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
Date Written: March 2017
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: Suggested Citation