return to equity, financial structure and risk

8/10/2019 Return to Equity, Financial Structure and Risk

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By Ajay Jain

Prashant Fegade


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Traditional method- Government providesinfrastructure facilities

Modern Method- Private sector investment

Why such a shift? Limitation of Governments in developing countries

New models for private participation

Efficiency gain from private participation

Economic benefits from the infrastructure


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Why should invest? Appropriate rate of return on equity

Tolls and tariffs to recover operating costs and providereturn on capital employed

ROE overall viability and acceptability

Most elements of cost can be decided by market prices,ROE cannot be.


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Depend on Risk of cash flows

Financial structure(i.e debt to equity ratio)

Risk Mitigation contracts( BOOT, BOT, BOOST etc.)


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1. BOOT scheme- an extension of project financing

Assets, contracts, inherent economics and cash flowsare separated form promoters

Assets- Collateral for loan Loan payment made from the cash flows

2. Corporate Financing/ Balance sheet financing

Lenders looks the cash flows and assets of the whole

company to service the debt and provide security


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Made possible by combining undertakings and variouskinds of guarantees by parties interested- no one partyalone has to assume full credit responsibility

BOOT projects can be solicited or unsolicited.


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Allocate risks to those party who are best in position tocontrol particular risk factor.

Reduces Moral Hazard problem and minimizes cost

of bearing risk1. Project completion risk

2. Market Risk

3. Foreign Exchange risk

4. Supply of inputs

5. Government Guarantees


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Developing countries have pattern of 20-30 percentequity and 70-80 percent debt.

Power projects 68:32

Telecom 1:1


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Both are functions on risk of cash flows Guarantees and risk mitigation arrangements affect the

risk of cash flow Difference between ROE and IRR

ROE should be commensurate with risk of cash flow toequity Risk of cash flow depends on uncertainty of revenues and

operating and financial leverage ROE determined by another existing project with same

business risk Risk is measured by Ks =kRF + (kM - kRF).


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Determines overall distribution of risk and return between twoclasses of investors

Increasing debt- increase risk and return to equity

Risk and return to debt also increases to account for the increasein bankruptcy risk.

Change in financial structure leaves risk and return, andtherefore the value for the firm as a whole unchanged

Alternative interpretation-structure doesnt affect cost of capital

If debt is cheaper than equity, increased proportion increases the

risk and cost of equity-overall cost remains same Interest on debt is tax deductible

If income from infrastructure enjoys tax benefits advantagesreducing debt


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Implications for financial distress Interest and principal repayments on debt have to made

as per schedule no fixed commitment for dividendpayments

Project with lower level of debt has greater flexibility inmanaging cash flows Cost of financial distress may not be an important

consideration for projects in presence of guarantees reduce risk of project cash flows

Government restrictions In India 4:1 Consideration of government ECBs and minimum

equity participation


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ROE will be determined by the risk of specific projects,sectors and countries taking into account guarantees

Development period has the highest risk with thepromoter running the risk of project being abortedbefore financial close or the development periodtaking longer and requiring more resources

Implications for government to reduce delays and

uncertainties . Competitive bidding


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return to equity, financial structure and risk

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