Consistent valuation of project finance and LBO's using the flows-to-equity method

Finance

IFA Working Paper

Cooper I A;Nyborg K G

Ian Cooper

2010

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 re-leveraging 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.

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

IFA Working Paper

No

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