove the riskiness of the project.  The fact is that when risk transpires it is the taxpayer that funds the risk.

If this was not the case, the logical consequence would be that government would finance everything, and replace commercial sources of finance. Since it is generally agreed that this would not be a desirable outcome, it is clear that it is the expected returns of the project and the risks associated with them, rather than the costs of debt for public, or private financiers, which determine the cost of capital. Further, if government was to finance all projects, the large increase in public debt would create a corresponding increase in the cost of public borrowing.

Should government use a single Discount Rate for all projects?

A further common argument is that government should use a single Discount Rate. The fact that government borrows at a single rate is sometimes used to support this view. Alternatively this view might be advanced as simpler, or somehow more efficient, because all projects are treated the same.

The flaw in this argument is the same as the flaw in the argument that government's cost of capital is always low. A project's cost of capital is not set by the cost of borrowing; it is the cost of bearing the market risk of a project. Since individual projects vary in their riskiness, they vary in their cost of capital. This is so whether the project is undertaken by the public, or the private sector.

The variation of risk extends to the allocation of risk between government and each private sector bid.

It follows that government should apply different Discount Rates to projects with different levels of risk. If government applied an average Discount Rate across all projects, it would advantage risky projects (by demanding a return lower than their risk warranted) and disadvantage low risk projects, by demanding excessive returns from them. The result would be that government would tend to over-invest in risky projects, and under-invest in low risk projects.

Suppose government uses a single Discount Rate when considering the case for public, or private finance, while the private sector uses project-specific costs of capital. Government will tend to finance projects where its Discount Rate appears to be lower than the private sector. The result will be that government will tend to finance high-risk projects, leaving low-risk projects to the private sector.

Why is it that only Systematic Risks are incorporated in the Discount Rate?

The Capital Asset Pricing Model (CAPM) assumes that investors - including Public Sector investors on behalf of taxpayers - will, through the process of portfolio Diversification, eliminate all the Diversifiable Risks.  For example, umbrella makers do well when there is a lot of rainy weather, but badly when the weather is sunny.  For ice cream makers, it's the opposite.  Returns to investors in either umbrella makers, or ice cream makers are affected by weather risk.  But this risk can be diversified by investing in both umbrella makers and ice cream makers, so no matter what the weather is, investment returns in total are unaffected.

The essential point is that investors should not be rewarded with a higher return for taking on risks that they can eliminate through portfolio Diversification.  Systematic Risks, on the other hand, cannot be eliminated through portfolio Diversification.  Systematic Risks are those that affect the market as a whole. For example, the economy might go into a recession.  If so, that will affect the returns on all investments (to varying degrees).  No amount of portfolio Diversification can eliminate the risk of recession, because recession affects everybody.  Investors need to be rewarded for taking on Systematic Risk, otherwise they won't make the investment.  How much they get rewarded depends on how much risk they take on.  This is summarised by the parameter Beta in the CAPM.

What goes into the cash flows in a Discounted Cash Flow calculation?

The Expected Value of all revenues and expenses associated with a project.  Often, these will not be known with certainty in advance, so the average (also known as expected) value over all contingencies is used.  These contingencies may relate to events like the weather (which could cause cost overruns), or the state of economy (which could cause demand and sales revenue to be different from expected), or anything else, which might affect the cash flows of the project.  Unlike the Discount Rate, in the cash flows there is no need to make any distinction between Systematic and Non-Systematic Risk.

You say that if the Public Sector retains all the Systematic Risks, the correct Discount Rate is the Risk-free Rate. But if the project is risky, how can you use the Risk-free Rate?

The Discount Rate is the cost of capital for the supplier of the services.  If the Private Sector supplier is not facing any Systematic Risks, then there is no need to reward that supplier with a rate of return that is any higher than the Risk-free Rate.  Therefore, when evaluating the cost to the Public Sector of the private supplier's bid, the Risk-free Rate should be used.  Other things being equal, the cost to the Public Sector will be higher (i.e. a higher net present cost) when evaluating this bid at the Risk-free Rate.  This makes sense, because the Public Sector is retaining the risks.

Do I evaluate bids at the same rate?

No.  In practice PPP projects include Systematic Risks not reflected in the PSC.  This is of value to the public sector and should be taken into account in the Discount Rate calculation.  The differing levels of Systematic Risk between PSC, PPP and among different PPP bids should be reflected in the Discount Rate used to assess the cash flows for each bid.