Once the risk allocation chart between the public and private sectors has been produced, as described in Part A of this module, the private concession holder will then seek to quantify and price the residual risk of the project that must be borne. This risk is assessed by producing a country and project rating. Once this first stage is carried out, rating the risk is then defined by setting a minimum financial profitability threshold for the project below which a private concession holder will refuse to commit itself. In other words, the more risk associated with the project by the concession holder, the higher the required project profitability.
It is within this framework that one analyzes the financial profitability of the project. The financial analysis is designed to determine the conditions under which the proposed project can respond to market requirements, which usually vary with time, or in other words, determine the bankability of a project. In terms of methodology, the financial profitability of a project is determined by forecasting the cash flows generated by operation of the project. This aspect will be developed later in the section on financial modeling.
The calculation of the financial profitability of a project does not take into account the envisaged financing structure. In practical terms, only operating cash flows (calculated after tax and duty), consisting of investment and operational flows, are considered. Taking the predicted financing structure into account in the project’s forecasted cash flows would result in accounting for them twice. The purpose of this first stage of the financial profitability analysis is to decide whether it is interesting for the private concession holder (sponsors and banks) to continue the analysis of the project from a financial point of view. In fact, a financially unprofitable project at this stage will not become profitable regardless of how it is financed.
This economic model of the prospective project, described later in this module, is usually produced by the sponsors in collaboration with the financial advisors (merchant banks or specialist agencies). The economic model should not to be confused with the economic analysis carried out by the concessioning authority as described above.
Part A of this module presented the principles for allocating and managing risks between the concessioning authority and the concession holder on the one hand, and between the concession holder and the sponsors or lenders on the other. The method used, inspired by the logic of the banking analysis of project financing, consisted of:
The next stage consists of quantifying the residual risk that will be borne by the SPC. This risk is assessed by producing a rating. There are two types of ratings: a country rating to quantify the risk attached to the project’s background and, therefore, to establish whether the country risk is acceptable to the market, and a project rating, a project risk assessment through the establishment of a checklist, which establishes whether the intrinsic risks in the project were correctly handled by the sponsors.
There are numerous country risk assessment methods. Box 9a and 9b presents the method developed by Nord Sud Export (NSE), which acts as an adviser to the French insurance company COFACE (Compagnie Française d’Assurance du Commerce Exterieur) in its country risk assessment process. The project rating checklist, established following the principles spelled out in Part A of this module, is included as an annex to this document.
The purpose of financial profitability indicators is to determine the conditions under which the proposed project is financially justified. There are four main measures used to assess a project’s financial viability: payback, IRR, NPV, and investment cover.
Payback Time. The payback time, or the time required for a return on investment, is the first indicator enabling investors and operators to assess the financial profitability of a project. It is measured by relating the value of the investment to the average annual cash flow.
T = years to pay back investment
I = total investment
R = average annual operating income
C = average annual operating Costs
R – C = average annual operating cash flow
Other things being equal, an investment project will be more interesting for the private investor if its payback period is shorter. A high value for T reveals, among other things, the need for long-term financing and introduces great uncertainty.
Project IRR. The advantage of the IRR is that it does not rely on the notion of average year cash flow, which can be dangerous in the case of income and costs that are very changeable with time.
The project IRR is the solution r of the equation:
Ii = amount invested in year i
Ri = operating income in year i
Ci = operating costs in year i
Ri – Ci = operating cash flow in year i
n = length of concession contract
The higher the value of r, the more interesting a project will be from the financial point of view.
Project NPV. A third indicator of financial profitability is the project NPV. A project will be considered insufficiently profitable from a financial point of view if the obtained project NPV is negative. The NPV value is an absolute figure that does not allow for comparisons among several projects or variants. Because of this shortcoming, it is generally appropriate to calculate the investment cover ratio as well.
Ii = amount invested in year i
Ri = operating income in year i
Ci = operating costs in year i
n = length of concession contract
t = project discount rate
Investment Cover Ratio. The investment
cover ratio (ICR) compares the project’s discounted
cash flows to the total of the discounted
investments.
The factors are the same as those used in calculating the project NPV.
A project will be considered profitable from a financial point of view if its ICR is greater than one. This is a variant of the previous indicator, but it has the advantage of providing a relative value, thus enabling investors to compare the results of several projects or variants.
Apart from the rate of return on investment (the payback method), the other three measures of profitability noted above take into account performance over a project’s lifetime. These methods require the use of a project discount rate based on the notion of the time value of money. This rate can be used directly in the formula (project NPV and ICR) as well as indirectly (comparing the project IRR obtained to the project’s discount rate). The concession holder, therefore, requires an accurate value for the project discount rate. In financial analysis, the profitability of an investment is measured against the cost of the financing required to own the resources placed under the company’s control. In other words, it is the cost of capital (weighted average cost of capital [WACC]) that gives a true measure of the project’s discount rate.
Traditionally, the cost of capital represents the weighted average cost of all the financial resources invested in the project and is measured as follows:
g = financial gearing or leverage or the amount of the financial debt in relation to the total financial capital
rd = cost of the financial debt or the financial debt remuneration requirement
re = cost of equity (the return on equity requirement)
In the next section, the remuneration requirements of the various private capital providers (lenders and sponsors) will be analyzed, including the determination of both rd and re.
The financial debt remuneration requirement relates to the yield to maturity of the financing. It is the discount rate that cancels the present value of the sequence of expenses created by this financing. It therefore incorporates all the elements of the cost of finance, that is, the interest rate of the loan and all the fees charged in setting up the loan. If there are no fees and expenses, the yield to maturity is the same as the interest rate.
The yield to maturity engendered by the flow sequence [F0,F1,...,FN] is the solution for the rate r of the equation:
There are four fees usually charged by lenders in financing projects:
The interest rate is expressed as follows: interest rate = base rate + bank margin. The bank margin is known as the “spread.” It is usually fixed and determined when the loan agreement is signed.
The interest rate may be any of the following:
It should be remembered that a rate is said to be “revisable” if the reference is predetermined; in the bond market, the coupon relating to a period (paid at the end of the period) is known at the beginning of the period. Also, a rate is said to be “variable” if the reference is postdetermined; in the bond market, the coupon relating to a period is not known until the end of the period.
Real and nominal interest rates translate the cost of money at a given moment in time, for a specific period, and in a specific financial market place. The nominal interest rate initially represents the sum of the real interest rate and expected inflation. The real interest rate therefore represents the cost of the money excluding all monetary erosion. The relationship between the real and nominal interest rates is given by the following formula:
Within the framework of assessing financial profitability, the rate used for the initial approximation is the nominal interest rate.
The financial analyst faces the difficult problem of translating the risk, established by means of the project rating, into a remuneration requirement. That is, the analyst must determine the risk premium, or the spread attached to the project for the lenders on the understanding that there are no guarantees other than the cash flows produced by the project.
The spread is established by the lenders and accounts for:
Based on these various elements, it becomes a relatively easy task to determine the financial debt remuneration requirements. However, these largely theoretical calculations must not lead one to lose sight of the fundamental objective of commercial banks to not get “stuck” with a high level of commitment above the ceiling allowed by their management board and defined within the framework of their own development and risk management policies.
Since the beginning of the 1980s, deregulation of financial activities has occurred contemporaneously with an increase in market volatility and competition between financial establishments. This situation has contributed to the development of assets and liabilities management as a stand-alone function in the banking world. Traditionally focusing mainly on development of commitments and increases in market share, commercial banks have come to appreciate the need to enhance their balance sheet value and their operating margins.
The decision on whether to invest in a specific project thus has to meet all these considerations, largely intrinsic to the company and generally unknown to the other private partners in the project. And when a positive decision is reached, it is not unusual to notice significant differences in the remuneration levels required by different banks. This underscores the theoretical nature of the approach described above and illustrates the complexity of the job of the financial analyst assigned to this kind of project.
Assessing the equity remuneration requirement in a port project is a difficult exercise. Undoubtedly the most commonly used approach in financial analysis is the capital asset pricing model (CAPM), which is used in assessing the risk-profitability profile.
The equity remuneration requirement, re, is given by the formula:
re = equity remuneration requirement
rf = risk free rate
ß = equity beta parameter representing sensitivity
rm = market rate
rm – rf = market risk premium
a = sovereign risk factor
This method is based on the strong hypothesis that the risk in any financial security can be broken down into two categories: market risk (systematic or nondiversifiable risk) due to a set of factors exogenous to the company (for example, changes in the economy, tax system, interest rates, inflation), and specific risk (intrinsic or diversifiable risk) due to a set of factors endogenous to the company (all the risks previously mentioned under project risks).
The CAPM translates the fact that the profitability required by an investor is equal to the risk-free money rate plus a security risk premium, that premium being equal to a market-risk premium multiplied by the security’s volatility factor. The market risk premium measures the difference in profitability between the market as a whole and the risk-free asset. The current level market-risk premium in France is in the region of 3–4 percent.
There are two questions that are essential for a financial analyst involved in a port privatization project to pose:
These are complex questions requiring complex answers. As far as the risk premium is concerned, it is generally determined following normative approaches. These approaches consist of determining the beta parameter for each of the sectors the project sponsors are involved in (contractors, terminal operators, cargo handling companies, shipowners, shipping companies, and so forth) and comparing them to the parameter generally assigned to a port operating company. The value assigned to the project, called asset beta, should logically be the highest value uncovered in this process. Finally, the determination of the equity beta stems from the difference that could exist between the specific financial structure of the project (as determined by the SPC) and the one observed in the normative approach.
“Differentiated” remuneration requirements depend on the type of shareholder. It should be remembered that the expected remuneration requirement levels of the project differ depending on the type of shareholder concerned. This fundamental point can be explained by the different outcomes sought by the various sponsors involved in the project:
There is also the difficult problem of differentiating the remuneration requirement for the pure investor and the other types of sponsors, with respect to which the SPC represents only a fraction of their objectives in the project. Generally speaking, discussions relate to the optimal time for the pure investor to place its capital with the SPC, given a traffic risk may be experienced. In this regard, should the investor come in as early as the project set-up stage, at the beginning of the operating stage, or when the operation of the investment has shown its ability to produce sufficient revenue?
All of these questions, which are of interest not only to the concessioning authority but also to the lenders, are at the heart of the discussions surrounding the financial analysis of the project.
If the project offers both a positive discounted socioeconomic net benefit and project NPV, it should be carried out because it is favorable for the community and the concession holder alike. Conversely, when both discounted socioeconomic net benefit and project NPV are negative, the project should not be carried out. These are fairly straightforward outcomes leading to relatively straightforward “go no-go” decisions.
The real challenge is how to reach a reasonable decision when the operation is profitable from the socioeconomic point of view but not from the financial point of view. With port projects this is the most frequent situation given that port infrastructure investments are discontinuous or “lumpy,” with a long working life. They must therefore be designed from the start to their definitive size, even if port traffic only builds up gradually.
As a result, it is not unusual for the government to contribute to the funding of a project. This constitutes the value of the project to future generations, which is often difficult to ask the customers of the present generation to bear without running the risk of increasing the cost of using the port to such a level that the port loses its competitiveness. Even though proper remuneration of the benefits offered within a reasonable economic life of the project should be the rule, depreciation and remuneration of the government’s contribution over a longer period, commensurate with the life of the longterm assets it financed, should not be seen as a departure from this principle. It would obviously be different if the capital market offered financing on a cycle equal to the investment cycle existing for port projects (25 to 50 years). This, however, is not the case today.
In conclusion, the financial constraints imposed by the market on this fragile public-private partnership often leads to a sharing of financial commitments between the concessioning authority and the concession holder. The search for an equitable split is based on the need to balance the socioeconomic profitability of a project and the financial profitability.
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