Putting a value on early-stage infrastructure

There remains a significant amount of uncertainty regarding the progress of government initiatives in the UK’s infrastructure sector.

Investors are nervous about a lack of concrete action by the government despite a series of positive announcements, including: Chancellor George Osborne’s economic recovery plan (which has at its heart spending of £250 billion [€309 billion; $398 billion] on infrastructure investment); the second reading in the House of Commons of the Government’s Infrastructure (Financial Assistance) Bill; and an expected announcement later this year of the successor to the Private Finance Initiative (PFI). Despite all of these actions, investor confidence remains fragile due to other less supportive government decisions being enacted, such as the cut to feed-in tariff subsidies.

An interesting question for valuation practitioners is how to factor this uncertainty into the valuation of early-stage projects. The approach is far from straightforward and the lack of a standard methodology can lead to material differences in approach and opinion.

In particular, when there are disputes between parties involved in a project, the quantification of damages at such an early stage raises a surprising number of conceptual and technical challenges for valuation experts.

THE RISK PROFILE OF A PROJECT

Infrastructure projects typically include an extended planning and consultation process and have to jump a multitude of hurdles including detailed feasibility studies, permissions and regulatory agreements and the securing of appropriate funding. The existence of multiple stakeholders, especially in the context of joint venture vehicles or cross-jurisdictional projects, means that projects can, and often do, fall down before construction even starts.

The cash flow profile of a project will almost invariably include cash outflows in early years, followed by a ramp-up phase in operations and a series of medium- to long-term cash inflows as the project reaches full capacity in the operational stage. Once a project is fully operational, a discounted cash flow analysis is often the preferred approach among valuers, given the long-term nature and degree of certainty of future receipts.

An assessment of value at the early stages of the project is, therefore, far more problematic. Any valuation approach needs to address the different risk associated with each phase of the project from both an operational and financing perspective, as well as the risk of the project failing.

For example, we have seen valuations of large-scale infrastructure projects which completely disregard how the project is to be funded. Given that the typical profile of a project will include multiple periods of negative cash flow, it is essential to model the timing and scale of funding. It is also important to determine how the costs of such funding will be met in early years, as interest will need to be accrued or rolled up, if funds are not available to pay it.

ADJUSTING FOR THE ASSOCIATED RISK

There are a number of valuation approaches aimed at reflecting the risk profile of different project phases.

Some valuers advocate the discounted cash flow (DCF) method with the application of risk premia in the early stages of a project to reflect the belief that cash flows in the early phases of a project are more uncertain.

An alternative approach is to apply a probability factor to the cash flows in the DCF method.  This seeks to address the risk, at various stages of the project, that it does not overcome the required hurdles to become fully operational.  The problem with this approach, however, is that the estimation of a probability factor will be highly subjective.

Even when a DCF approach is considered appropriate, there can be disagreement between valuers as to the appropriate discount rate to apply and how to apply it.

APPLICATION OF DISCOUNT

Some practitioners advocate the application of different discount rates to the construction and operational phases of a project, while others prefer a single discount rate which reflects the risk of the project over its entire life.

The application of different discount rates to different phases of a project raises a surprising number of issues. For instance, the application of a risk premium to negative cash flows during the construction phase of a project has the opposite of its intended effect, and results in an increase in the net present value of a project. It can be argued that this is offset by the impact the higher discount rate will have on later years’ cash flows which will be discounted at the higher rate, but this depends on the method used to apply the discount rate.

Other practitioners prefer the adoption of a risk-free rate in the construction phase to reflect the fact that construction costs are known.  A premium could be argued to reflect the default risk that applies to the financing entity.

An alternative approach is the application of a risk-free rate to risk-adjusted cash flows. There are a number of methods for reflecting risk in forecast cash flows, and these vary from complex assessments of investor risk to the more straightforward  approach of applying a ‘haircut’ to forecasts.

MARKET OBSERVATIONS

Valuation theory and market practice sometimes diverge. The risk-free rate has fallen by almost 3 percent over the last five years. A simplistic view would be to expect discount rates to fall, all other things being equal. However our analysis of PFI valuations disclosed in published accounts indicates that discount rates applied by PFI investors have remained constant over the period based on the widely held view that project valuations should not be affected by short-term fluctuations in interest rates.

A further observation is that the discount rate disclosed on valuation of PFI projects is generally conservative. The implied discount rate based on a number of recently disclosed transactions tends to be materially lower than that used by operators in current valuations.

SHORTCOMINGS

The risk of applying a DCF method, when cash flows are so uncertain, is that it can lend an illusion of science to a process that, for early-stage projects at least, may be far from scientific.

Arguments between experts over the inputs to a DCF and the exact discount rate which should be used can sometimes overlook the obvious fact that the project was unlikely to even reach an operational stage.

An alternative approach is to value early-stage projects at historical cost plus a premium for the option value on further development.  The adoption of an option pricing methodology can be a useful tool for incorporating uncertainty and flexibility in valuations.

CONCLUSIONS

There is no single correct approach to reflect the uncertainty inherent in long-term projects and this can lead to a difference of opinion among valuation experts.

Determination of the most appropriate method requires an understanding of where the project is in terms of lifecycle, the risks associated with project returns at that point in time, as well as consideration of how the project is to be funded. It also requires an appreciation that complex financial models or financial simulations are of limited value in the absence of sound commercial reasoning and familiarity with current industry practice.

Susan Blower is a senior manager, share and business valuations, in the London office of BDO LLP, the audit, accounting and business services firm.