PPP Development Stage – Financing (Investments)
12.5 What are the key issues?
Cost of capital
Cost of capital is designed to give an idea of the costs associated
with the different financing options – debt and equity.
It is rather easy to find out the cost of debt, as it carries
an explicit interest rate paid to the lender. The cost of
equity is the cost to be paid to attract investors to invest
in the stock of a company and to keep them interested in retaining
their investment. Weighted average cost of capital is the
average of the cost of each of these sources of financing weighted
by their respective usage in the given situation.
There are numerous formulas to determine company's financial
performance. Two general formulas are used to determine the
value of an investment:
Investment = Fixed Assets + Working Capital
Cost of Capital = [(Repayment - Investment) x 100]/Investment
These two formulas can be used to calculate the optimum
debt to equity ration necessary to finance further growth
Equity capital is more costly than debt because it requires
higher premiums for risk and interest on debt is tax deductible
while dividends and equity capital are not. However, although
debt is generally cheaper than equity, a long-term equity
stake by the sponsor (which is sometimes also the operator)
ensures that management has a long-term interest in the
project and that cash flow growth leads to capital appreciation.
Equity also reduces the debt service burden on the cash
flow, which can be especially important in a project’s
early development phase.
In full concessions and privately owned utility companies
internal cash generation can provide an important source
of equity for financing investment.
Besides the cost of capital per se the cost of private
- Government taxes and duties: customs duties, equipment
insurance, vehicle and company registration, corporate
income and property tax;
- Transaction costs: costs of putting partnership together,
from tender through negotiation of the partnership framework;
- Informal costs…
…associated with bureaucratic structures and political manipulation.
Rate of returns
Rate of Return on Invested capital (ROI) is the measure
of the assess value, and is expressed as a percentage ratio:
ROI= Profit x 100 /
Often an investor has, as one of their investment criteria,
a minimum acceptable rate of return on an acquisition.
The rate of return should cover the cost of debt and equity
financing, or, the weighted average cost of capital (WACC)
of the project.
Inflation, taxes, depreciation, and international currency
fluctuations may also need to be considered. One method is
to calculate both Internal Rates of Return (IRR) and Net
Present Value (NPV) using various cash flows and discount rates
to determine the true value of investment.
Investment project can be recognized as applicable if one
of the following conditions is reached:
IRR >E (E-Interest rate)
Capital and operational costs
Capital costs include the costs of building assets used for
service and products production and in some cases costs
for buildings and grounds. The capital costs in a tariff
formula are comprised of the return on and of these capital
Operational costs often called operating and maintenance
expenses, are the costs of operating the business and performing
routine maintenance of the assets in order to produce and distribute
The measurement of Borrowing Requirements intends to provide
the information about the financial results of the activities
carried out by the company in order to comply with its
functions, in a summarized and timely fashion.
These indicators are the result of an effort to collect
and regroup information, most of which is already known
by the public, but that in the past was published separately
or in aggregated manner.
Borrowing requirements by governments are met, in large part
by funds raised on financial markets. Debt management
techniques and policies can influence substantially the functioning
of capital markets and the development of new financial
instruments. As a consequence of globalisation, cross-border
government borrowings have become more significant. Government
debt instruments attract both institutional and retail
investors and have an important share in the portfolios of fund
Finance structuring (financing and tariffs)
Financial structuring need to be developed for each project.
It should involve a mix of financing sources, secured by
revenue stream. In structuring the finances there is
a need to have the correct structure in respect to:
- 1. Mix of debt to equity. This is an important mix and
one that if it is out of balance means excessive risk
or under realisation of the potential of the business.
- 2. Maximisation of internal funding. This is the cheapest
form of finance to a business and is internally generated
by cash flow optimisation and the correct management
of working capital.
- 3. Sources of finance. This depends on numerous features
such as the type of industry, the stage of growth, the
funding needs etc. There is a risk in obtaining funding
from numerous sources equally as much as there is a risk
in being too limited in your financiers. However, building
a solid relationship with the financiers is important.
- 4. The types of financing
instrument. Examples of these
are leases, short term facilities, long term funding,
perpetual debt, etc.
- 5. Terms of finance. The terms of the finance include
the period of finance, the repayment programme, the
interest rate, the costs in establishing and obtaining
the finance, the covenants and restrictions placed by
the lender on the business, the required level of security
and the information flow that is required by the financiers.
All of these areas need to be considered.
- 6. Planning for the future business and
funding needs is an extremely important issue. You are not borrowing
for today's events, you are borrowing for the future
and in this regard, planning is essential.
- 7. Management control
over the business. It is important
that management reporting and control procedures are
in place to ensure that the financing is optimised.
Because finance structuring is a complicated procedure,
it is strongly advised to engage professional consultants.
Municipal finances and budgets
A budget is a financial plan, which summarises, in financial
figures, the activities planned for the forthcoming year
by setting out the costs [expenses] of these activities, and
where the income will come from to pay for the expenses.
There are two types of budgets: operating budget and capital
… deals with big costs that you
pay once to develop something, and how you will pay for this – for
example putting in water pipes to a new township.
…deals with the day-to-day costs
and income to deliver municipal services – for example the
meter readers’ wages
and maintenance work to keep the water flowing.
Municipalities must ensure that there will be adequate
money to pay for their planned expenditure if they are to "balance
the budget". There are various sources of income that
can be used by municipalities to finance their expenditure,
which could be divided on capital and operations budget
A. Main sources of capital budget financing
- External loans
- Internal loans
- Contributions from revenue
- Donations and public contributions
B. Main sources of operational budget financing
- Service Charges / Tariffs
- Equitable share - an amount of money that a municipality gets
from national government each year.
Asset management and valuation
Asset / liability management – the task of managing the funds
of a financial institution to accomplish the two goals of a financial
- to earn an adequate return on funds invested; and
- to maintain a comfortable surplus of assets beyond liabilities.
Asset management encompasses a wide range of management
decisions, such as capacity allocation, asset purchase/lease
decisions and pricing. In high-fixed-cost businesses
such as manufacturing and most types of service provision,
asset management is often one of the most powerful levers in
determining relative profitability.
What are the key issues?
◊ Cost of capital
◊ Rate of returns
◊ Capital and operational costs
◊ Borrowing requirements
◊ Finance structuring
◊ Municipal finances and budgets
◊ Asset management and valuation