Max Sawicky and yours truly receive some interesting comments regarding the financing of the Indiana Toll Road, which deserves some follow-up. We also received some rather dumb comments from Patrick R. Sullivan aka Patrick Roland whose blog did provide a nice picture of the Millau Viaduct (which has nothing to do with the point Max raised) as it blocks comments from anyone other than his rightwing team (which appears to have no members). Patrick did question Max’s claim that the sale of the toll rights to private firms is dissaving – to which we’ll spend a little time at the end explaining some basics to Patrick. But let’s first turn to Patrick’s comment that this is nothing but a business deal – which misses the point of whether the deal was a fair deal or some giveaway from the state to a private sector – by thanking Don Don Coffin for his comments.
What’s in it for the foreign companies? Huge potential profits. Gigantic, steady profits. Toll roads are an incredible asset class. They’re often monopolies. They can support debt, since they provide a recurring guaranteed revenue stream that is likely to rise over time, as more people take to the roads and tolls increase. According to Cintra, the Indiana Toll Road generated $96 million in revenues in 2005, and Cintra expects a 12.5 percent internal rate of return on its investment. The heavy lifting has already been done: The state or federal governments have acquired the land and rights of way, built the roads and maintained them for years, and enacted toll increases. All the private companies have to do is deliver cash upfront, maintain the roads, and collect the windfall … What’s in it for the foreign companies? Huge potential profits. Gigantic, steady profits. Toll roads are an incredible asset class. They’re often monopolies. They can support debt, since they provide a recurring guaranteed revenue stream that is likely to rise over time, as more people take to the roads and tolls increase. According to Cintra, the Indiana Toll Road generated $96 million in revenues in 2005, and Cintra expects a 12.5 percent internal rate of return on its investment. The heavy lifting has already been done: The state or federal governments have acquired the land and rights of way, built the roads and maintained them for years, and enacted toll increases. All the private companies have to do is deliver cash upfront, maintain the roads, and collect the windfall … Of course, by selling public infrastructure at high prices, state governments could be taking foreigners for a ride. The Japanese famously overpaid for Rockefeller Center, after all. It’s possible that Indiana just ripped off the Spaniards and Aussies. But I doubt it.
Don is saying that only $90 million per year in revenues are being generated by tolls and that the private entity will incur $60 million per year in expenses with cash flows being a mere $30 million this year. I’ll accept his premise that nominal cash flows will increase at only 2%, which reflects the expected inflation rate but note something Movie Guy hinted at when he asked us to focus on the Washington Post discussion:
In response, the administration persuaded Congress last summer to take steps to make it easier for the private sector to finance new roads – and take over existing ones. Lawmakers removed several legal barriers to charging tolls on interstates and gave private investors new access to tax-free bonds for transportation projects.
Don even noted the possibility of toll increases in his first post with a hat tip to Mark Thoma (more on Mark’s January 25, 2006 at the end). In other words, expected cash flows might be significantly more than Don’s $30 million per year guess. The value of the deal depends also on the discount rate and Cintra’s claim that it expects a 12.5% internal rate of return is rather staggering. But note this article that Don provides:
Allen said the estimated internal rate of return will be between 12.5% to 13.5% a year, providing a risk premium of between 8% to 9% per annum over US 10 year bond yield.
In other words, Macquarie Infrastructure Group (Cintra’s partner in this and other ventures of this sort) is arguing that they receive a 4.5% nominal risk free rate (2.5% real risk free rate if expected inflation is 25%) plus a staggering 8% premium. Gross, however, is suggesting that these firms face little systematic risk, which I’ll take to suggest that the appropriate discount rate for constant dollar cash flows should be 3.5% versus the Cintra-Macquarie projection of a 10.5% real internal rate of return.
But here is the puzzle. If the discount rate is 3.5% in real terms and we are expecting constant real cash flows over 75 years, the value to cash flow multiplier is only 2.55, which implies that cash flows would have to be $150 million per year. Don’s question as to the elasticity of demand for deriving on toll roads and how much will Cintra & Macquarie have to incur in expenditures begs the question as to whether we would reasonably expect more than $150 million per year in cash flows. If we assume as Cintra & Macquarie do that the real internal rate of return is as high as 10.5%, then cash flows would have to be $440 million per year. Now if Cintra & Macquarie are correct, which would imply that cash flows will be this high and if we use a 3.5% real discount rate, the value of this deal jumps to almost $12.7 billion, which means the state is selling this deal at a 70% discount rate.
So who is right? Don Coffin is worried that Cintra & Macquarie is guilty of the Andrew Fastow finance that wrecked Enron (see Brad DeLong discuss Enron as his drinks from his large cup of coffee).
Gross shares the same concern that Max and I do – that in some ways, Mitch Daniels is doing for the state of Indiana what he did as OMB director for Federal finances. Gross provided the state’s Fact Sheet, which has a very familiar ring:
Indiana faces a $2.8 billion dollar shortfall in its transportation budget over the next ten years. Continuing the status quo would result in only half of Indiana’s critical transportation construction projects being built.
Notice the fact that Governor Daniels has a 10-year focus when the deal is a 75-year deal. Did I say Enron financing? If Daniel Gross is correct, then Daniels is reducing long-term revenues by more than the $3.8 billion collects. But even if this is a fair deal – something Roland Patrick suggests with no backup but Don Coffin has thought more seriously about – notice that the starve the beast theorists that permeate rightwing thinking should be worried that state governments have found a way around balanced budget restrictions. So Max’s dissaving claim may have two distinct but complementary elements: (1) Gross’s bad deal claim; and (2) the Governor’s own words that he’ll spend these inflows of cash. Actually, this kind of creative financing is what is wrong with the simpleminded starve the beast theorists who thought the 2001 and 2003 Federal tax cuts would reduce Federal spending. It did not precisely because Bush’s first OMB director was so willing to engage in Enron financing games.
But let’s get back to Mark Thoma’s point. Even if the Indiana Toll Road deal is not as bad as Gross claims and even if Governor Daniels will not use the funds to go on a spending spree, we are talking about increasing state revenues by a deal that will increase the cost of driving for the average Joe. For more on this issue – see Joe Mysak.
Many thanks to Don Coffin and I would hope the Indiana legislature withhold passage of this proposal until they give very good economics such as yourself a chance to review its terms more closely.
Footnote: Alas, we have some troll from the Minnesota GOP hack machine who does not have a clue what the issue is. This troll says the State of Indiana had to go with this type of financing because of “scarcity of resources”. Never mind financing decisions and scarcity of resources are two very different things, it seems Mitch Daniels does not think the State of Indiana has a scarcity of labor resources as he is trying to justify more construction on the grounds of jobs, jobs, jobs. Checking the Bureau of Labor Statistics, it seems the state unemployment rate is 5%. So if Patrick Sullivan wishes to disagree on this scarcity of resources issue, it strikes me that BLS data is on the Governor’s side on this one. Now the Governor and Mr. Sullivan might worry about a scarcity of current tax revenues but borrowing can relax a financing constraint. After all – construction is often put on the state’s capital account, not its current account. And as Max Sawicky points out, having a capital account is no excuse for bad financing decisions and not paying attention to long-run budget constraints. But now we have gone beyond the comprehension of the former OMB director and that GOP hack from Minnesota.
But the troll did provide us a link to an analysis from Crowe Chisek & Company. Page 16 suggests the present value of toll revenues is $5.3 billion. Now if Don Coffin can figure out what portion of the expenses will be borne by the state and what portion will be borne by the private entities …