Optimal Debt Capacity for BOT Projects in Emerging Economies

Abstract

This article determines the optimal debt to equity ratio for BOT projects in emerging economies. Using a risk identification and allocation approach, the article finds that the optimal debt to equity ratio depends on the political risk, bankruptcy risk, and cost of insuring debt. The value of the project is maximized at low levels of equity when the risks of bankruptcy and political risk are low. However, when the risk of bankruptcy is high, the project is more valuable with higher levels of equity financing even when political risk and the cost of insurance are high. Thus, the most important determinant of the project's value is the probability of bankruptcy. The article concludes by asserting that a government can increase the value of BOT projects by finding creative ways of reducing bankruptcy and political risks instead of demanding higher levels of equity from the private contractor.