Consistent Valuation of Project Finance and LBO's Using the Flows-to-Equity Method

33 Pages Posted: 25 Aug 2010 Last revised: 13 Mar 2017

See all articles by Ian A. Cooper

Ian A. Cooper

London Business School

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Multiple version iconThere are 2 versions of this paper

Date Written: March 2017

Abstract

The flows-to-equity method is often used to value highly leveraged projects, or transactions, where debt typically amortises over time according to a fixed schedule. This requires a formula that links the changing leverage over time with a time-varying equity discount rate. We show that the extant formulas in the literature and in textbooks yield incorrect discount rates and valuations because they are inconsistent with fixed debt plans. They result in values that are at odds with the Miller and Modigliani result that levered value equals unlevered value plus financing side effects (adjusted present value). The error from using the wrong formula can be large at the currently low levels of interest rates. We derive an equity discount rate formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress that, when applied in the flows-to-equity method, yield values that are consistent with adjusted present value. In short, our formula allows for the correct implementation of the flows-to-equity method under fixed debt plans. In the formula, the cost of debt is the promised yield rather than the expected rate of return of debt.

Keywords: Valuation, flows-to-equity, equity cash flow, cost of equity, project finance, LBO

JEL Classification: G12, G24, G31, G32, G33, G34

Suggested Citation

Cooper, Ian Anthony and Nyborg, Kjell G., Consistent Valuation of Project Finance and LBO's Using the Flows-to-Equity Method (March 2017). Available at SSRN: https://ssrn.com/abstract=1664605 or http://dx.doi.org/10.2139/ssrn.1664605

Ian Anthony Cooper (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 171 262 5050 (Phone)

Kjell G. Nyborg

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland
+41 (0)44 634 2980 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
642
Abstract Views
3,091
rank
17,162
PlumX Metrics