A guidebook on public-private partnership in infrastructure

Financial structure 
Careful analysis of alternative financial structures is required to establish the 
right financing structure for a project. As the expected return on equity is higher than 
return on debt, the relative shares of debt and equity in the total financing package 
have important implications for cash flow of the project. Their relative share is also 
important for taxation purpose (generally, the higher the debt the lower is the tax on 
return).
Higher proportion of debt, however, requires larger cash flow for debt 
servicing. This could be problematic, particularly in the early years of project 
operation when the revenue earnings are generally low. This is a typical situation 
faced by transport and water sector projects. In such a possibility, the risk of default 
would be considered high.
Cost of capital 
The cost of capital for a project is a weighted sum of the cost of debt and the 
cost of equity. Risk is an important element which is factored in to determine the cost 
of debt and equity.
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Lenders determine risk premiums to take into account the 
assessed levels of risks from various sources. These are added to risk-free rate of 
borrowing to determine the required return on debt finance. The risk-free rate of 
borrowing is practically the rate at which government can borrow money from the 
market.
Similarly, the cost of equity is defined as the risk-weighted projected return 
required by the investors. However, unlike debt, equity does not pay a set return to 
its investors. The cost of equity is therefore established by comparing the investment 
to other investments with similar risk profiles.
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23.
The viability gap funding scheme of the Government of India is an example of an institutional mechanism for 
providing financial support to public-private partnerships in infrastructure. A grant, one-time or deferred, is 
provided under this scheme with the objective of making projects commercially viable. The viability gap 
funding can take various forms including capital grants, subordinated loans, operation and maintenance 
support grants, and interest subsidies. A mix of capital and revenue support may also be considered. 
A special cell within the Ministry of Finance manages the special fund, which receives annual budget 
allocations from the government. Implementing agencies can request funding support from the fund 
according to some established criteria. In case of projects being implemented at the state level, matching 
grants are expected from the state government. 
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The cost of capital is often used as the discount rate, the rate at which projected cash flow is discounted to 
find the present value or net present value of a project. It is also important to mention here that consideration 
of the cost of capital is required to determine an appropriate tariff level by the government or by a regulator. 
Ideally, the Internal Rate of Return of a project should be equal to its cost of capital. If IRR is greater than the 
cost of capital, the concessionaire/investor makes excess profit, and if IRR is less than the cost of capital, 
the concessionaire/investor loses money and may even go bankrupt. 
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There are methodologies to establish the expected rates of return on debt and equity. For example, the 
capital assets pricing model or CAPM is used to determine the expected return on equity for a particular type 
of asset. Governments (through the Treasury or Ministry of Finance) may also establish the expected rates 
of return considering alternative investment opportunities and the level of risks involved in different types of 
infrastructure projects in their countries.

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A Guidebook on Public-Private Partnership in Infrastructure 
43 
 
Once these rates of return on debt and equity are established, the cost of 
capital can be determined as follows: