Simulation-Based Valuation of Project Finance - Does Model Complexity Really Matter?

CEFS Working Paper No. 2010-3

23 Pages Posted: 23 Apr 2010 Last revised: 29 Sep 2011

See all articles by Florian Weber

Florian Weber

Technische Universität München (TUM) - Center for Entrepreneurial and Financial Studies (CEFS)

Thomas Schmid

The University of Hong Kong - Faculty of Business and Economics

Matthäus Pietz

Technische Universität München - Center for Entrepreneurial and Financial Studies

Christoph Kaserer

Technische Universität München (TUM)

Date Written: September 29, 2011

Abstract

This paper analyzes the impact of model complexity on the valuation of a project financed power plant along two dimensions: The NPV distribution and the expected cumulative default probability of the project. Model complexity is separated into forecast and simulation complexity. Thereby, we aim to identify elements of model complexity that are crucial for the valuation result.

For this purpose we develop a project finance valuation tool, which generates cash flow distributions on the basis of a Monte Carlo simulation. This model is applied for in a case study, i.e. a project financed gas power plant.

The analysis reveals, among others, the following results: First, risk-neutral valuation should be used for determining the cost of capital. Second, we demonstrate that 10,000 iterations in the Monte Carlo simulation are sufficient to obtain stable results. Third, the choice of the volatility forecasting mode affects the simulation results significantly. Fourth, we find a significant impact of correlation versus no correlation but do not find a strong impact of sophisticated correlation forecasting techniques versus constant correlation.

Keywords: Project Finance, Investment Valuation, Stochastic Modeling, Monte Carlo Simulation, Forecasting, Model Complexity

JEL Classification: C63, Q40

Suggested Citation

Weber, Florian and Schmid, Thomas and Pietz, Matthäus and Kaserer, Christoph, Simulation-Based Valuation of Project Finance - Does Model Complexity Really Matter? (September 29, 2011). CEFS Working Paper No. 2010-3. Available at SSRN: https://ssrn.com/abstract=1594116 or http://dx.doi.org/10.2139/ssrn.1594116

Florian Weber (Contact Author)

Technische Universität München (TUM) - Center for Entrepreneurial and Financial Studies (CEFS) ( email )

Arcisstraße 21
München, 80333
Germany
++49 89 289 25479 (Phone)
++49 89 289 25488 (Fax)

HOME PAGE: http://www.cefs.de

Thomas Schmid

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

Matthäus Pietz

Technische Universität München - Center for Entrepreneurial and Financial Studies ( email )

Arcisstraße 21
Munich, 80333
Germany
+49 89 28925487 (Phone)
+49 89 28925488 (Fax)

HOME PAGE: http://www.cefs.de

Christoph Kaserer

Technische Universität München (TUM) ( email )

Arcisstr. 21
Munich, D-80290
Germany
+49 89 289 25489 (Phone)
+49 89 289 25488 (Fax)

HOME PAGE: http://www.cefs.de

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