consistent valuation of project strongfinancestrong and lbos using the.pdf

Consistent valuation of project finance and LBOs using the flows-to-equity method Ian Cooper and Kjell G. Nyborg1 November 2010 Abstract A common method of valuing the equity in leveraged transactions is the flows-to- equity method whereby the free cash flow available to equity holders is discounted at the cost of equity. This method uses a standard definition of equity free cash flow, but the cost of equity varies over time as leverage varies. Various formulas can be used to calculate the time-varying cost of equity, most of which are inconsistent with the assumptions underlying the free cash flow calculation. In this paper we show how to include correctly the following in the flows-to-equity method: • A releveraging formula consistent with a fixed debt plan; • A yield spread on debt which is fair compensation for default risk; • The part of the yield spread which is excessive; • The expected cost of financial distress. We show that each of these can have a significant effect on valuation and the value derived in a consistent way can differ substantially from that derived by more conventional procedures. JEL Codes: G12, G24, G31, G32, G33, G34. Keywords: Valuation, flows-to-equity, equity cash flow, cost of equity, project finance, LBO. 1 This research has benefited from a grant from the Research Council of Norway, grant number 1798866/S20. We also thank NCCR-FINRISK for financial support. Cooper: London Business School, Regent’s Park, London NW1 4SA, UK. Email: icooper@london.edu. Nyborg: Department of Banking and Finance, Univeristy of Zurich, Plattenstrasse 14, 8032 Zurich, Switzerland. Email: nyborg@isb.uzh.ch. * Note that the formula in Table 1 is in terms of 7. Howeve