Step 1. Categorize each financing component by source separately as shown in the table
below. These components should be taken from the Project Financing Plan as the
WACC is calculated only for the project—not the organization as a whole.
Step 2. Estimate the Cost of Funds. Ascertain the actual lending (or onlending)
rates, even where these may not be the current market rates, together with
the cost of equity contributed as a result of the project. Other factors:
• A cost of debt should be computed for each source of debt, (domestic
currency denominated debt, ADB debt, cofinanced debt, etc.).
• Cost of debt should include interest, service charges, commitment fees,
and front end fees as applicable. The front end fees and commitment
charges occur at the beginning of the loan term. The average cost of
debt can be estimated by totaling the entire amount of interest to be
paid over the life of the loan, with the projected commitment charges
and computed front end fee and dividing by the tenure of the loan.
• Cost of debt should be based on the face value interest rate of the debt
instrument; for example, the bond coupon rate or the interest rate
applicable to a particular loan.
• For debt instruments with a variable interest rate, the cost of debt will
vary over the life of the loan. As such, the WACC should be computed
using an estimated average interest rate. The forward London interbank
offered rate (LIBOR) swap rate is considered to be an appropriate proxy
for what the likely average cost of debt would be over the tenure of the
loan. For example, for ADB LIBOR based products, the indicative 10-
year LIBOR swap rate (as indicated by ADB’s Treasury Department)
should be used, adjusting for lending spreads and/or other charges.
• The cost of equity is more difficult to compute. In theory, it represents the
opportunity cost of investing in the project. The most appropriate cost of
equity would be the Government’s economic cost of capital. However, in
most cases, the economic cost of capital is difficult to determine. The cost
of equity should reflect the Government’s cost of raising capital, the tenure
of the investment and the risks associated with the project.
One approach to establishing a cost of equity would be to consider
the Government’s long-term bond rate (presuming bonds are issued
and are deemed to be risk free), adjusted upward to reflect the term
(i.e., bonds are often issued for 5–15 years, project investments tend
to cover a longer period), and then adjusted upward to reflect project
risks. Another approach would be to consider the desired rate of return for
an equally risky venture were it to be financed through the private
sector. The Capital Asset Pricing Model provides a methodology for
this computation. However, emerging markets may be relatively small
and underdeveloped. Determination of an appropriate beta coefficient
and market premiums may be problematic. In the absence of such a
beta, one approach would be to use a USA beta or betas for other
neighboring countries (such as India, Thailand, etc.) for the relevant
sector and adjust upwards to reflect country and project risk. The
formula to be applied is:
Nominal Cost of Equity = Rf + B * (RPm) + RPo
Where:
Rf is the risk free interest rate (i.e. government treasury
bills)
B is the equity beta
RPm is the market risk premium
RPo reflect other premiums as necessary to reflect
project specific risks.
The nominal cost of equity should be converted to real cost of
equity as noted above.
Irrespective of the methodology applied, the rationale for the cost
of equity should be noted in the financial evaluation appendix of
the RRP.
• Grant funds provided to the project also have an opportunity cost. As
such, it is proposed that grants be treated in a similar fashion to equity
and the cost of grant be assumed to be the cost of equity.
most cases, the economic cost of capital is difficult to determine. The cost
of equity should reflect the Government’s cost of raising capital, the tenure
of the investment and the risks associated with the project.
One approach to establishing a cost of equity would be to consider
the Government’s long-term bond rate (presuming bonds are issued
and are deemed to be risk free), adjusted upward to reflect the term
(i.e., bonds are often issued for 5–15 years, project investments tend
to cover a longer period), and then adjusted upward to reflect project
risks. Another approach would be to consider the desired rate of return for
an equally risky venture were it to be financed through the private
sector. The Capital Asset Pricing Model provides a methodology for
this computation. However, emerging markets may be relatively small
and underdeveloped. Determination of an appropriate beta coefficient
and market premiums may be problematic. In the absence of such a
beta, one approach would be to use a USA beta or betas for other
neighboring countries (such as India, Thailand, etc.) for the relevant
sector and adjust upwards to reflect country and project risk. The
formula to be applied is:
Nominal Cost of Equity = Rf + B * (RPm) + RPo
Where:
Rf is the risk free interest rate (i.e. government treasury
bills)
B is the equity beta
RPm is the market risk premium
RPo reflect other premiums as necessary to reflect
project specific risks.
The nominal cost of equity should be converted to real cost of
equity as noted above.
Irrespective of the methodology applied, the rationale for the cost
of equity should be noted in the financial evaluation appendix of
the RRP.
• Grant funds provided to the project also have an opportunity cost. As
such, it is proposed that grants be treated in a similar fashion to equity
and the cost of grant be assumed to be the cost of equity.
