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Maximizing Equity Net Present Value

of Project-Financed Infrastructure
Projects under Build, Operate,
Transfer (...
Andreas Wibowo

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International Conference on Sustainable Infrastructure and Built Environment in Developing Countries
November, 2-3, 2009, Bandung, West Java, Indonesia
ISBN 978-979-98278-2-1

Maximizing Equity Net Present Value of Project-Financed Infrastructure

Projects under Build, Operate, Transfer (BOT) Scheme

Andreas Wibowo1
1
Research Institute for Human Settlements
Agency for Research and Development, Ministry of Public Works
Jalan Panyawungan Cileunyi Wetan Kabupaten Bandung 40393
E-mail: andreaswibowo@daad-alumni.de

Abstract
Capital structure is one of most relevant issues in greenfield infrastructure projects which
typically require a bulk of up-front capital. The underlying problem is to set the capital
structure that optimally creates wealth to the project promoter while maintaining the
attractiveness of the project for the creditor(s) to provide debt financing. This paper presents
a financial model of maximizing the equity net present value of projects implemented under
build, operate, transfer (BOT) contract with debt arranged on non-recourse basis. The
proposed model takes into account both interest rate and cost of equity as the functions of
leverage ratios which many previous studies fail to address.

Keywords: build/operate/transfer, cost of equity, infrastructure, interest rate, net present

value.

1. Introduction
Due to fiscal constraints and disenchantments with the quality service of public
infrastructure, many governments around the world have contracted out the service delivery
to the private sector. It is widely acknowledged that a major infrastructure project is typically
funded with mixed debt and equity capital because of high up-front capital requirements. To
what extent the project is debt financed is of the concern of different project stakeholders.
From the creditor’s perspective, a project is bankable if the project under evaluation has
(expected) sufficient cashflow to service debt over the repayment period. This is essentially
germane to projects with debt arranged on a non-recourse or project finance basis where the
project cashflow and its asset are the only collateral.
For the project promoter, employing more debt financing allows them to enjoy a higher
interest tax shield. However, if the project is more leveraged, both cost of debt and cost of
equity nonlinearly increase which may offset to some extent the benefit of tax shield, thereby
lowering the project market value. From the government’s angle, the equity level represents
the commitment of the project promoter to succeed the project in question. With no equity
injected, the project promoter may not be more incentivized than otherwise would be if some
money invested to the project.
This paper presents a spreadsheet-based model that addresses the issue of capital structure
of non-recourse financed infrastructure projects, especially those implemented under build,
operate, transfer (BOT) contracts. Under the contract, the private sector is required to build a
new facility, commercially operate it during the concession term and transfer the facility
back, usually at no cost, to the government when the term expires. The paper is motivated by
at least two reasons. First, existing literatures often do not take into account the issue of risk-
return relationships that serve as the backbone of modern finance theories. Second, if they do,
the computational requirements are often cumbersome as involving complex calculus algebra

198 / F: CONSTRUCTION MANAGEMENT

or simulations. To illustrate the use of the proposed model for clarification purpose, the model
is applied on as case study.

2. Previous Studies on Capital Structure

The issue of capital structure has attracted many researchers. It began with the
breakthrough work by Miller and Modigliani (1958). The discussions never end and have
been indeed expanding to date. In the area of construction management, Dias and Ioannou
(1995) first employed the Capital Asset Pricing Model (CAPM) to find different optimal
capital structure of single period project. Dias and Ioannou claimed that the proposed
framework is trivially expandable to multi-period projects with simple worksheet model being
sufficient for solving problems. The present author believes, however, this is not as simple as
it appears. Additionally, Ping Ho (2001) argued that Dias and Ioannou’s is too close with Kim
(1978) on which the author entirely agree.
Bakatjan et al. (2003) introduced the linear programming (LP) model to optimize the
project capital structure for multi-period projects with BOT power projects in Turkey chosen
as a case study. Wibowo (2004) criticized the model approach with the argument that LP is
not necessary and, more importantly, that cost of debt and cost of equity cannot simply be
assumed constant for different levels of leverage.
Zhang (2005) proposed a framework to have equity internal rate of return (IRR)
maximized but still assumed constant cost of equity Another theoretical study is the work of
Wibowo (2008) that employed a simulation approach to solve the optimization problem for
multi-period projects under the CAPM framework. But, the work needs to use a commercial
software package that not everyone can have access on it.

3. Cashflow Modeling
The cashflow modeling and some notations presented here follow that of Zhang (2005) to
not replicate the previous studies. The total project is defined as follows:

CT  CB  CE  CI

C
(1)

CB 
m
i
(2)
i 1
B

  

 i  
 B  1  ek   1 

CE  CEi 
m m i

i 1 
  k 1 
C (3)
i 1

CI  C  1  R
m
i

i 1
I

  
   
  CBi 1  rD  1  ek   CBi 1  ek 
(4)
m11
m i i

 
i 1  k 1  k 1 

where m=construction period; CT=total project cost as discounted to the end of the
construction period; CB=base construction cost as estimated at the beginning of the
construction period; CE=cost escalation during construction; CI=interest during construction;
th th
C Bi =base cost for construction for i year; C Ei =cost escalation for i year; C Ii =interest
incurred for ith year; ek=construction escalation rate for kth year; e0=0; R=equity level;
r D=borrowing rate.

E i  RCBi  1  ek  for i=0,1,2..,m

i
(5)
k 0

Di  1  R CBi  1  e  for i=0,1,2..,m

i
(6)
k 0
k

F: CONSTRUCTION MANAGEMENT / 199

where Ei and Di=equity and debt drawings in the ith year of the construction period.

NATCI j  PBITj  DE j  D j  TAX j for j  1,2,..., n (7)

where NATCIJ =annual net after tax cash inflow for jth period.

PBITj  RE j  OM j  DE j for j=1,2,..,n (8)

where PBITJ=profit before interest and tax for jth year; REj=annual revenue for jth year;
OMj=operation/maintenance expenses for jth year; DEj=depreciation expenses for jth year and
calculated using the following formula

DE j  CT nd for j=1,2,..,nd (9)

where nd=design life of the project. The total accumulated debt at the end of the construction
period, P D, is computed as:

  1  e 
 i 
PD  1  R CB 1  rD 
mi
m i

i 0 
(10)
k 0
k

Depending on the credit agreement, the debt repayment can be structured in many ways.
Debt service may be made on an equal installment basis or equal principal repayment. Debt
repayment structure also sometimes includes the so-called grace period during which the
project promoter may only pay interest or nothing. This feature enhancement is especially
advantageous to a project that generates low revenues during earlier phases of operation such
as toll facility projects.
j
Next, given the tax rate rtax , tax payment for jth year TAXj is calculated as:

   
TAX j  rtaxj PBITj  I j  rtaxj Rj  OM j  DE j  I j for j=1,2,..n (11)

where Ij=interest payment for jth year.

3.1. Project Debt Service Capacity
From the creditor’s perspective, three ratios may reflect the project’s capacity to service
debt, i.e., debt service coverage ratio (DSCR), loan life coverage ratio (LLCR) and project life
coverage ratio (PLCR). DSCR is simply computed as:


DSCRj  PBITj  DE j  TAX j  D j for j=1,2,...,N (12)

where DSCRJ =DSCR for jth year, N=debt service period, Dj=debt service for jth year. A project
should have DSCR at least 1.0x to be acceptable; it is regarded as bankable when DSCR is in
the range of 1.10x-1.25x, satisfactory and comfortable when DSCR is between 1.30x and
1.50x and above 1.50x is preferable (Yescombe, 2007). Fierce competition amongst creditors
is believed to have lowered the minimum DSCR from between 1.5x and 2.0x in 1970s and
1980s to between 1.3x and 1.5x in 1990s (Reuter and Wecker, 1999).
LLCR is a ratio of net present value of future income over the debt maturity period
against outstanding debt. It is a useful measure for the initial assessment of a project to
service debt over the whole term but clearly is not useful if there are likely to be significant
cashflow fluctuations from year to year. LLCRk is calculated as:

200 / F: CONSTRUCTION MANAGEMENT

   1  r 
PBITj  DE j  TAX j
LLCRk 
1  rD 
N N
Dj
j k j k
(13)
j k j k D

where LLCRk=loan life coverage ratio, as measured in the kth year of the loan repayment
period of N years. The minimum initial LLCR requirement is typically around 10% higher
than minimum annual DSCR (Yescombe, 2007). The last ratio to measure the project capacity
to service its debt is PLCR; it is a ratio of net present value of future income over the whole
life of the project to outstanding debt. Creditor may wish to see PLCR around 15-20% higher
than the minimum annual DSCR (Yescombe, 2007). PLCR is calculated as:

  1  r 
PBITj  DE j  TAX j
PLCRk 
1  rD 
n N
Dj
j k j k
(14)
j k j k D

where PLCRk=project life coverage ratio for kth year.

3.2. Opportunity Cost of Capital
Ceteris paribus, more leverage translates into lower capacity of the project to service
interest payment. It can theoretically be explained that cost of debt or interest increases when
the project is more leveraged (Dias and Ioannou, 1995; Kim, 1978; Brealey and Myers, 2000).
Table 1 shows the relationship between interest coverage ratio (ISCR) and bond rating and
spread over T-bond. However, given the constrained space of the paper not all data are
presented. ISCR is defined as:

ISCRj  PBITj I j (15)

where ISCRj=interest coverage ratio for jth year. Given ISCR, the respective interest rate is T-
bonds plus some spread. Table 1 demonstrates that the less the project’s capacity to satisfy
interest payment the higher will be the spread of the interest rate and T- bonds, denoting a
higher risk to the creditor.

Table 1 Bond Rating and Interest Coverage Ratio, abridged (Damodaran, 1994)
ISCR Range Bond Rating Spread over

9.65
T. Bonds (%)
AAA 0.30
6.85 – 9.65 AA 0.70
2.76 – 3.29 BBB 2.00
2.18 – 2.76 BB 2.50
1.57 – 1.87 B 4.00
1.27 – 1.57 B- 5.00
0.25 – 0.67 C 9.00
<0.25 D 12.00

Because ISCR likely fluctuates from year to year, to the extent of practicable, the ratios
can be averaged to result in one single ratio that correspondingly determines the costs of debt
or interest rates. This aggregation substantially reduces the computational complexity
involved. During the computational process, Damodaran (1994) has however alerted the
existence of a circular reference problem between ISCRs and interest rates. Users therefore
need to allow for recalculation option to resolve the problem when using spreadsheet Excel.
Instead of using arithmetic or geometric mean, the author employs a harmonic mean
technique to mitigate the impact of large outliers and aggravate the impact of small ones:

F: CONSTRUCTION MANAGEMENT / 201

 ISCRav  N  ISCR
N
1
(16)
j 1 j

where ISCRav=harmonic mean of ISCR. This approach is adopted because the ratio may be
abnormally small when the project starts commercially operating during which revenues
generated are low and interest paid is high and substantially increases to a very high level
once the project comes into fruition and the interest paid becomes much smaller.
While the cost of debt is relatively easy to determine, estimating the cost of equity is
more complex (Yescombe, 2007). Cost of equity represents the minimum rates of return
required by equity investors for accepting certain level of risk. The first stage of computing
cost of equity is to isolate the financial effect of leverage and for this purpose one need to
determine unleveraged cost of capital. The un-levering process is performed using the
following relationship (detailed step-by-step calculations are available in Brealey and Myers,
2000):

r  rD D  D  E   rE E  D  E  (17)

where r = unlevered cost of capital or opportunity cost of capital, r E=cost of equity, E=equity
market value, D=debt market value. The opportunity cost of capital is kept constant for
different debt to equity ratio (DER) as the result of the so-called Miller-Modigliani
preposition (Brealey and Myers, 2000). With DER modified, the corresponding cost of equity
is:

rE  r   r  rD  D E (18)

Debt-to-equity ratio in Eq. 18 is based on the market values. To calculate the DER for
certain period, the respective market value of unlevered project PMVk must be initially

  PBIT  1  r 
determined.

PMVk   DE j  TAX j
j k
n
(19)
j k
j

th
If the outstanding debt for k year, DMVk is known, the corresponding equity market
value EMVk should be the project market value less the outstanding debt:

EMVk  PMVk  DMVk (20)

Following Eqs. (19) and (20), Eq. (18) needs to be modified as follows:

rEk  r   r  rD  DMVk EMVk (21)

where r Ek=cost of equity for kth year, r E0=0. From equity perspective, the project is financially
feasible if the net present value NPVE is positive.

 NATCI  1  r    E  1  r 
j m
NPVE 
n m i
i
(22)
j 1 k 0 i 0 k 0
j Ek Ek

where NPVE=net present value from equity perspective. Alternatively, the accepted project
should generate equity internal rate of return (IRR) greater than the minimum required IRR.
Because multiple costs of equity serving as the minimum required IRR may exist, they should
be translated into one single equivalent cost of equity, IRRE, to which the project IRR is
compared to accept or reject the project under evaluation. Algebraically, it can be found by
solving the following Eq. (23):

202 / F: CONSTRUCTION MANAGEMENT

 0  NATCI 1  IRRE    E 1  IRRE   NPV
j m
n m
i i
(23)
j 1 i 0
j E

3.3. Optimization Problem Formulation

The model objective is to maximize the net present value from the equity perspective or
the equity IRR with equity level R being the variable. The following are the formulated
objective and constraint functions.

Max NPVP(R) or IRR (R) (24)

Subject to:

DSCRk  R  DSCRmin for all k

0≤R≤1 (25)

LLCRk  R  LLCRmin for all k

(26)

PLCRk  R  PLCRmin for all k

(27)
(28)

It is worth noting here that maximization of NPV and IRR does not automatically lead to
a unique solution of R. In some cases the optimal solutions may differ. If the host government
requires the project promoter to inject equity at least at a certain level, the additional
constraint function can be incorporated and the resulting optimization model is
correspondingly recalculated.

4. Numerical Example
A numerical example is used to illustrate the application of the proposed model. The
example is taken from a real BOT project in Indonesia. The project runs for 44 (forty-four)
years, including four years of construction. The total project investment is about Rp. 575,117
million.
The project promoter is assumed to be able to raise debt financing with a 15-year maturity
and a 10-year grace period during which no debt service is made. The debt service is made in
annual equal installments and begins at year 15. For security reasons, the creditor requires
individual DSCR, LLCR, and PLCR to be at least 1.0x. Due to very limited space available
for the paper, the detailed tables of cash flows and computations are not possibly presented
here (detailed data are available on request).
Table 2 displays the results of NPV equity, IRR, and relevant debt financial ratios for
varied R from 0.1 to 0.9 at interval 0.1. As demonstrated, both equity NPV and equity IRR
decrease as R increases. On contrary, both cost of debt and cost of equity escalate at higher
leverage levels, as theories confirm. The solutions at both R=0.1 and 0.2 are infeasible
because the corresponding DSCRmin is below the minimum level i.e. 1.0x. Accordingly, the
optimal solution should be in the range of 0.2 and 0.3. A more exact solution can be found by
a trial-error approach. Alternatively, a what-if-analysis tool Solver of latest version of Excel
can facilitate searching the optimal solution. Solver finds the optimal solution at R=0.290 that
generates the optimal NPV equity of IDR 31,130 million and IRR equity of 24.95% or it
requires the project promoter to provide equity capital in amount of approximately 30% of
total investment cost.

Table 2 Computational results for different Rs

R NPV IRR IRRE Interest DSCR LLCR PLCR
(IDR million) (%) (%) Rate (%)
0.1a 62,056 38.08 23.05 12.50 0.75 1.53 2.72
0.2a 41,625 27.79 22.69 12.50 0.82 1.72 3.07
continued

F: CONSTRUCTION MANAGEMENT / 203

 R NPV IRR IRRE Interest DSCR LLCR PLCR
(IDR million) (%) (%) Rate (%)
0.3 28,968 24.67 22.29 11.50 1.01 2.29 4.41
0.4 10,089 22.68 22.04 11.25 1.19 2.78 5.49
0.5 -8,706 21.36 21.81 11.00 1.43 3.48 7.03
0.6 -27,214 20.40 20.75 10.70 1.82 4.58 9.51
0.7 -45,442 19.66 20.63 10.30 2.51 6.55 14.06
0.8 -64,669 19.02 21.28 10.30 3.69 9.87 21.28
0.9 -83,343 18.50 21.14 10.30 7.24 19.84 42.97
a
Note: infeasible solution

5. Conclusion
This paper presents a spreadsheet based financial model for obtaining the optimal capital
structure to maximize the NPV equity of project-financed infrastructure projects implemented
under build, operate, transfer. The model takes into account the adjustments of interest rate
and cost of equity as the equity fraction changes which many papers often fail to notice. To
illustrate the model application, a numerical example is presented and examined.

6. References
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204 / F: CONSTRUCTION MANAGEMENT