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Appraising PPP Projects

46.1 The Macroeconomic Assumptions

A relevant group of data that should be put into the Model are the macroeconomic assumptions. General inflation, relative inflation, base interest rates, risk-free interest rates, and exchange rates are key elements for long-term estimates.

General inflation and relative inflation are the first group of assumptions. It is generally good practice to construct the model in nominal terms (that is, including projected inflation).

The model is sometimes designed in real terms, rather than nominal terms, that is, without the effect of general inflation in either costs or revenues. The rationality behind this decision is the following: if the contractually determined revenues and the total expenditures follow the exact same inflation, one can consider a free cash flow in the monetary units of today[12]. This technique appears to simplify the model where all the values are expressed in constant terms.

However, since relative variations of costs are very likely in the long term, and some items are not directly affected by inflation (for example, traditional debt repayments), this simplification distorts the conclusions. Therefore, when there are reasons to believe that costs will vary in relation to each other or the indexation of revenues can differ from the cost variations in time, the model should be designed in nominal terms (including projected inflation) to avoid significant distortions.

The risk-free interest rate (the interest rate at which the respective government issues debt for the relevant term) is also an important macroeconomic assumption. It can be used (together with a risk premium – see chapter 2.8.1) in estimating the minimum expected return required by equity investors. Some countries also use it as a discount rate for estimating the present value from the government’s perspective (see chapter 3, section 3.8.1) in Value for Money (VfM) calculations and in the assessment of Fiscal Impacts. These uses will be detailed further throughout the chapter.

Exchange rates are particularly relevant when a source of foreign capital is considered and the borrowings can be in foreign currency. They are also relevant when a part of the expenditures is indexed to foreign currency (for example, when a relevant proportion of capital expenditures is spent with imported equipment).

All these variables should be estimated for the duration of the contract, with the best available information. Market data, when available, should be a preferred source (for example, hedge contracts for exchange rates, implied inflation from inflation-indexed bonds, and so on). Another possible source of projections is governmental agencies responsible for economic policy or macroeconomic consultancy companies.

When the results of the financial model are particularly sensitive to some of these variables, they should be included in the sensitivity analysis mentioned in section 8.4.

 

[12] The use of the Model in nominal or real terms also affects the analytical tools used to assess commercial feasibility such as the Internal Rate of Return and the Net Present Value (see section 8.1). This choice, along with the operation of the analytical tools, should thus be made by a technically experienced team to avoid misleading conclusions.

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