28.5.2.1 The discount rate to be used in the calculation set out in (Section 28.5) is the original base case equity internal rate of return (IRR), 5 since:
• this is the Threshold Equity IRR used for sharing the Refinancing Gain (see Section 28.5.3);
• if the investors did not undertake the Refinancing, this is the rate they would be earning from capital invested in the project, so the benefit of refinancing should be evaluated against that benchmark; and
• it is the effect of the Refinancing on equity returns which is being measured.
28.5.2.2 It is not appropriate to use alternative discount rates such as:
• the Equity IRR expected by investors in the project at the time of refinancing;
• the Project IRR; or
• Senior Debt interest rate.
28.5.2.3 The equity IRR which an investor in the project at the time of the refinancing would expect (i.e. the then current market for investment returns) should not be used because it is not feasible to find an objective way of determining this rate in advance, and would provide opportunities to construct a rate at the time which is unduly favourable to one party or the other.
28.5.2.4 The project IRR should not be used because the purpose of the discount calculation is to look at the effect of changes in the debt structure or terms, which were not considered in the original project IRR calculation.
28.5.2.5 Similarly, using the debt interest rate as a discount rate is also inappropriate, because in many cases this would lead to an artificial reduction of the Refinancing Gain to zero.6
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5 This should be the "blended" equity IRR - i.e. including both share capital and shareholder subordinated debt. If projects are calculated on a nominal basis then the IRR used should also be a nominal rate. The IRR used should be on the post-tax basis i.e. post tax of Contractor, but pre tax of Shareholders or Senior Lenders (see HMT's "Guidance Note in the Use of IRRs in PFI Contracts, at www.hm-treasury.gov.uk).
6 Because the NPV of a series of future debt interest and principal payments, discounted at the debt interest rate, and deducting the original debt amount, is zero.