# Economic Principles of PPP Valuation CAPITAL BUDGETING.

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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 : PPP Expressway,, PPP bridge, Housing projects, etc..

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 2 nd 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 2 nd 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

Time Periods in Years 0 1 2 …… 14 Revenue-1 - - - Revenue-2 - - - Total Revenue - - - Variable Cost-1 Variable cost-2 - Total Variable cost - - - Total Fixed cost - - - Total Cost - - - Format of Financial Analysis of PPP Projects - Part 1

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 2

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 3

Time Periods in Years 0 1 2 …… 14 INVESTMENT COST Machinery Cost - Structure Cost - Physical Contingency & misc. cost - Total - Working Capital - Total Investment and Working Capital - Continuation of Financial Analysis Format - Part 4

Time Periods in Years 0 1 2 …… 14 Total Revenue --- Total Cost --- Gross Profit --- Loan - Principal and Interest Repayment (Equal Annual Installment) - --- Equity - Total Investment & Working Capital - Cont. to next slide Summary of Complete Format For Financial Analysis - Part A

Time Periods in Years 0 1 2 …… 14 CASH FLOW Gross Profit – Principal - Interest Per period --- - Cumulated --- - B/C Ratio - 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) Complete Format For Financial Analysis - Part B

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