Economic Principles of
PPP Valuation
CAPITAL BUDGETING
• Economic Valuation Means
• Valuations of
Investment projects, like PPP Projects
• It is also known as Capital budgeting.
• This shows how capital fund or
investment is used
• Examples are :
projects, etc..
PPP Expressway, , PPP bridge, Housing
Principles of Valuation
1. Finding present value of benefits
materializing over its lifetime and present
value of costs incurred over the lifetime.
1. Comparing the rate of return of the invested
capital with the opportunity cost of the
capital.
Principles of Valuation: Financial –
Simple one period case
EXAMPLE OF AN INVESTMENT
DECISION
Country A wants to start a PPP Housing
Project and buys land worth Tk 8.5 billion
with the assumption that it will sell land
next year when land value will rise to Tk.
9.3 billion.
Common men usually will calculate 9.4 % profit (9.3 – 8.5 )/ 8.5= 9.4%
profit. However this calculation is wrong.
Principles of Valuation: Financial one period case
• Finding Present Value of Tk9.one year
later.
• Formula used, PV = 9.3/ (1+ 0.1)
(Assuming rate of interest is 10%)
• PV becomes equal to Tk8.45
Principles of Valuation: Financial one period case
• Net Present Value of Investment
= -8.5 + 8.45
= - 0.05
The value of the PPP investment is –0.05 when all
the benefits/values and all the costs are converged
in time scale. E.g., at time zero or present time
Benefit /Cost Ratio of the project
• B/C ratio = Present Value of Benefit/ Present value of
cost
• 8.45 / 8.5
• = 0.99
• Unviable PPP project as B/C is < 1
• It is better to use money in alternative investments
like buying government bonds or keeping money in
FDRs.
Principles of Valuation: Financial –
multi-period case
• 2nd Example
Country A wants to start a PPP Housing
Project and buys land worth Tk 8.5 billion
with the assumption that it will sell a part of
the land at Tk 5 billion one year later and
remaining at Tk 4.5 billion two year later.
Principles of Valuation: Financial –
multi-period case
• Finding Present Value (PV) of Tk 5 billion
one year later
• Formula used, PV = 5/ (1+ 0.1)
• Assuming rate of interest is 10%
• PV becomes equal to Tk 4.54 billion
Principles of Valuation: Financial –
multi-period case
• Finding Present Value of Tk4.5 billion two
year later
• Formula used, PV = 4.5 (1+ 0.1)**2
(Assuming rate of interest is 10%)
• PV becomes equal to Tk3.72 billion
Principles of Valuation: Financial –
multi-period case
• Cash-flow at time zero is:
= -8.50 + 4.54 + 3.72
= - 0.24
The value of the PPP investment is –
0.24 when all benefits and costs where
converged into a singular time. E.g., at
time zero e.g., present time.
Calculation of B/C ratio in
multi-period case
B/C = Present Value of Benefit streams/
Present Value of cost streams
B/C = 8.26/ 8.50 = 0.97
Unviable Project,
General formula for Calculating
Benefit-Cost or B-C Ratio
• In this measure, Present Value of the Benefit
stream is divided by Present value of the
cost stream.
n
• { Bt = B1/(1+ri) + B2/(1+ri)**2 …upto n
t =1
n
{ Ct = C1/1+ri + C2/(1+ri)**2 …upto n
t =1
If the ratio{ Bt / { Ct > 1, the project is said to
be viable that is, benefit outweighs cost.
Net Present Value (NPV)
• In this measure, Present Value of Benefit
Stream is subtracted from Present value of
cost stream.
n
• { Bt = B1/(1+ri) + B2/(1+ri)**2 …upto n
t =1
n
{ Ct = C1/1+ri + C2/(1+ri)**2 …upto n
t =1
If NPV ={ Bt - { Ct > 0, the project is said to
be viable – benefit outweighs cost.
Limitations of B/C ratio and
NPV
Both B/C ratio and NPV provides some
numerical value about the viability of the
Project.
• However none of the B/C ratio and NPV
allows us to compare the project benefit to
the cost of the fund e.g., using money for
alternative use or keeping money at bank at
certain rate of interest.
IRR or Internal Rate of Return (IRR) is the most
widely used indicator.
IRR is a rate at which “net present value of
benefits – costs” is zero
0
=
=
{ Bt – Ct
B1-C1/(1+irr) +B2-C2/(1+irr)**2
t =1 ..n
upto n
IRR is that value that makes NPV = 0
• This means that if prevailing bank interest rate
(ri) is below (irr) then NPV > 0.
• Suppose for 8% value of IRR, NPV becomes
zero
• Now if we use a figure of 6%, NPV will turn to be
a positive number rather than zero. As irr is in
the denominator.
• On the other hand if we use a figure of 10%,
NPV will turn to be a negative number rather
than zero.
Example of IRR Calculation
• Land Purchase 1st Example
• We had a cash flow
• 0 = -8.5 +9.3/ (1+irr)
Continuation of IRR Calculation
•
•
•
•
•
Or,
or 8.5 = 9.3 / (1 +irr)
or 8.5 + 8.5 irr = 9.3
or 8.5 irr = 9.3 – 8.5 = 0.8
or
irr = 0.8 / 8.5 = 9.4%
Example of IRR Calculation
Land Purchase 2nd Example: NPV =
-0.24 = 5.0 / (1 +.1) + 4.5 / (I+0.1)**2
0 = 50,000 / (1 + irr) + 45,000 / (I +irr)**2
Using Excel Program, irr = 8%
Internal Rate of Return
• It shows the maximum interest rate that
an enterprise could pay on the capital
invested and still break-even financially
( e.g, NPV is either zero or positive).
• IRR is that rate that equalizes present
value of the initial investment (-ve
cash-flows) with the present value of
the future cash flows (+ve cash-flows).
IRR is regarded as the most complete
measure of the return on investment
from the view point of investor
.
COST Estimates:
Different components of costs
• Listing of all costs (local, foreign, capital,
recurrent, material, service):
• Construction cost
• Consultancy cost
• Incremental Administration cost
»Cont. to next slide
• Initial working capital cost
• Taxes and duties
• Cost of monitoring, reporting of the
project etc.
BENEFIT Estimates
• Listing all sorts of revenue like:
• main products,
• by-products,
• Direct and indirect benefits etc.
Format for Capital Budgeting
• Capital budgeting format
can be developed in Excel
program
Format of Financial Analysis of PPP
Projects - Part 1
Time Periods in Years
0
……
1
2
Revenue-1
-
-
-
Revenue-2
-
-
-
Total Revenue
-
-
-
Variable Cost-1
-
-
-
Total Fixed cost
-
-
-
Total Cost
-
-
-
Variable cost-2
Total Variable cost
14
Continuation of Financial Analysis
Format - Part 2
Time Periods in Years
0
1
2 ……
14
(TOT REV – Total
Cost)
Gross Profit
-
-
-
Value
Addition/contributi
on to GDP
(REV –
Intermediate Cost)
-
-
-
Continuation of Financial Analysis
Format - Part 3
Time Periods in Years
0
1
2 ……
14
FINANCING
Loan e.g., 70% of
total PPP cost
-
Repayment
Principal
-
-
-
-
Interest
-
-
-
-
Total
Equity
30%
Continuation of Financial Analysis
Format - Part 4
Time Periods in Years
0
1
INVESTMENT
COST
Machinery Cost
-
Structure Cost
-
Physical
Contingency &
misc. cost
-
Total
-
Working Capital
-
Total Investment
and Working
Capital
2 ……
14
Summary of Complete Format For Financial Analysis - Part A
Time Periods in Years
0
1
2 ……
14
Total Cost
-
-
-
Gross Profit
-
-
-
-
-
-
Total Revenue
Loan
-
Principal and
Interest
Repayment (Equal
Annual
Installment)
-
Equity
-
Total Investment &
Working Capital
Cont. to next slide
Complete Format For Financial Analysis - Part B
Time Periods in Years
0
1
2
……
14
CASH FLOW
Gross Profit –
Principal - Interest
Per period
-
-
-
-
Cumulated
-
-
-
-
Excel gives
result
when
Formula
applied to cash-flow
(per period)
NPV
-
Excel gives
result
When
formula
applied to cash-flow
(per period)
FIRR (%)
-
Excel gives
result
When
Formula
applied to cash-flow
(per period)
B/C Ratio
Practical Lessons
SENSITIVITY ANALYSIS
• This is done to test robustness or sensitivity
of the measure to critical variables.
• For example, what would be the effect on IRR
for say 10% rise in investment costs or 10%
decline in sales revenue.
• Sensitivity analyses allow identifying design
options so as to reduce risks.
ECONOMIC ANALYSIS
• Reasons:
• Due to various distortions in the prices of
inputs and outputs, true “scarcity” of the
resources is not reflected.
• For example, due to un-competitive labor
market, labor wages are artificially blown -up.
•
• Similarly, due to over-valuation of local
currency compared to the foreign currency,
imports are artificially made cheaper.
• Therefore these need to be corrected.
ECONOMIC ANALYSIS
• A conversion factor is used to adjust wages
and salaries.
• A Shadow exchange rate factor is used to
convert non-tradable to tradable.
• Similarly in case of exportable and imported
products, corrections are made for taxes and
transfers.
• Once corrections are made, B/C ratio, NPV
and EIRR are calculated in the usual manner(
same as financial analysis).
The End