The internal rate of return is widely used in PPP contracts as "…a measure of the underlying return the private sector expects to achieve by investing in the project" (HM Treasury, undated). It has an important role because it is used for the calculation of the Unitary Charge at financial close of the project. It is also used in calculating compensation in the event of default or termination, and determining refinancing gain to be shared with the public sector.
Rates of return are normally calculated for a project, representing the weighted average cost of capital for the project "…usually calculated from all of the non-financing project cash flows, including capital costs, operating and maintenance costs, revenues and working capital adjustments" (ibid). An equity rate of return is the return to investors after senior debt has been taken into account. A blended equity rate of return takes account of all payments received on equity and junior debt (dividends, capital repayment and interest). Rates of return must also take account of whether inflation is included in cash flows and whether tax is included or excluded from cash flows.
The Weighted Average Cost of Capital (WACC) is a benchmark that measures the cost of equity and debt and thus the overall cost of capital for a project. A few studies have examined rates of return and WACC, for example, prospective returns in ten NHS hospital PPP business cases (Hellowell and Vecchi, 2012). Nominal project rate of returns varied between 7.22% and 10.72%. The ESSU database records equity transactions in only three of the ten hospitals, one of which was part of a bundle of projects, hence it is difficult to draw any indication of what has happened in practice compared to business case forecasts.
Another financial analysis of six PPP projects (three hospitals, schools, office and college) estimated internal rates of return between 16.9% and 23.2% (Cuthbert and Cuthbert, 2008). Another study that examined the SPC accounts of PPP road projects concluded the first eight PPP projects have an average return on equity of 29.9% and an average WACC of 10.9% (Bain, 2008). However, this study did not examine the seven PPP equity transactions in these projects.