A guidebook on public-private partnership in infrastructure

Cost of capital = Return on debt x % of debt + Return on equity x % of equity
Box 1. How subordinate debt helps in debt financing 
The revenue available for debt service is used first to meet the senior 
claims. If revenue is still available, it is used to meet the junior claims 
(subordinate debt and thereafter equity). A simplified example below shows how 
it works in reducing the burden of debt on a project. 
Amount 
Coverage 
Ratio 
Revenue:
$1,050 
Senior claims:
$700 
1,050/700 = 1.50 
Junior claims: 
$230 
1,050/(700+230) =1.13 
On a combined claim (if the whole amount of loan was of the same type, 
i.e. senior debt), the coverage ratio is 1.13, which may be considered low and 
may not qualify for cheaper credits. The coverage ratio, however, is significantly 
improved if the debt is divided into two parts: a senior debt and a subordinate 
debt. As the senior debt is only a portion of the total debt and has the first claim 
on all the revenues available for debt service, its coverage is increased to 1.5 
and its credit quality would be enhanced. The credit quality is very important to 
debt financing. With a good credit rating the project may also be bond financed. 
As the cost of bond financing is generally lower than commercial borrowing from 
banks and financial institutions, bond financing can also significantly enhance 
the financial viability of a project. 
The availability of subordinate debt helps in reducing the risk to senior debt 
lenders and allows the project sponsor to borrow at lower interest rates. The 
subordinate debt provider, however, absorbs a share of the risk if revenues fall 
short of debt service requirements. 
Because of this feature of subordinate debt in reducing the monetary cost 
of debt, some governments provide loans to implementing agencies (under 
public credit assistance programmes) to improve the credit quality of senior 
debt. It lowers the risk to lenders and helps the implementing agency to obtain 
loans at a lower interest rate reducing the debt burden on the project. 
_______________ 
Source: 
Based on an example given in a publication of the Federal Highway 
Administration, US Department of Transportation (undated). Innovative 
Finance Primer, Publication Number FHWA-AD-02-004, available at 
http://www.fhwa.dot.gov/innovativeFinance/ifp/ifprimer.pdf