agarwal kaul

8/6/2019 Agarwal Kaul

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Project finance

Aditya AgarwalSandeep KaulFuqua School of Business


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Contents

The MM Proposition

What is a Project?

What is Project Finance? Project Structure

Financing choices

Real World Cases

Project Finance: Valuation Issues

The MM Proposition


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The MM PropositionThe Capital Structure is irrelevant as long as the

firms investment decisions are taken as given

Then why do corporations: Set up independent companies to undertake

mega projects and incur substantial transactioncosts, e.g. Motorola-Iridium.

Finance these companies with over 70% debtinspite of the projects typically having substantialrisks and minimal tax shields, e.g. Iridium: veryhigh technology risk and 15% marginal tax rate.


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C

ontents The MM Proposition

What is a Project?

What is Project Finance?

Project Structure

Financing choices

Real World Cases Project Finance: Valuation Issues


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What is a project?

High operating margins.

Low to medium return on capital.

Limited Life. Significant free cash flows.

Few diversification opportunities. Asset

specificity.


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What is a project? Projects have unique risks:

Symmetric risks: Demand, price.

Input/supply.

Currency, interest rate, inflation. Reserve (stock) or throughput (flow).

Asymmetric downside risks: Environmental.

Creeping expropriation.

Binary risks Technology failure.

Direct expropriation.

Counterparty failure

Force majeure

Regulatory risk


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What does a Project need?

C

ustomized capital structure/asset specificgovernance systems to minimize cash flowvolatility and maximize firm value.


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What is Project Finance?Project Finance involves a corporatesponsor investing in and owning a single

purpose, industrial asset through a legallyindependent entity financed with non-recourse debt.


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Project Finance An Overview

Outstanding Statistics Over $220bn of capital expenditure using project finance in 2001

$68bn in US capital expenditure

Smaller than the $434bn corporate bonds market, $354bn asset

backed securities market and $242bn leasing market, but largerthan the $38bn IPO and $38bn Venture capital market

Some major deals: $4bn Chad-Cameroon pipeline project

$6bn Iridium global satellite project

$1.4bn aluminum smelter in Mozambique

900m A2 Road project in Poland


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Total Project Finance Investment

Million USD

Year

Total Project Finance Investment

it Finance

on s

an loans

Overall -YearCAGR of % for private sector investment.

Project en ing -YearCAGR of 3%.


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Number of Projects

Number f

r jects

Years

Number f r jects

Project t o ce

Projects t oce


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Lending by Type of Debt

Percen Lending y ype of de

ears

Percen

age

ond

n Lo n


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Project Finance Lending by Sector

Amo n

ears

Amo n o roject Lending by ector

nd tria

Lei re

Petroc e ica

ining

eeco

i and Ga

n ra tr ct re

Po er

3 % o overa ending in Po er Project , % in te eco

5 Year CAGR or Po er Project : 5%, i & Ga : % andn ra tr ct re: %


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C

ontents The MM Proposition

What is a Project?

What is Project Finance?

Project Structure

Financing choices



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Project Structure Structure highlights

Comparison with other Financing Vehicles

Disadvantages

Motivations

Alternative approach to Risk Mitigation


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Structure Highlights

Independent, single purpose company formed to buildand operate the project.

Extensive contracting As many as 15 parties in upto 1000 contracts.

Contracts govern inputs, off take, construction and operation.

Government contracts/concessions: one off or operate-transfer.

Ancillary contracts include financial hedges, insurance for Force

Majeure, etc.


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Structure Highlights

Highly concentrated equity and debt ownership One to three equity sponsors.

Syndicate of banks and/or financial institutions provide credit.

Governing Board comprised of mainly affiliated directors fromsponsoring firms.

Extremely high debt levels Mean debt of 70% and as high as nearly 100%.

Balance capital provided by sponsors in the form of equity or

quasi equity (subordinated debt). Debt is non-recourse to the sponsors.

Debt service depends exclusively on project revenues.

Has higher spreads than corporate debt.


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Disadvantages of Project Financing

Takes longer to structure than equivalent sizecorporate finance.

Higher transaction costs due to creation of anindependent entity. Can be up to 60bp

Project debt is substantially more expensive (50-400 basis points) due to its non-recourse nature.

Extensive contracting restricts managerial

decision making. Project finance requires greater disclosure of

proprietary information and strategic deals.


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Motivations: Agency Costs

Problems: High levels of

free cash flowdue to few

investmentopportunities.Possiblemanagerialmismanagementthrough wasteful

expendituresand sub optimalinvestments.

Structural solutions: Traditional monitoring mechanisms such as

takeover markets, staged financing,product markets absent.

Reduce free cash flow through high debtservice. Contracting reduces discretion. .Cash Flow Waterfall: Pre existing

mechanism for allocation of cash flows.Covers capex, maintenance expenditures,debt service, reserve accounts,

shareholder distribution.


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Problems: High levels of

free cash flowdue to few

investmentopportunities.Possiblemanagerialmismanagementthrough wasteful

expendituresand sub optimalinvestments.

Structural solutions: Concentrated equity ownership provides

critical monitoring. Bank loans provide credit monitoring.

Separate ownership: single cash flowstream, easier monitoring. Senior bank debt disgorges cash in early

years. They also act as trip wires formanagers.


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Problems: Opportunistic

behavior bytrading partners:hold up. Ex-antereduction inexpected returns.

Structural Solutions: Vertical integration is effective in

precluding opportunistic behavior but not

at sharing risk (discussed later). Also,opportunities for vertical integration maybe absent.

Long term contracts such as supply andoff take contracts: these are moreeffective mechanisms than spot market

transactions and long term relationships.


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behavior bytrading partners:hold up. Ex-antereduction inexpected returns.

Structural Solutions: Joint ownership with related parties to

share asset control and cash flow rights.

This way counterparty incentives arealigned.

Due to high debt level, appropriation offirm value by a partner results in costlydefault and transfer of ownership.


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behavior by hostgovernments:expropriation.Either direct throughasset seizure orcreeping through

increasedtax/royalty. Ex-anteincrease in risk andrequired return.

Structural Solutions: Since company is stand alone, acts of

expropriation against it are highly visibleto the world which detracts futureinvestors.

High leverage forces disgorging ofexcess cash leaving less on the table tobe expropriated.


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behavior by hostgovernments:expropriation.Either direct throughasset seizure orcreeping through

increasedtax/royalty. Ex-anteincrease in risk andrequired return.

Structural Solutions: High leverage also reduces accounting

profits thereby reducing local oppositionto the company.

Multilateral lenders involvementdetracts governments fromexpropriating since these agencies aredevelopment lenders and lenders of last

resort. However these agencies onlylend to stand alone projects.


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Problems: Debt/Equity holder

conflictin

distribution of cashflows, re-investmentand restructuringduring distress.

Structural Solutions: Cash flow waterfall reduces managerial

discretion and thus potential conflicts in

distribution and re-investment. Given the nature of projects, investment

opportunities are few and thus investmentdistortions/conflicts are negligible.

Strong debt covenants allow both

equity/debt holders to better monitormanagement.


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Problems: Debt/Equity holder

conflictin distributionof cash flows, re-investment andrestructuring duringdistress.

Structural Solutions: To facilitate restructuring, concentrated

debt ownership is preferred, i.e. bank

loans vs. bonds. Also less classes ofdebtors are preferred for speedyresolution. Usually subordinated debtis provided by sponsors: quasi equity.


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Why Corporate Finance cannot Deter

Opportunistic Behavior ? Do not allow joint ownership.

Direct expropriation can occur without triggering default.

C

reeping expropriation is difficult to detect and highlight. Multi lateral lenders which help mitigate sovereign risk

lend only to project companies.

Non-recourse debt had tougher covenants thancorporate debt and therefore enforces greater discipline.

In the absence of a corporate safety net, the incentive togenerate free cash is higher.


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Motivations: Debt Overhang

Problems: Under investmentin

Positive NPV projects at

the sponsor firm due tolimited corporate debtcapacity. Equity is not avalid option due to agencyor tax reasons. Fresh debtis limited by pre-existing

debt covenants.

Structural Solutions: Non recourse debt in an

independent entity allocates

returns to new capital providerswithout any claims on thesponsors balance sheet.Preserves corporate debt capacity.


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Motivations: Risk Contamination

Problems: A high risk project

can potentially drag

a healthycorporation intodistress. Short ofactual failure, therisky project canincrease cash flowvolatility and reduce

firm value.Conversely, a failingcorporation can draga healthy projectalong with it.

Structural Solutions: Project financed investment exposes

the corporation to losses only to the

extent of its equity commitment,thereby reducing its distress costs.

Through project financing, sponsorscan share project risk with othersponsors. Pooling of capital reduceseach providers distress cost due to the

relatively smaller size of the investmentand therefore the overall distress costsare reduced. This is an illustration ofhow structuring can enhance overallfirm value. Re: MM Proposition.


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Motivations: Risk Contamination

Problems: A high risk project

can potentially drag

a healthycorporation intodistress. Short ofactual failure, therisky project canincrease cash flowvolatility and reduce

firm value.Conversely, a failingcorporation can draga healthy projectalong with it.

Structural Solutions: Co-insurance benefits are negative

(increase in risk) when sponsor and

project cash flows are stronglypositively correlated. Separateincorporation eliminates increase inrisk.


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Motivations: Risk Mitigation

Completion and operational risk can bemitigated through extensive contracting. This will

reduce cash flow volatility, increase firm valueand increase debt capacity.

Project size: very large projects can potentiallydestroy the company and thus inducemanagerial risk aversion. Project Finance cancure this (similar to the risk contaminationmotivation).


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Motivations: Other

Tax: An independent company can avail of tax holidays. Location: Large projects in emerging markets cannot be

financed by local equity due to supply constraints.

Investment specific equity from foreign investors is eitherhard to get or expensive. Debt is the only option andproject finance is the optimal structure.

Heterogeneous partners: Financially weak partner needs project finance to participate. It bears the cost of providing the project with the benefits of

project finance. The bigger partner if using corporate finance can be seen as

free-riding. The bigger partner is better equipped to negotiate terms with

banks than the smaller partner and hence has to participate inproject finance.


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Alternative Approach to Risk Mitigation

Risk Solution

Completion Risk Contractual guarantees frommanufacturer, selecting vendors of

repute.Price Risk hedging

Resource Risk Keeping adequate cushion inassessment.

Operating Risk Making provisions, insurance.Environmental Risk Insurance

Technology Risk Expert evaluation and retentionaccounts.


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Alternative Approach to Risk Mitigation

Political andSovereign Risk

Externalizing the project company by forming itabroad or using external law or jurisdiction

External accounts for proceeds

Political risk insurance (Expensive)

ExportC

reditG

uarantees Contractual sharing of political risk between lenders

and external project sponsors

Government or regulatory undertaking to coverpolicies on taxes, royalties, prices, monopolies, etc

External guarantees or quasi guaranteesInterest RateRisk

Swaps and Hedging

Insolvency Risk Credit Strength of Sponsor, Competence ofmanagement, good corporate governance

Currency Risk Hedging


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Financing Choice

Portfolio Theory

Options Theory

Equity vs. Debt

Type of Debt

Sequencing


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Financing Choice: Portfolio Theory

Combined cash flow variance (of project and sponsor)with joint financing increases with: Relative size of the project.

Project risk. Positive Cash flow correlation between sponsor and project.

Firm value decreases due to cost of financial distresswhich increases with combined variance.

Project finance is preferred when joint financing

(corporate finance) results in increased combinedvariance. Corporate finance is preferred when it results in lower

combined variance due to diversification (co-insurance).


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Financing choice: Options Theory

Downside exposure of the project (underlying asset)can be reduced by buying a put option on the asset(written by the banks in the form of non-recourse debt).

Put premium is paid in the form of higher interest andfees on loans.

The underlying asset (project) and the option provides

a payoff similar to that of call option.


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Financing choice: Options Theory

The put option is valuable only if the Sponsor might beable/willing to exercise the option.

The sponsor may not want to avail of project finance

(from an options perspective) because it cannot walkaway from the project because: It is in a pre-completion stage and the sponsor has provided a

completion guarantee.

If the project is part of a larger development.

If the project represents a proprietary asset. If default would damage the firms reputation and ability to raise

future capital.


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Financing Choice: Options Theory

Derivatives are available for symmetric risks but not forbinary risks, (things such as PRI are very expensive).

Project finance (organizational form of risk management)is better equipped to handle such risks.

Companies as sponsors of multiple independent

projects: A portfolio of options is more valuable than anoption on a portfolio.


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Financing Choice: Equity vs. Debt

Reasons for high debt:

Agency costs of equity (managerial discretion,expropriation, etc.) are high.

Agency costs of debt (debt overhang, risk shifting) arelow due to less investment opportunities.

Debt provides a governance mechanism.


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Financing Choice: Type of Debt

Bank Loans: Cheaper to issue. Tighter covenants and better monitoring.

Easier to restructure during distress. Lower duration forces managers to disgorge cash early.

Project Bonds: Lower interest rates (given good credit rating). Less covenants and more flexibility for future growth.

Agency Loans: Reduce expropriation risk. Validate social aspects of the project.

Insider debt: Reduce information asymmetry for future capital providers.


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Financing Choice: Sequencing

Starting with equity: eliminate risk shifting, debt overhangand probability of distress (creditors requirement).

Add insider debt (Quasi equity) before debt: reducescost of information asymmetry.

Large chunks vs. incremental debt: lower overalltransaction costs. May result in negative arbitrage.


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Contents

The MM Proposition

What is a Project?


Financing choices



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Case : BP Amoco

Background: In 1999, BP-Amoco, the largest shareholder inAIOC, the 11 firm consortium formed to develop the Caspianoilfields in Azerbaijan had to decide the mode of financing for its

share of the $8bn 2nd phase of the project. The first phase cost$1.9bn.

Issues:

Size of the project: $10bn.

Political risk of investing in Azerbaijan, a new country. Risk of transporting the oil through unstable and hostile countries.

Industry risks: price of oil and estimation of reserves.

Financial risk: Asian crisis and Russian default.


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Case: BP Amoco

Structural highlights:

Risk sharing: Increase the number of participants to 11 anddecrease the relative exposure for each participant. Since partners

are heterogeneous in financial size/capacity, use project finance. Sponsor profile: Get sponsors from major superpowers to detract

hostile neighbors from acting opportunistically. Get IFC and EBRD(multilateral agencies) to participate in loan syndicate and reduceexpropriation risk.

Staged investment: 2nd phase ($8bn) depends on the outcome of the1st phase investment. Improves information availability for thecreditors and decreases cost of debt in the 2nd phase.


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Case : Australia Japan Cable

Background: 12,500km cable from Sydney, Australia to Japan viaGuam at a cost of $520m. Key sponsors: Japan Telecom, Telstraand Teleglobe. Asset life of 15 years.

Key Issues: limited growth potential Market risk from fast changing telecom market Risk from project delay Specialized use asset: Need to get buy in from landing stations and

pre-sell capacity to address issue of Hold Up Significant Free Cash Flow


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Case : Australia Japan Cable

Structural highlights: Avoid Hold up Problem through governance structure:

Long term contracts with landing stations.

Joint equity ownership of asset with Telstra and landing stationowners both as sponsors.

High project leverage of 85%

Concentrates ownership and reduces equity investment.

Shares project risk with debt holders.

Enforces contractual agreement by pre-allocating the revenuewaterfall. Enforces Management discipline.

Short term debt allow for early disgorging of cash.


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Case : Polands A2 Motorway

Background: AWSA is an 18 firm consortium with concession tobuild and operate toll road as part of Paris-Berlin-Warsaw-Moscowtransit system. Seeking financing for the 1bn deal (25% equity). Is

being asked to put in additional 60-90m in equity. Concession dueto expire in 6 weeks.

Key Issues:

Assessment of project risk and allocation of risks.

How can project risk best be managed?

Developing a structuring solution given the time pressure.


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Structure or allocation o Risk Construction Risk:

Best controlled by builder and government. Fixed priced turnkey contract with reputed builder. Government responsible for procedural delay and support infrastructure. Insurance against Force Majeure, adequate surplus for contingencies.

Operating Risk: Best controlled by AWSA and the operating company. Multiple analyses by reputable entities for traffic volume and revenue

projections. Comprehensive insurance against Force Majeure. Experienced operators, road layout deters misuse.


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Structure or allocation o Risk Political Risk:

Best controlled by Polish Government and AWSA.

Assignment of revenue waterfall to government: Taxes, lease and profitsharing. Use of UK law, enforceable through Polish courts. Counter guarantees by government against building competing

systems, ending concession.

Financial Risk: Best controlled by Sponsor and lenders. Contracts in to mitigate exchange rate risk. Low senior debt, adequate reserves and debt coverage, flexible

principle repayment. Control of waterfall by lenders gives better cash control. Limited floating rate debt with interest rate swaps for risk mitigation.


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Case : Petrolera Zuata, Petrozuata C.A.

Background: $2.4bn oil field development project in Venezuelaconsisting of oil wells, two pipelines and a refinery. It is sponsoredby Conoco and Marvan who intend to raise a portion of the $1.5bndebt using project bonds.

Key Issues: What should be the final capital structure to keep the project viable? What is the optimum debt instrument and will the debt remain

investment grade? How can the project structure best address the associated risk?


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Operational Risk Management

Pre Completion Risk Includes resource, technological and completion risk.

Resource and technology not a major factor ( 7.1% of resources consumed andproven technology).

Sponsors guarantee to mitigate completion risk.

Post Completion Risk Market risk and force majeure.

Quantity risk is mitigated by off-take agreement with CONOCO. However pricerisk not addressed due to secure deal fundamentals.

Sovereign Risk Key risk is of expropriation. Exchange rate volatility is a minor consideration.

Fear of retaliatory action on expropriation. Government ownership of PDVSA.


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Financial Risk and Capital Structure Financial Risk:

Optimum leverage at 60% for investment grade rating.

Evaluation of Debt Alternatives

BDA/ MDA: Reduced political insurance, and loan guarantees athigher cost and time delay.

Uncovered Bank Debt: Greater withdrawal flexibility at a fee.Shorter maturity, size and structure restrictions, variable interestrate.

144A bond market: Longer term, fixed interest rates, fewer

restrictions and larger size. Relatively new and negative carry. Equity returns:

Equity can be adjusted within reason to get better rating.


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Case : The Chad Cameroon Project

Background:An oil exploration project sponsored by Exxon-Mobilin Central Africa with two components:

Field system: Oil wells in Chad, cost: $1.5bn. Export System: Pipeline through Chad and Cameroon to the

Atlantic, cost: $2.2bn.

Key Issues: Chad is a very poor country ruled by President Deby, a warlord.

Expropriation risk.

Possibility of hold up byC

ameroon. Allocation of proceeds World Banks role and Revenue

Management Plan.


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Possible inancing Strategies or Exxon-Mobil

Financing Options Field System Export System Total

Investment

Corporate Finance: 1 sponsor, EM100% owner $1521m $322m+$1881m=$2203m $3723m

Corporate Finance: 3 Sponsors, EM40% Owner

40%*

$1521m = &608m

40%*($2203m) =$881m

$1489m

Hybrid structure: 3 Sponsors, EM 40%

owner

Corp. Finance

40%*

$1521m = $608m

Project Finance

40%*(123+680)=

$321m

$929m

Project Finance: 3 sponsors D/V=60%

EM 40% Owner

16%*$1521m =$243m

16% * ($2203)

=$352m

$596m


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Structural choice: Hybrid structure

Brings in the World Bank to address the issue ofSovereign Risk.

Exxon-Mobil chooses corporate finance for oil fieldssince investment size is small. Other means ofmanaging sovereign risk.

Exxon-Mobil chooses project finance for the pipeline todiversify and mitigate risk.

Involves the two nations to prevent post opportunisticbehavior with the export system.


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Case : Calpine Corporation

Background: $1.7bn company with 79% leverage seeking over$6bn in financing to construct 25 new power plants. ChangingRegulatory Environment allows for selling of power at wholesale

prices over existing transmission systems with no discrimination inprice or access. Firm wants to change from IPP to Merchant powerprovider.

Key Issues:

Seizing the initiative and exploiting first movers advantage. Possible alternative sources for finance.

Limited corporate debt capacity.


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Options or Project Structure: Corporate Finance:

Public Offering of senior notes.

Project Finance : Bank loans 100% construction costs to Calpine subsidiaries for each

plant. At completion 50% to be paid and rest is 3-year term loan.

Revolving credit facility: Creation ofCalpine Construction Finance Co. (CCFC) which receives

revolving credit.

Debt Non-recourse to Calpine Corp. High degree of leverage (70%). 4 year loan allowing construction of multiple plants.


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Comparison o Financing Routes: Corporate Finance:

Higher leverage: violates debt covenant for key ratios. Issuance of equity to sustain leverage would dilute equity. Debt affected by the volatility in the high yield debt market.

Project Finance: Very high transaction costs given size of each plant. Time of execution: potential loss of First Mover advantage.

Hybrid Finance: Best ofCorporate and Project Finance. Low transaction costs and shorter execution time. New entity can sustain high debt levels: ability to finance. Non-recourse debt reduces distress cost forCalpine Corp.


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Case : Iridium LLC

Background: A $5.5bn satellite communications project backed byMotorola which went bankrupt in 1999 after just one year ofoperations. Had partners in over 100 countries.

Issues:

Scope of the project: 66 satellites, 12 ground stations around theworld and presence in 240 countries.

High technological risk: untested and complex technology.

Construction risk: uncertainty in launch of satellites.

Sovereign risk: presence in 240 countries.

Revolving investment: replace satellites every 5 years.


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Case: Iridium LLC

Structural highlights:

Stand alone entity: Size, scope and risk of the project in comparisonto Motorola. Allows for equity partnerships and risk sharing.

Target D/V ratio of 60%: Cannot be explained by trade off theory since tax rate is 15% only.

Pecking order theory and Signaling theory also do not explain the highD/V ratio.

Agency theory best explains the D/V: Management holds only 1% ofequity and the project has projected EBITDA of $5bn resulting in high

agency cost of equity. Also, since Iridium has no other investmentoptions, risk shifting and debt overhang do not increase agency costs ofdebt.

Partners participating through equity and quasi equity to deteropportunistic behavior and align partner incentives.


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Case: Iridium LLC

Financing choices: Presence of senior bank loans:

lower issue costs. Act as trip wire. Easier to restructure. Avoids negative arbitrage (disbursed when required). Duration aligned with life of satellites. Provide external review of the project.

Sequencing of financing: Started with equity during the riskiest stage (research) since debt would

be mispriced due to asymmetric information and risk. In development, brought in more equity, convertible debt and high yield

debt. This portfolio matches the risk profile then. For commercial launch, got bank loans: agency motivations emerge.


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Case: Iridium LLC

Contention: The Structuring and financing of Iridium wasfaulty and partially responsible for its demise.

Reality: Since Iridium was incorporated as an independententity and not corporate financed, its prime sponsorMotorola is still solvent inspite of Iridiums bankruptcy.Moreover, the Bank loan default which seeminglytriggered the bankruptcy also avoided fresh capital from

being ploughed into what was essentially atechnologically doomed project.


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Case : Bulong Nickel Mine

Background: In July 1998 Preston Resources bought the BulongNickel Mine in the pre-completion phase and financed it with abridge loan. The bridge loan was financed with a 10 year project

bond in December 1998. Within one year, Bulong defaulted on thenotes after operational problems.

Issues:

Concentrated and weak equity ownership: Preston Resources.

Cash flows very close to debt service.

Processing technology is unproven.

The output faces severe market risk and currency risk.

The company has exposure to currency risk through forwardcontracts.


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Case: Bulong Nickel Mine

Structural / inancing highlights: Project finance: the right choice given the nature of the project and

its size relative to the sponsor. 72% D/V ratio: very high given the projected cash flows of the

project. Severely limits flexibility. Optionality: financial structure resembles an out of the money call

option from the sponsors perspective. Importance of completion guarantees: EPC agency guarantees

commissioning of plant and not ramp up. This misinterpretation ofcompletion guarantee results in project exposure to technology risk.

Project Bonds instead of bank loans: Motivation is flexibility in futureinvestment (Preston has a similar project on the cards which it wantsto facilitate with Bulong cash flows). However bonds limit flexibilityduring restructuring and delays it by 2 years.


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Contents

The MM Proposition

What is a Project?


Financing choices



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Project Finance: Valuation Issues

Valuation Issues in Projects

Traditional and Non Traditional Approach

Capital Cash Flow Method

Appropriate Discount Rate

Valuing Risky debt

Real Options


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Valuation Issues in Projects

Projects are exposed to non-traditional risks(discussed earlier).

Have high and rapidly changing leverage. Typically have imbedded optionality.

Tax rates are continuously changing.

Projects have early, certain and large negativecash flows followed by uncertain positive cashflows.


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Failure of Traditional Valuation

Usage ofCorporate WACC is inappropriate: Different risk profile of the project from the sponsor.

Project has rapidly changing leverage.

Considers promised return on risky debt and notexpected return.

Traditional DCF method is inaccurate: Single discount rate does not account for changing

leverage. Ignores imbedded optionality.

Idiosyncratic risks are usually incorporated in thediscount rate as a fudge factor.


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Non-traditional Approaches

Using Capital Cash Flow method which acknowledgeschanging leverage and uses unlevered cost of capital.

Usage of non CAPM based discount rates especially for

emerging markets investments. Valuation of risky debt as a portfolio of risk free debt and

put option. Incorporation of imbedded Optionality: Valuation of Real

Options.

Usage of MonteC

arlo Simulations to incorporateidiosyncratic risks in cash flows and to value RealOptions.


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Capital cash Flow method

Computing capital cash flow: Take Net Income (builds in tax shields directly) Add depreciation and special charges, Add interest Subtract change in NWC and Subtract incremental investment.

Discount capital cash flow with unlevered cost of equityto arrive at firm value.

Equity value can be derived by subtracting risky debtvalue.

Advantages: Incorporates effect of changing leverage. Avoids calculation of debt discount rate. Assumes tax shields

are at similar risk as whole firm.


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Discount Rate for Project Finance

Corporate WACC is an inappropriatediscount rate (discussed above).

Incorporate idiosyncratic risks in cashflows and account for systematic risks indiscount rate. Avoid double accounting.

Ensure that discount rate is consistent withthe cash flow: unlevered rate for capitalcash flows.


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Discount Rate in Emerging Markets

This is a major area of concern:

Many mega projects are in emerging markets.

Many of these markets do not have mature equitymarkets. It is very difficult to estimate Beta with theWorld portfolio.

The Beta with the World portfolio is not indicative ofthe sovereign risk of the country (asymmetricdownside risks). E.g. Pakistan has a beta of 0.

Most assumptions ofCAPM fail in this environment.


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Playing with the CAPM!

Approaches to calculating the Cost ofCapital inEmerging Markets:

WorldCAPM or Multifactor Model (Sharpe-Ross)

Segmented/Integrated (Bekaert-Harvey) Bayesian (Ibbotson Associates)

CAPM with Skewness (Harvey-Siddique)

Goldman-integrated sovereign yield spread model

Goldman-segmented

Goldman-EHV hybrid CSFB volatility ratio model

CSFB-EHV hybrid

Damodaran


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Playing with the CAPM!

Most CAPM based methods fail to accuratelycalculate cost of capital in emerging markets dueto one or more of the following:

Method does not incorporate all risks in the project. Assume that the only risk is variance. Fail in capturing

asymmetric downside risks. Assume markets are integrated and efficient. Arbitrary adjustments which either over or

underestimate risk. Use sovereign bond returns as a proxy for cost of

equity.


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The Country Risk rating Model

Erb, Harvey and Viskanta (1995)

Credit rating a good ex ante measure of risk

Impressive fit to data

Explores risk surrogates: Political Risk,

Economic Risk,

Financial Risk and

Country Credit Ratings

Fits developed and emerging markets (nearly 136countries)


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Sources

Political Risk Services International Country Risk Guide

Institutional Investors Country Credit Rating Euromoneys Country Credit Rating

Moodys

S&P


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Steps: Cost ofCapital = risk free + intercept - slopexLog(IICCR)

Where Log(IICCR) is the natural logarithm of the Institutional

InvestorCountry Credit Rating

Gives the cost of capital of an average project in the country.

If cash flows are in local currency, then add forward premium lesssovereign risk of the currency to the cost of capital.

Adjust for global industry beta of the project.

Adjust for deviations in the project from the average level of a givenrisk in the country (Risk management will have a downward effect).


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Valuing Risky Debt

Differentiate between expected yield andpromised yield.

Options approach: Face value of corporate debt: k (strike price)

Underlying assets of the firm: S

Equity value: C(k) (call value with strike price = k)

Riskless debt: PV (k,r) (r: risk free rate of interest)

Put option: P(k) (put value with strike price = k)

By Put-Call Parity: S = C(k) + PV (k,r) P(k)

Value o risky debt, V(D): PV (k,r) P(k)


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Valuing Multiple Classes of Risky Debt

Senior debt: face value = D1 strike price, k1 = D1.

Junior debt: face value = D2 strike price, k2 = D1+D2.

Value of senior debt, V(D1) = V(riskless,D1) P(k1)

Value of junior debt, V(D2) = V(riskless,k2) P(k2) V(D1)

Value of total debt, V(D) = V(D1) + V(D2)


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Real Options: Generic Types


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Real Options in Project Finance

Scale up: Are usually in the form of replication.These also include contractual real options inthe form of leases etc. Affects project NPV.

Switch up: Affects projectN

PV. Scope up: Affects value of Sponsors

involvement.

Study/start: Affects project NPV. Critical for

stock type projects where precise estimation ofreserves is critical to success.


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Real Options in Project Finance

Scale down: Mostly applicable in the pre-completion stage. Scale down is rarely an optionpost-completion since projects are valuablealmost exclusively as going concerns. Affectsproject NPV.

Switch down: Rarely an option for a project.

Scope down: Similar to the scale down option.

Flexibility option: The option to switch input oroutput mix is key to projects and can helpreduce cash flow volatility. Affects project NPV.


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Real Options: Industry Examples

Automobile: RecentlyGM delayed its investment in anew Cavalier and switched its resources into producingmore SUVs.

Aircraft Manufacturers: Parallel development of cargoplane designs created the option to choose the more

profitable design at a later date. Oil & Gas: Oil leases, exploration, and development are

options on future production Refineries have the optionto change their mix of outputs among heating oil, diesel,unleaded gasoline and petrochemicals depending on

their individual sale prices. Telecom: Lay down extra fiber as option on future

bandwidth needs


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Real Options: Industry Examples

Real Estate: Multipurpose buildings (hotels, apartments,etc.) that can be easily reconfigured create the option tobenefit from changes in real estate trends.

Utilities: Developing generating plants fired by oil & coal

creates the option to reduce input costs by switching tolower cost inputs.

Airlines: Aircraft manufacturers may grant the airlinescontractual options to deliver aircraft. These contractsspecify short lead times for delivery (once the option is

exercised) and fixed purchase prices.


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Real Options: Valuation Approaches

Black Scholes formula: The PV of cash flows is asset price and the variation in returns is

volatility. It is difficult to find real world situations which fulfill assumptions

underlying the BSM.

Binomial Option Pricing model: The most illustrative method. Have to incorporate varying risks of cash flows at each decision

node. It is better to risk adjust the cash flows and use a risk freerate.

Monte Carlo Simulation: The most robust and accurate method. Easy to integrate multiple and interacting real options. Can be used to accurately value an option when multiple options

are present by comparing the analysis results with and withoutthe option.


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The MM PropositionM&M premise oStructure irrelevance

No transaction Costs

No taxes

No cost of FinancialDistress

No agency conflict

No asymmetricInformation

Real World situations

Very high transaction costs that canaffect the investment decision.

Taxes are mostly positive and high

and results in valuable tax shields.

Capital and governance structuredecreases risk thereby decreasingcost of distress.

Behavior of various parties can becontrolled through structure.

Type and sequence of financingcan improve information.


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The MM proposition

Since real world situations do not alwaysfulfill the assumptions of the MM

Proposition, structure does affect firmvalue in reality.


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Acknowledgements

The content of this presentation has been derived primarily from the:

Project Finance course taught by Benjamin Esty at the HarvardBusiness School.

Emerging markets Corporate Finance course taught by CampbellHarvey at the Fuqua School of Business.

Advanced Corporate Finance course taught by Gordon Phillips at theFuqua School of Business.

We thank the above for their contribution to this effort. We also acknowledgethe usage of content from Project Finance Internationaland Journal ofApplied Corporate Finance. We thank them for access to their databases.

agarwal kaul

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