Public Private Partnerships in India are evaluated by professional firms called Transaction Advisors before they are cleared by the various committees empowered to clear such projects in the Centre and the States. This evaluation is generally funded by dedicated PPP project development funds either by the centre or states. This exercise of a financial, technical and legal feasibility is called a "Feasibility Report" which is of immense value to both Sponsoring Agencies, PPP Approving Authorities and finally the bidders who use this document as a base to bid for the project.
The financial feasibility exercise is key to a successful PPP bid outcome - it assesses the infrastructure project cost based on certain standard cost of an equivalent project adjusting the same to match the existing project cost requirements. The funding cost of the project is also based on a debt equity mix that is being generally followed by concessionaires in the project. Thereafter, based on sound principles the project traffic is assessed on a current basis and thereafter estimated on a future basis on growth in traffic, all of which have a sound basis of evaluation followed by the Transaction Advisors. The projected revenues and expenses (including capital cost) over the life of the concession are aggregated year on year to arrive at the net project cash flows.
The net cash is thereafter discounted to arrive at "discounted cash flows" where the time value of money is over the years is adjusted to the present scenario. This whole exercise is to determine (a) whether sufficient cash flows are generated by the project to make it financially feasible and (b) to what extent are project cash flows deficient in order for the Sponsoring Agency / Centre intervene by way of a Viability Gap Funding (VGF) to make the project financially feasible to concessionaires and bankable to funding agencies. The financial feasibility is based on target Net Present Value (NPV) that the project would return that makes the bidder comfortable to invest in such. Therefore in a financial feasibility report three critical elements are present that require in-depth understanding and evaluation:
a) Project Costs - in India project costs may vary but there is a clear understanding amongst the Authority and Developers as to what should be the costs. This is out of sheer experience in actual PPP project implementation. Project costs refer to both capital and recurring project costs.
b) Project Revenues - Like project costs, project revenues are based on traffic and other project revenue evaluation. Lots of studies have been conducted to evaluate traffic in the PPP project along with deeper understanding of how traffic is related to competition, economy growth in future, fuel prices currently and in future. There exists a fair method of evaluation of project revenues in India.
c) Discount rate on cash flows - in road PPPs the discount rate of 12% is used. However, very few studies have been done to justify this discount rate.
In other developed countries eg Australia where PPPs are practised over a long period of time high emphasis is given on discount rate used in project evaluation. In fact the National PPP Guidelines of Australia has a whole chapter on "Discount Rate Guidance Methodology". The principles for determining discount rates for DCF analysis, in Australia, are based on the theory used to calculate cost of capital represented by the capital asset pricing model (CAPM). In CAPM, the cost of capital reflects the return required by an investor to undertake or invest in a particular project. The required return is equal to the risk free rate, plus a risk premium for the systematic or market risks retained by the investor. This risk free rate, in the Australian context, is the recent average of the ten-year Commonwealth Bond rate. Systematic risks are risks that effect all assets within a diversified portfolio and therefore cannot be eliminated by holding such a portfolio. Systematic risks include (a) demand risk related to general economic activity (b) unexpected inflation (c) unexpected changes in interest rate or foreign exchange rates on asset values (d) unexpected obsolesence and (d) broad market risks such as material rise in bankruptcies affecting supply. In short, to arrive at a discount rate there is strong link to current market scenario. In other countries, the discount rate is specifically linked to risks envisaged in the particular sector and project affecting CAPM.
PPPs in India also require such a detailed "discount rate study". The other critical reason for having a proven discount rate is because it directly impacts VGF. Suppose road project A after having been discounted at discount rate of 12% has a positive NPV of say Rs x crores. However, considering a CAPM method the discount rate is estimated at 8.5% leaving an NPV of Rs (x+y) crores. This means the project is far more attractive than earlier projected. Therefore, the target IRR of say 18% need not be achieved but a lower IRR can be targetted to achieve the same NPV and therefore quantum of VGF, if any, would reduce. However, in a high inflation scenario the converse may be true - discount rates could be higher than 12%. In my personal opinion, discount rate of 12% used presently in road projects is on the higher side as compared with the present Indian inflation rate and world economic scenario of falling interest rates.
One can argue that such discount calculations may not affect bid price, but the counter argument would be that seeing the Govt. discount rate the private sector could be tempted to use a similar rate to arrive at a more realistic NPV. Otherwise, why would Australia and other Developing Countries need to have a Guidance Note on Discount rate methodology for PPPs? It would definitely merit a relook at our discount rate processes and put in line with International Best Practices.
For PPPs to develop in India, apart from financial incentives that are currently in place some non-financial processes (like discount rate review) need to be strengthened that could have a direct and potent impact on the financial outflows of the Government. At a time when the India's fiscal deficit is high, any measure that may have a positive impact in reducing such deficit should be a welcome step.
The financial feasibility exercise is key to a successful PPP bid outcome - it assesses the infrastructure project cost based on certain standard cost of an equivalent project adjusting the same to match the existing project cost requirements. The funding cost of the project is also based on a debt equity mix that is being generally followed by concessionaires in the project. Thereafter, based on sound principles the project traffic is assessed on a current basis and thereafter estimated on a future basis on growth in traffic, all of which have a sound basis of evaluation followed by the Transaction Advisors. The projected revenues and expenses (including capital cost) over the life of the concession are aggregated year on year to arrive at the net project cash flows.
The net cash is thereafter discounted to arrive at "discounted cash flows" where the time value of money is over the years is adjusted to the present scenario. This whole exercise is to determine (a) whether sufficient cash flows are generated by the project to make it financially feasible and (b) to what extent are project cash flows deficient in order for the Sponsoring Agency / Centre intervene by way of a Viability Gap Funding (VGF) to make the project financially feasible to concessionaires and bankable to funding agencies. The financial feasibility is based on target Net Present Value (NPV) that the project would return that makes the bidder comfortable to invest in such. Therefore in a financial feasibility report three critical elements are present that require in-depth understanding and evaluation:
a) Project Costs - in India project costs may vary but there is a clear understanding amongst the Authority and Developers as to what should be the costs. This is out of sheer experience in actual PPP project implementation. Project costs refer to both capital and recurring project costs.
b) Project Revenues - Like project costs, project revenues are based on traffic and other project revenue evaluation. Lots of studies have been conducted to evaluate traffic in the PPP project along with deeper understanding of how traffic is related to competition, economy growth in future, fuel prices currently and in future. There exists a fair method of evaluation of project revenues in India.
c) Discount rate on cash flows - in road PPPs the discount rate of 12% is used. However, very few studies have been done to justify this discount rate.
In other developed countries eg Australia where PPPs are practised over a long period of time high emphasis is given on discount rate used in project evaluation. In fact the National PPP Guidelines of Australia has a whole chapter on "Discount Rate Guidance Methodology". The principles for determining discount rates for DCF analysis, in Australia, are based on the theory used to calculate cost of capital represented by the capital asset pricing model (CAPM). In CAPM, the cost of capital reflects the return required by an investor to undertake or invest in a particular project. The required return is equal to the risk free rate, plus a risk premium for the systematic or market risks retained by the investor. This risk free rate, in the Australian context, is the recent average of the ten-year Commonwealth Bond rate. Systematic risks are risks that effect all assets within a diversified portfolio and therefore cannot be eliminated by holding such a portfolio. Systematic risks include (a) demand risk related to general economic activity (b) unexpected inflation (c) unexpected changes in interest rate or foreign exchange rates on asset values (d) unexpected obsolesence and (d) broad market risks such as material rise in bankruptcies affecting supply. In short, to arrive at a discount rate there is strong link to current market scenario. In other countries, the discount rate is specifically linked to risks envisaged in the particular sector and project affecting CAPM.
PPPs in India also require such a detailed "discount rate study". The other critical reason for having a proven discount rate is because it directly impacts VGF. Suppose road project A after having been discounted at discount rate of 12% has a positive NPV of say Rs x crores. However, considering a CAPM method the discount rate is estimated at 8.5% leaving an NPV of Rs (x+y) crores. This means the project is far more attractive than earlier projected. Therefore, the target IRR of say 18% need not be achieved but a lower IRR can be targetted to achieve the same NPV and therefore quantum of VGF, if any, would reduce. However, in a high inflation scenario the converse may be true - discount rates could be higher than 12%. In my personal opinion, discount rate of 12% used presently in road projects is on the higher side as compared with the present Indian inflation rate and world economic scenario of falling interest rates.
One can argue that such discount calculations may not affect bid price, but the counter argument would be that seeing the Govt. discount rate the private sector could be tempted to use a similar rate to arrive at a more realistic NPV. Otherwise, why would Australia and other Developing Countries need to have a Guidance Note on Discount rate methodology for PPPs? It would definitely merit a relook at our discount rate processes and put in line with International Best Practices.
For PPPs to develop in India, apart from financial incentives that are currently in place some non-financial processes (like discount rate review) need to be strengthened that could have a direct and potent impact on the financial outflows of the Government. At a time when the India's fiscal deficit is high, any measure that may have a positive impact in reducing such deficit should be a welcome step.
