CAPM-Based Valuation of Financial Government Supports to Infeasible and Risky Private Infrastructure Projects

Abstract

Driven by acute fiscal problems and disenchantment with the performance of publicly delivered quality services, many governments in both industrial and developing countries are now relying on the private sector to deliver infrastructure services. In the context of private infrastructure financing, the provision of governmental support is not uncommon. The present paper discusses the theoretical framework of the valuation of the financial impact of support on the cost of debt, cost of equity, the expected return on equity (ROE), and the project's net present value (NPV), based on the capital asset pricing model (CAPM) within a single-period context. Special focus is placed on a minimum revenue guarantee, a direct cash subsidy, and a subsidized subordinated debt. This paper shows that a guarantee reduces the cost of debt and can increase or decrease the cost of equity depending on the leverage, while a subsidy increases only the cost of equity. A subsidized subordinated debt increases both the cost of senior debt and the cost of equity. For all cases, all the supports improve the NPV because the expected increase of ROE can more than sufficiently offset any change in the cost of equity. This paper is of interest to academics because it provides the theoretical analysis of how a support can affect the rates of return expected by debt and private equity investors from risky and, probably, infeasible privately financed infrastructure projects. Practitioners, particularly those from the public sector, can also benefit from research findings that may inform decision makers about what support to provide.