3.4.5. Cost of capital in project finance - WACC

Despite all required securities and guarantees required to address the investors and lenders risk profile all project participants expect certain minimum economic return of their investment.

The minimum rate of return (from the investors view) is equal to the cost of capital (from the projects view). The cost of capital can be calculated as weighted average of the cost of available capital.

Though the height of equity is adding security to the lenders it also impacts the chances of realization as the weighted average cost of capital (WACC) for the project changes and along with this the minimum return the project is expected to deliver. As the cost for equity is usually higher than the cost for debt 61 and as the return to equity is paid after tax whereas the interest for debt is tax deductable the WACC increases.

With WACC = weighted average cost of capital, i_E = cost of equity, i_D = cost of debt, T = tax rate, D = debt, E = equity

The cost of debt is the interest rate that project and lender have agreed to, whereas the cost of equity is the sponsors expected rate of return. The latter is not fixed but the evaluation of the projects economic profitability has to result in a return to equity that is equal or higher as the sponsors’ expectation with reasonable probability to attract sufficient equity volume.

Only when the project’s ROE is greater than the expected return it creates added value for the shareholder.

⁶¹ Because of the function as risk capital as discussed in chapter 6.2