Debt Theories

In this section, we will address the financial structure in terms of debt and equity capital. The starting point for this analysis lies with the various theories that seek to explain the financial structure of a company. In a seminal work, Modigliani and Miller demonstrated that, under certain ideal conditions, the capital structure - the proportion of debt to equity capital - does not alter the value of the company.

However, in the real world, companies present material differences in their financing structure. Several theories explain the determination of an optimal structure: tax advantages, aspects of corporate governance rules, signals, and so on. Even though a detailed discussion of these theories is beyond the purpose of this work, below is a brief summary of the main arguments.160

A first explanation is based on the tax savings associated with debt. The differences in the tax treatment accorded to debt and equity capital give the company an incentive to use debt financing exclusively. Since, from the tax perspective, interest payments are considered costs (whereas dividends are not), by using debt financing the company can increase its return on equity capital. It should be noted that this effect is specific to each tax regime, which is why the effects vary over time and from one country to the next.

An alternative explanation is based on corporate governance problems. The separation of ownership and management of the company's resources, which is critical to any modern economic organization, creates principal-agent problems. This requires that incentives be created in order that managers (agents) will act in the best interest of investors (principal), not just in their own interest. Debt financing causes the managers' actions to be monitored - as managers must prove to the lenders that they have projects that are economically and financially viable. From this approach, debt then becomes a control instrument applied by the principal to the agents.

A third explanation is based on debt as an instrument of "signaling." According to this theory, the capital structure is a mechanism through which signals are sent to the market regarding the company's financial strength. There is a "pecking order" under which investment financing through retained earnings would be indicative of greater strength, followed by debt and, lastly, new stock issues.161 By issuing new debt, a company undertakes to pay interest. This is a sign that the company is in a stable financial position. Conversely, a decline in debt would be perceived by the markets as a sign of financial weakness.

The other side of the various benefits of debt as a source of financing - whether tax-related, as signals or as incentives - has to do with the costs associated with a structure featuring a high level of debt capital. The first cost is the risk of bankruptcy faced by the company; this is an increasing function of the amount of debt. To the extent that there are bankruptcy costs, there is a point beyond which an increase in bankruptcy risk carries expected costs that exceed the benefits of taking additional debt.

Additionally, a company with a high level of debt forgoes some flexibility in its decisions, as a relatively high portion of its future revenue is already set aside to service interests and principal.

This commitment of future income creates relative illiquidity, which restricts the company's capacity to respond to changes in circumstances or market conditions.

Considering the various explanations of the benefits and costs of debt, there are a series of factors inherent in each company that will determine the optimal degree of leverage: size, the industry in which the company operates, the variability of its income and costs, the ownership structure, etc. Normally, the optimal degree of leverage will include a mix of debt and equity even though there are exceptional cases in which the capital structure presents only one component (see BOX 42).

BOX 42: Pure Debt Company

Source: Glas Cymru's webpage

The legal form adopted by PPP will also directly affect the company's financing structure. There are noticeable differences between the outline following the project finance logic and those in which the private sector participation usually occurs within the framework of a traditional corporation that follows the corporate finance logic.

To a certain extent, the adoption of one option or the other depends on the technological features of the project. Green field projects, which constitute a self-contained technical and economic unit such as a highway, a water treatment plant or an electric power generation unit, typically adopt the project finance format. Whereas, projects involving multiple investments in an interdependent network such as the water or electricity distribution generally operate in the form of corporations that follow the corporate finance logic.

The legal environment of the project can also affect the choice between corporate or project finance. Faced with the risk of an uncertain legal or regulatory framework a company may choose the project finance alternative as a means of limiting its liability.

These different governance, logic and risks of the alternative project structuring possibilities imply that the optimal capital structure between them may substantially vary. Standard & Poor's provides a series of reasons upon which the cost of debt is -ceteris paribus- lower in project finance (see BOX 43).

BOX 43: Standard & Poor's Debt Evaluation

Regulated utilities also have their own inherent characteristics that directly and indirectly affect their financing structure. On the one hand, because they are monopolies with limited market risk, the stability of their revenue and costs allows them to have a higher degree of relative debt (since their risk of bankruptcy is lower).

In terms of governance, the fact that the company is regulated would provide incentives for higher debt levels in order to limit regulatory action. According to these models, as the regulator needs to avoid bankruptcy costs, the higher debt level restricts the tariff levels it can apply to the company.162

In their work on the capital structure of regulated companies, Spiegel and Spulber state:

Empirical evidence suggests that the regulated firm's capital structure affects the allowed rate of return on equity. Besley and Bolton (1990), in a survey of 27 regulatory agencies and 65 utilities, fin that about 60 percent of the regulators and utilities surveyed believe that an increase in debt relative to equity increases regulated prices. Hagerman and Ratchford (1978) show that, for a sample of 79 electric utilities in 33 states, the allowed rate-of return on equity is increasing in the debt-equity ratio.

In the same vein, Sanyal and Bulan (2005) show how the deregulation of the electricity market reduces the degree of leverage by increasing the risks perceived by the companies. A comparison of the evolution of leverage in the US and the UK allows the authors to maintain that "deregulation policies and key firm attributes that contribute to a greater competitive threat to firms, greater variability in earnings and a decline in asset values result in lower leverage ratios".

To sum up, the companies' capital structure is the result of a complex set of factors that directly and indirectly influence managerial decisions, including tax-related aspects, governance problems, market structure, financial market conditions, etc. In the case of PPPs, this set is expanded and strengthened by the technological and institutional features of the infrastructure sectors.

Regulatory concern over the financing structure, the costs of potential bankruptcy aside, stems from the incentives given to managers in a high-debt context. An excessive leverage ratio may provide incentives for the companies in two different directions: to make high-risk investments (that are potentially high-profit investments) or to minimize expenditures by adopting a sub-optimal level of investments. Such concern was openly expressed in a recent document authored by UK regulators:163

"In the years preceding the 2004 Ofwat price control review, commentators had expressed concerns about the adoption by a number of regulated water companies of highly geared capital structures. This trend culminated in the creation of Glas Cymru, a company with no share capital, in 2001. The concerns expressed at the time were that regulators would be less able to act to protect consumers if highly geared companies were to become subject to financial distress. As a consequence, risk might be transferred from shareholders and lenders to consumers. Ofwat sought to make it clear that it would not allow this to happen. Nevertheless a number of commentators made proposals for revisions to the regulatory approach designed to address those concerns."

Likewise, Correia de Silva et al (2004) present an analysis of the capital structure of the energy (electricity and gas), water and transport (infrastructure and services) sectors for a sample of 121 publicly-traded companies in 16 developing countries. The work reveals a strong variation in the leverage level from one sector to the next. The evidence presented in that work also reveals a growing trend in the leverage ratio. These authors also found that after the 1997 Asian crisis, the operators adjusted their capital structures differently in the various regions.

Table 33: Leverage across Sectors

Source: Estache Correia da Silva - Table 8

The difference in financing structure among sectors simply reflects the strong connection between the economic features of a project and its financing method. The economic features in general and the temporal profile of cash flows in particular, represent key elements at the time of structuring a company's financing or project in an optimal way.

Correia de Silva et al found that the results obtained are partially dependent on the measuring method, i.e. on whether book values or market values are used (see Table 33). In this regard, they note that it is necessary for the regulators to take market values explicitly into consideration in their analysis: "An increase in the relative importance of debt in the financing of public services can be, and has in the past been, an issue that only appeared too late on the radar screen of the regulators. The evidence reviewed here would suggest that it is important for regulators to monitor both book and market valuations of the assets."

Hand in hand with this difference comes the problem of the different valuation alternatives for the asset base. In general, the different asset base valuation methods will affect the debt/equity ratio.

The choice of new replacement values vs. historical values affects the value of the assets and, accordingly, the financial ratios that depend on this value, such as leverage.164

A particular aspect of the problem of the valuation of the firm's asset base has to do with the criterion used to select the private partner, as this may, in some cases, materially affect the financial structure.165 In particular, the choice of a lower-tariff or higher bid for the stock package basis will directly affect the valuation of the asset base and thereby the debt/equity ratio.

Where the selected basis is the higher payment for the concession, i.e. there is a direct initial transfer in exchange for the right to the PPP contract, the amount secured at the bidding process is, in general, factored into the initial asset base of the concessionaire. This, for instance, has been the selected method in the electricity, gas and water sectors in the United Kingdom.

Alternatively, where the awarding basis is the lowest tariff, in an extreme case there may be no equity capital at all. Water concessions in Argentina (particularly the concession for the Capital City and Greater Buenos Aires area, Aguas Argentinas) are an example of this. Each of these two alternatives determines a different value for the initial asset base, thus affecting the capital structure.

An additional issue arises where debt obligations are transferred to the concessionaire as part of the PPP contract. The amount (and market value) of the transferred debt is one further element that affects the initial situation, and this can influence the concessionaire's access to credit, particularly over the first few years of the contract term.

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160 F. ALLEN and A. WINTON, Corporate Financial Structure, Incentives and Optimal Contracting, 1994, Rodney L White Center for Financial Research 15-94

161 Myers & Maluf 1984 Corporate Financing and Investment Decisions when the Firms have information that Investors do not have - Journal of Financial Economics Issue 13 1984

162 These incentives can be analyzed in a broader context in which the company's financing structure affects its own relationship with other firms (competitors, vendors, clients). For a general discussion, see Tirole (2006) Chapter 7.

163 OFWAT - OFGEM 2006

164 On the different alternatives for the valuation of the asset base, see …

165 Such analysis is not crucial for green field projects where there is no initial asset base to be considered.