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Assessing the Cost of Capital for PPP Contracts

Abstract

This chapter outlines the theoretical frameworks and practices used by firms to estimate the appropriate rate of return on their investments in healthcare PPP projects. Our aim is to outline the appropriate method for assessing the “reasonableness” of returns, drawing on capital budgeting theory. We focuse on estimates of the cost of capital for the direct investor of primary equity in the SPV. In other words, we are interested in the rate of return that directly affects the bid and contract price, because this is the price that is ultimately be paid for by the users of the infrastructure or technologies to which the project relates. The cost of equity is, in this sense, an important variable in the financial appraisal and value-for-money analysis for the PPP.

Keywords

  • Capital budgeting
  • IRR
  • economic efficiency
  • cost of capital
  • value-for-money
  • market psychology

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Notes

  1. 1.

    The effect of the Blume adjustment is to reduce the difference between the Beta and the market average (i.e. 1). Blume (1971) found that adjusting estimated Equity Betas towards unity improved their ability to forecast subsequent period stock returns. The most widely held explanation for this is that unusually low or high Betas are subject to measurement error. Blume adjustment is standard in the calculation of Equity Betas by regulators in respect of the UK, USA and Australian utilities in determining the appropriate rate of return to investors, and is recommended in the most prominent corporate finance textbooks (e.g. Brealey et al. 2008). Blume-adjusted Betas are available from most commercial databases, such as Bloomberg and the London Business School Risk Management Service. The formula is: Blume-adjusted Equity Beta = (0.67)* βOLS + (0.33)*1.

  2. 2.

    In addition, our interviews and survey data suggest liquidity risk is carefully considered an adjustment of the EMRP, for the market capitalisation is a common approach, and is done by adding a premium to the expected return (from the CAPM) of small cap stocks (Damodaran 2016b). For example, to take into consideration illiquidity, an extra premium of 3–3.5% is added, reflecting the excess returns earned by smaller cap companies over very long periods (Damodaran 2016b).

  3. 3.

    The PRS group considers political, financial and economic risk indicators to come up with a composite measure of risk for each country that ranks from 0 to 100, with 0 being highest risk and 100 being the lowest risk. http://www.prsgroup.com.

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Hellowell, M., Vecchi, V. (2018). Assessing the Cost of Capital for PPP Contracts. In: Vecchi, V., Hellowell, M. (eds) Public-Private Partnerships in Health. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-69563-1_5

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