Public versus Private Cost of Capital with State-Contingent Terminal Value

IMF Working Papers, March 10, 2023

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The economic debate underlines the reasons why discount rates of infrastructure projects should be similar, regardless the public or private source of financing, during the forecast period when flows are risky but predictable.
In contrast, the authors show that the incompleteness of contracts between governments and private firms beyond the forecast period (i.e., when flows of net social benefits are state-contingent) entails expected terminal values that are systematically larger under government rather than private financing.
This effect provides a new rationale for applying a lower discount rate in the assessment of projects under public financing as compared to private financing.

Discount rates for infrastructure projects: should be similar across public and private financing during the forecast period when flows are risky but predictable.
Contract incompleteness beyond the forecast period: leads to state-contingent net social benefit flows and to expected terminal values that are systematically larger under government financing than under private financing.
Implication for discounting: the difference in expected terminal values provides a rationale for applying a lower discount rate to projects under public financing compared to private financing.

Consider applying a lower discount rate for public-financed infrastructure projects relative to privately financed projects to reflect systematically larger expected terminal values under government financing due to contract incompleteness and state-contingent post-forecast flows.
Account explicitly for contractual incompleteness and state-contingency of long-run net social benefits when assessing public versus private infrastructure financing options.