Good morning. It is Friday, and we really wish to finish the saga Entrepreneurs without Money. I have a lot to share, so let´s start.

Technically, the cost of capital is the weighted average cost of capital that we have to use when discounting the cash-flows of a proposed project. The CAPM or Capital Asset Pricing Model is a methodology. It is used to calculate the cost of equity which is part of the cost of capital.

 The CAPM can´t be taught in one blog publication. It is not possible. It took me several courses (semesters) to study it, digest it and understand it when I was doing my postgraduate studies. In addition, as a practitioner, I have learned to apply the theory by doing the valuation of capital investments; and the calculation of the cost of capital is like the basic tool or the equivalent “pruning shears” for gardeners.   I will be happy to advise you in relation to the heart and soul of CAPM details if you write to me.

For today, my purpose is to trigger in you the desire to understand the CAPM as the methodology utilized to calculate the cost of equity, which is a component of the cost of capital. The cost of capital is a rate (a percentage). It is a weighted average estimation because it includes the cost of equity (re), the cost of debt (rd), the proportion of equity financing and the proportion of debt financing. The cost of capital can be calculated because there is a capital structure (a proportion of debt which belongs to debtholders, and a proportion of equity which belongs to the shareholders.

Definition of WACC. Source:  https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/

To calculate the cost of equity (re) the methodology used is the CAPM.

Let´s use an example of a project that I would like so much to see in San Salvador: a new Metrorail to solve the problem of traffic congestion in the capital city and nearby towns.  It is one of my most beautiful dreams: to see my country with a modern Metrorail system. Let´s use this example to explain the importance of the financial rate called the cost of capital.

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The Government of El Salvador through the Ministry of Transportation decides to open a tender bid for the design, construction, finance, and operation of the first two lines of the Metrorail.  The government of El Salvador is planning to do it under the modality of a win-win project. Since the project will cross several municipalities or boroughs: San Salvador, Soyapango, Mejicanos, San Marcos, Apopa and Cuscatancingo;  a new entity will be created by the Government of El Salvador, with some participation of these municipalities. Let´s imagine the Government of El Salvador will create the “El Salvador Metrorail Authority (“ESMA”). This new organization will be the contracts signatory on behalf of the Government of El Salvador. It is a public entity. The owner of the project is the ESMA which is owned by the Government of El Salvador. This new entity ESMA will have to be created by Presidential decree with a mandate to “design, execute, manage, operate, and maintain the Metro”. ESMA will report directly to the Ministry of Transportation and the Presidency.

Let´s suppose that the first two lines of the Metro will cost 5 Billion USD. The first line or Line A will start at Unicentro, Soyapango and will finish at the Monument Plaza Masferrer, Escalón Neighborhood. This first line will have 14.8 kilometers. The second line or line B will start in Monument Cristo a la Paz, San Marcos and will finish in Apopa. Line B will have around 18.5 Km. Three more lines will be developed in the future, which will connect other cities and will be planned accordingly using other routes.

The Government has to call to an international tender bid process before assigning this project. It is still not clear for the ESMA whether the project would be implemented on a design-build, a design-build-finance, a design-build-operate or a design-build-operate-finance scheme, or if there will be two separate bids for two separate entities: design-build-finance and operations-maintenance. There are many modalities to make it.

Let´s see one hypothetic first approach. Seven governments in a consortium, all working together, decide to invest in the project because they wish to reduce corruption in El Salvador. These governments wish to help El Salvador authorities to stop corruption, and the project has sense to fight this national cause of poverty. The government of Denmark, Germany,  France, The Netherlands, United Kingdom, Switzerland, and Canada. All of them will provide the funds (debt and grants) for the finance, design, construction, and operation-maintenance of our new Metrorail. In addition, these 7 governments have a motivation for altruism-humanitarian aid with El Salvador, and all have decided to gift or grant or make a donation of 40% of the project (2 billion dollars) as non-reimbursable funds for it. The total cost of the project will be 3 billion dollars. In exchange, the anti-corruption intl. government consortium will choose the winner of the first bid for the design-build-finance component to  European and Canadian companies only.  The financing will come via a structured finance syndication where each of these nations development banks will provide the total funds.  In addition, a second bid, for the Operation-Maintenance component will be in hands of another European-Canadian company which will be selected through a second tender bidding process. The project will generate between 20,000 to 34,000 jobs during the phase of Construction, and an average of 1,000 new jobs for each year during the phase of Operations. All labor force will be 85% Salvadoran, and 15% will come from Europe and Canada. The seven governments have decided to hire the World Bank as an intermediary to do this whole process with ESMA, to establish transparency and to help ESMA to do the things right.

Let´s explore a second way to do this project: the Salvadoran ESMA decides to do it directly by inviting private international companies. This motivation doesn´t have any altruism factor involved. It is simply economic. In this scheme, the government of El Salvador will directly choose a private company to finance, design and build the project, and another private company to operate and maintain the project. No donations involved. This path is more expensive for my people since the project will be 5 billion dollars. It is the same project but will cost 2 billion more from our taxes. And here the measure “cost of capital” is determinant for the companies who decide to bid for the project.

Metro Panama

Which choice is more convenient for the people of El Salvador? Probably the ESMA  will choose the first option (which includes donation or nonreimbursable funds of 2 billion USD). But what could happen if other governments will like to participate directly via the same modality of altruism-tied aid too? Let´s imagine that once other governments know of the project and the intentions of anti-corruption from the European-Canadian consortium; the USA, China and other participants such as Brazil, UAE and Norway are also interested to invest here and all of them have a grant or donation pre-conditions.

Dubai Metro

All these nations want to fight corruption and help us to reduce poverty through this infrastructure for my people.  What will the ESMA do? Are altruism tied aid public projects subject to formal competitive bidding? The winner of the bid has to be fairly chosen not just by price or amount of donation, but by the quality and high level of ethics of the offers. Otherwise, why to call this project “an anti-corruption scheme”?  I am sure the World Bank has a lot to say in relation to these type of anti-corruption and bidding projects.

Metro Map- Santiago, Chile

Transportation projects are public projects. They can´t be owned privately only, because transportation is a public right. Why? In certain countries where the Metros have been privatized, they do not reach their expected returns, unless the ride ticket price is high. And the ticket ride has to be affordable for the majority of the population. These projects are not profitable for private corporations. These private companies end up leaving these transportation projects (selling back to the government) because they don´t see their expected returns accomplished or higher than the project cost of capital. Unless the investment generates sufficient revenues to repay suppliers of capital (banks-debt or equity investors) the private firm will not choose to be part of the project. That is why the majority of the metros are in the hands of public entities. The price you pay for a metro ticket is subsidized by your government (at the end, your own taxes).

This is all for the financial context. On my next post we will wrap up all the contexts of the Entrepreneurial contextual analysis and we will do a summary and conclusions of this big theme.

Thank you. See you.

Source References utilized for this article:

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/

Disclaimer: All the presentation slides shown on this blog are prepared by Eleonora Escalante MBA-MEng. Nevertheless, all the pictures or videos shown on this blog are not mine.  I do not own any of the lovely photos or images posted unless otherwise stated.

Published by eleonoraescalantestrategy

Corporate Strategy Artist, San Salvador, El Salvador View all posts by eleonoraescalantestrategy