Cost of Capital, Discounting, and Relational Contracting: Endogenous Optimal Return and Duration for Joint Investment Projects

Abstract

Concession, project-financing and public-private partnership schemes are investment projects that are generally submitted to valuation criteria based on discounted cash flow analysis. The theoretical basis of these valuation criteria are now at issue. Pursuant to recent advances in relational contracting economics and behavioural finance, joint investment projects can be considered as special relational environments where the project’s returns improve on alternative replacement opportunities. This article seeks to bridge the gap between new theories and widely used valuation techniques by providing a generalised approach to investment valuation. The article suggests reasonable valuation criteria that fit these new theoretical developments, including an endogenous optimal duration function that may be integrated into the project’s contractual agreement.

Keywords: discounting, investment decision criteria, capital budgeting, project finance and public private partnerships, endogenous optimal duration, cost of capital for government, value for money

JEL Classification: H43, H50, D61, D70, D90, G31, L20