4.4. Cost of capital

IDevice Icon What is the cost of capital?

The cost of capital for a project is a weighted sum of the cost of debt and the cost of equity. The cost of capital is often used as the discount rate, the rate at which projected cash flow is discounted to find the present value or net present value of a project.


Risk is an important element which is factored in to determine the cost of debt and equity. Interest rate charged by lenders will depend on the level of risk they estimate for the project. The higher the risk perceived, the higher the interest rate will be (interest rate can be decomposed as the sum of a risk free rate - practically the rate at which government can borrow money from the market - to which a risk premium is added).

Similarly, the cost of equity is defined as the risk-weighted projected return required by investors and is established by comparing the investment to other investments with similar risk profiles.

Government regulators need to consider the cost of capital when determining the appropriateness of tariff levels. Ideally, the Internal Rate of Return of a project should be equal to its cost of capital. If IRR is greater than the cost of capital, the concessionaire/investor makes excess profit, and if the IRR is less than the cost of capital, the concessionaire/investor loses money and may even go bankrupt.

Why the debt - equity ratio matters

Usually, banks will be more comfortable to lend to an entity which has a higher share of equity as it makes the project safer while investor will try to reduce equity investments to the minimum to increase their potential return through higher leverage.

How the cost of capital can be lowered 

The cost of capital of may be lowered through refinancing of PPP projects after their construction phase. Sponsors may be required to provide a significant amount of equity capital at the beginning of a project during the construction phase when the risk is high. Once the construction is complete, the construction risks associated with it have been overcome, and the cash flow begins to materialize, the expensive equity or debt capital can be refinanced using cheaper debt capital thus lowering the total cost of capital.

How refinancing helps 

The relationship between risk and return of a project changes over different phases. The highest level of risk exists during the construction phase of a project when construction delays and cost overruns can have serious consequences to a project's success. It is during this phase that investors require the highest return on their capital to compensate for the risk, thus the higher cost of capital. Once construction is over and the cash flow from operations has begun, project risks drop off substantially and it is possible for sponsors to refinance at a lower cost.

 

Copyright © 2008 by Transport Policy and Development Section, United Nations Economic and Social Commission for Asia and the Pacific (ESCAP).