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Basic Financial Concepts in PFI Contracts Avoiding financial bear-traps

March 2004. Yescombe Consulting. (1). NPV / IRR cash flow calculations. Two key financial concepts are used for measuring cash flows and returns in PFI deals:Net present value (NPV)Internal rate of return (IRR)The calculations may be based on:project cash flows before funding (e.g. project IRR)project cash flows to investors (e.g. equity IRR)pre- and post-tax cash flows (e.g. pre-tax equity IRR)nominal and real cash flows (e.g. nominal pre-tax equity IRR) Cf. OGC

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Basic Financial Concepts in PFI Contracts Avoiding financial bear-traps

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    1. 4 March 2004 Basic Financial Concepts in PFI Contracts Avoiding financial bear-traps Edward Yescombe Yescombe Consulting Ltd. www.yescombe.com SMi Conference on Financial Modelling in PPP/PFI

    2. March 2004 Yescombe Consulting (1) NPV / IRR cash flow calculations Two key financial concepts are used for measuring cash flows and returns in PFI deals: Net present value (NPV) Internal rate of return (IRR) The calculations may be based on: project cash flows before funding (e.g. project IRR) project cash flows to investors (e.g. equity IRR) pre- and post-tax cash flows (e.g. pre-tax equity IRR) nominal and real cash flows (e.g. nominal pre-tax equity IRR) Cf. OGC “Guidance on Certain Financing Issues in PFI Contracts - Section 3: The Use of Internal Rates of Return in PFI Projects” (2002 - to be revised shortly)

    3. March 2004 Yescombe Consulting (2) Use of NPV / IRR calculations in PFI NPV / IRR may be used to calculate, e.g.: the Public Sector Comparator the Unitary Charge at Financial Close U/C for funded capex on Compensation Events, Authority Change, or Qualifying Changes in Law compensation for Authority Default / Voluntary Termination “Value for Money” adjustments Estimated Fair Value of Contract on Contractor Default Refinancing Gain to be shared with the Authority

    4. March 2004 Yescombe Consulting (3) Many a Slip… Calculations may be outputs from the financial model or future calculations set out in the PFI Contract They all mean real money to the Authority but... Problems in the use of such financial concepts in PFI: Misunderstanding Misuse Mistaken use Gaps in standard PFI Contract provisions

    5. March 2004 Yescombe Consulting (4) Net Present Value (NPV) NPV assesses the value of a future cash flow today the choice between different investments if projects pass a “hurdle rate” of return

    6. March 2004 Yescombe Consulting (5) Internal Rate of Return (IRR) IRR measures the investor’s return on a project Basic IRR calculation - Higher IRR for Investment A - cash received quicker

    7. March 2004 Yescombe Consulting (6) NPV & different-sized projects NPV is biased in favour of bigger projects: NPV suggests D is better, but: Investment C: 1000 of investment produces 1400 of benefit Investment D: 1000 more of investment produces only 1200 more of benefit (hence the lower IRR)

    8. March 2004 Yescombe Consulting (7) IRR and cash-flow timing Calculation depends on reinvestment at IRR rate And does not work if there are mixed +ve/-ve flows

    9. March 2004 Yescombe Consulting (8) Modified IRR (MIRR) MIRR uses a realistic reinvestment rate -

    10. March 2004 Yescombe Consulting (9) Summary: Issues with NPV and IRR NPV calculations are misleading if used to compared two projects of different sizes IRR calculations exaggerate the value of early cash flows and understate the value of later cash flows

    11. March 2004 Yescombe Consulting (10) The Green Book - use of NPV The 2003 Green Book relies only on NPV to evaluate projects because of distortions caused by using IRR But this does not take account of the distortions caused by using only NPV for different-sized projects Which can be dealt with by looking at the cost/benefit ratio (but the Green Book does not say this):

    12. March 2004 Yescombe Consulting (11) IRR: (1) VfM clause MoD PFI contracts have commonly had a “value for money” clause which states that if the equity IRR exceeds x% (measured say every 5 years), the excess is shared with MoD But reaching an IRR threshold in the early years is very difficult - IRR is a project life measurement:

    13. March 2004 Yescombe Consulting (12) IRR: (2) Refinancing Gain-sharing SoPC requires 50:50 sharing of Refinancing Gains A Refinancing Gain is defined in SoPC as: the NPV of projected equity distributions post-refinancing minus the NPV of projected equity distributions pre-refinancing OGC recommends the nominal post-tax base case equity IRR as the NPV discount rate No sharing of refinancing gains if projected post-tax nominal equity IRR (over project life) is below base case Issues: Paradox that a higher discount rate generally produces a higher NPV (& hence gain to be shared) Cash v. commitment IRR in base case comparison

    14. March 2004 Yescombe Consulting (13) Refinancing Gain - Discount Rate

    15. March 2004 Yescombe Consulting (14) Base Case IRR: Cash v Commitment Base case IRR for VfM or Refinancing Gain-sharing threshold) should be measured on cash investment not just commitment of cash (or adjusted for this):

    16. March 2004 Yescombe Consulting (15) Termination - Contractor Default Compensation payment by the Authority on termination for contractor default “Estimated Fair Market Value” method (where there is no actual market) of calculating CompOnTerm = NPV of future Unitary Charges minus NPV of estimated future costs to the Authority NPV discount rate is nominal pre-tax project IRR Traps (small points with large financial effects): Mixing up real and nominal cash flows, especially where Unitary Charge is partly indexed Use of post-tax IRR instead of pre-tax Inadequate compensation for cost overruns — Any of which inflate the termination sum payment

    17. March 2004 Yescombe Consulting (16) Trap (1) - Real & Nominal Numbers Termination sum calculation based on NPV of inflated cash flow at nominal discount rate, or deflated cash flow at real discount rate

    18. March 2004 Yescombe Consulting (17) Trap (2) - Pre- and Post Tax As projected Unitary Charges are pre-tax the discount rate for the termination sum must also be pre-tax:- i.e. don’t mix apples and oranges N.B.: “Tax” means Project Co’s tax not investors’

    19. March 2004 Yescombe Consulting (18) Trap (3) - Covering Cost Overruns Authority’s future costs are deducted from the future Unitary Charges to produce net termination sum But discounting future costs at project IRR does not cover the Authority for future cost overruns :

    20. March 2004 Yescombe Consulting (19) Conclusions Small changes in words (e.g. nominal / real; pre / post-tax) may have large financial consequences When NPV and IRR calculations appear in a PFI deal, ask the questions: Why are they calculated in this way? Is this consistent and logical? You don’t need to be a financial modeller to do this. But the financial modeller must be part of the team, not stuck in a cupboard, and must understand what the PFI Contract is trying to do Contract standardisation (SoPC) does not remove the need for thought Documents govern the model, not vice-versa Financial advisers are not infallible…

    21. March 2004 Yescombe Consulting (20)

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