Consistent Valuation of Project Finance and LBOs Using the Flows‐To‐Equity Method

19 Pages Posted: 19 Jan 2018

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

Date Written: January 2018

Abstract

The flows‐to‐equity method is used to value transactions where debt amortizes according to a fixed schedule, requiring a formula that links the changing leverage with a time‐varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

Keywords: cost of debt, cost of equity, equity cash flow, flows to equity, LBO, project finance, valuation

Suggested Citation

Cooper, Ian Anthony and Nyborg, Kjell G., Consistent Valuation of Project Finance and LBOs Using the Flows‐To‐Equity Method (January 2018). European Financial Management, Vol. 24, Issue 1, pp. 34-52, 2018, Available at SSRN: https://ssrn.com/abstract=3105039 or http://dx.doi.org/10.1111/eufm.12136

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

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