Nominal and Real Value of Money
The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing […]
Degree of Financial Leverage Ratio
A high debt equity ratio makes the company financed by debt more than by equity. Therefore there are fixed interest payments involved. Hence when the going is good, the company makes a handsome return as a small percentage of change in EBIT creates a large percentage change in earnings per share. However the inverse of […]
Disadvantages of Black Friday Sales (Deep Discounting)
In the previous article, we have already seen what Black Friday sales or deeply discounted sales are. We also know the economic rationale behind such sales. Some of the benefits which are derived from these sales have also been discussed in the previous article. However, it would not be appropriate to say that deeply discounted […]
Accounting for Player Contracts
Sporting franchise clubs are business entities at the end of the day. Even though some of them may not be running their operations to maximize their profit, they are still considered to be “for-profit” entities. Hence, ideally, their accounting is supposed to be similar to other business entities. However, this is not the case. There […]
Financial Goal – Profit vs Wealth
Every firm has a predefined goal or an objective. Therefore the most important goal of a financial manager is to increase the owner’s economic welfare. Here economics welfare may refer to maximization of profit or maximization of shareholders wealth. Therefore Shareholders wealth maximization (SWM) plays a very crucial role as far as financial goals of […]
In every public-private partnership, it is the job of the public party to provide remuneration to the private party. There are various mechanisms in which this payment can be provided. In this article, we will discuss the mechanisms which are commonly used in public-private partnerships.
User charges are a commonly used mechanism when it comes to providing compensation to private parties in a contract. Toll roads and bridges are the best examples of how user charges can be used to provide remuneration to private parties. This mechanism has limited usability since it can only be used when the number of users is expected to be significant.
In case, user charges are chosen to be the remuneration method, and the private party is given the authority to collect money from the common people. However, the rate cannot be fixed by the private party. Since toll roads and other infrastructure projects fall under the category of monopoly services, their prices are heavily regulated. Hence, the government fixed the prices even though the private party collects them.
The prices which can be charged in such projects are not fixed arbitrarily. Instead, they are charged based on a pre-agreed formula. This formula takes into account factors such as traffic and inflation in order to decide the rates which will be paid by the public. In other cases, the prices are decided by a government-appointed committee. In some cases, a combination of the two approaches mentioned above is used.
A major criticism of the user fees model is that it is used to line the pockets of private contractors. Critics of the model often say that the revenue formula shows unrealistically low assumptions. As a result, per unit charges are increased. In reality, the traffic is much higher than the projections. As a result, the higher unit charge multiplied by higher traffic creates massive revenue. This revenue is used to enrich a handful of contractors at the expense of the larger public.
To overcome the shortcomings of this model, revenue-based payments are often used. This model operates just like the user charges model. There is only one key difference. The difference is that a ceiling level is set. Once the ceiling is reached, the payments no longer go to the private sectors. Instead, the excess payments go to the government. The benefit is that the risks and rewards of both parties are managed. The private sector faces a lower risk since they have the first right to receive compensation.
In many cases, the government guarantees a fixed payment to the private sector. In such cases, the risk of the private sector virtually goes down to zero. This is because they have a predictable stream of cash flows, which they can look forward to as long as they perform the tasks which they are supposed to.
If the quality of the work is below the agreed-upon quality, then the contractor may have to face some fines and penalties.
Similarly, if the work is behind schedule, there may be some more fines and penalties. Thus the private party only carries execution risk.
On the other hand, the demand risk is managed by the government. If the demand is lower than expected, there is no impact on the private party since they still get paid. Such contracts are considered to be quite favorable to the private sector. Hence, they are usually awarded when the government is trying to encourage the private sector to invest in public works projects.
In certain extraordinary cases, the payments related to an infrastructure project is not derived from the project. Instead, it is derived from a third-party source. This is often done when the project involves the use of a new or unproven technology where the financial inflows are difficult to predict. For instance, solar energy is a relatively new mode of energy. Hence, it would be incorrect to assume that it will be financially viable from day one.
In such cases, the government funds infrastructure projects related to solar energy by levying a tax on other goods and services. Commonly the tax is levied on the economic alternatives in order to make them more expensive. The money collected from these taxes is paid to the private party executing the project. Sometimes a fixed dollar amount is collected. At other times, private sector companies are willing to bear the risk of the uncertainty involved.
The bottom line is that the payment mechanism is considered to be vital for infrastructure projects. This is because of the fact that these mechanisms determine who will be bearing which risk. If the wrong payment mechanism is used, it creates a weak foundation for the entire project.
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Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance
February 12, 2025
