So, what’s your project worth? And how should you evaluate its merits against other possible uses of time and cash? To answer those questions, you’ll likely need to run a net present value, or NPV, calculation.
The definition of NPV is simple: NPV is the difference between the present value of all future cash inflows and all future cash outflows. If the difference between those two values is positive, meaning the NPV is positive, your project is likely worth the cash you’re investing in it. If the NPV is negative, you should not invest.
The formula for NPV is fairly simple: ∑ Cf t/ (1+rt)^t, where Cf t is a cash flow at time t, rt is a discount rate at time t, and t is the time period over which you’re evaluating the project. Basically, we discount cash flows by dividing them by (1+ the discount rate) raised to the power of the time period. As the time period gets larger, the denominator rises, increasing the amount by which our cash gets discounted. This means that cash flows further in the future will be discounted more heavily than cash flows nearer to today.
Once we start substituting values for variables in the NPV formula, we realize this too is fairly straightforward. We should know what our net cash flow looks like (Cf t) and we can understand the time period over which we’re evaluating this project. But once we get to rt, we may begin to realize we have some questions. Namely, what rate, or “r” should we use?
Well, our corporate finance colleagues would tell us that the answer to this question is to find the project’s weighted average cost of capital or WACC, and they’d be right. However, there are some pronounced differences between a corporate finance WACC and a project finance one. Let’s dive into those.
The formula for WACC is:
(Kd * D/(E+D) * (1 – T)) + (Ke * E/(E+D)), where:
Kd = Cost of debt;
D/(E+D) = relative weight of debt in the capital structure;
Ke = Cost of equity;
E/(E+D) = relative weight of equity in the capital structure;
T = tax rate.
Again, to simplify, the WACC formula is asking us to find the sum of the cost of equity and debt multiplied by their relative weights in the capital structure, with a small addition to account for the debt tax shield.
So, when substituting, the cost of debt, relative weights of debt and equity in the capital structure, and tax rate are all easy to ascertain. For projects with mezzanine debt or several tranches of debt, the cost of debt is the average cost of overall tranches. All relatively straightforward substitutions so far.
However, when we get to the cost of equity, we find a few more variables to consider. The formula for the cost of equity is:
Rfr + Beta * (MRP – Rfr) where Rfr is the risk-free rate, MRP is the market risk premium, and Beta is a measure of the riskiness of equity. The risk-free rate is generally assumed to be a Treasury rate matched to your project’s projection time period, i.e., 10-year, 30-year, etc. And the market risk premium is the premium that investors derive from investing in equities over other asset classes, namely debt. Historically, the MRP changes with conditions in the stock market. The recent average is around 6% though.
But again, how do we find Beta? The formula for beta is a bit obtuse, but we’ll unpack it shortly. Here’s the formula:
Covariance (Re, Rm) / Variance (Rm)
This formula is trying to tease out how risky this project might be relative to the riskiness of the overall market. In Corporate Finance, one can ask oneself (and expect a fairly simple answer): how risky is Apple relative to the Dow Jones Industrial Average? There are numerous news outlets from The Wall Street Journal to Yahoo! Finance from which we can ascertain thousands of data points to support historical returns for both assets, making this analysis pretty easy. Some corporate finance guidebooks and data services even publish regularly updated Beta calculations on wide varieties of stocks and indices.
However, finding data to support the analysis of Beta in project finance is a lesson in humility. Details of project finance transactions are rarely posted to publicly available news sources. News services that try through informal interviews often miss key details or crucial transactions altogether. And think about it: would you disclose your all-in costs on a transaction if you didn’t need to? So, there’s also an incentive by dealmakers to obfuscate transparency.
So, where does that leave us? Well, without a Beta, the cost of the equity component of our WACC calculation is looking pretty unstable. What should we do?
We can do an end-run around WACC by taking a step back. When we ask ourselves, what risks are really pertinent to the successful operation of our project financing, and hence the cash flows? For example, in a solar deal who is the key stakeholder in a bank financing? In an availability payment toll road deal, about whose credit do we really care?
Answer? The off-taker. If your off-taker is investment grade, chances are good your discount rate can afford to be lower than if your off-taker is sub-investment grade. This derives from the notion that investment-grade counterparties are less likely to move downward from one rating category to another during times of stress. Further, many investment-grade off-takers operate in industries that are asset-heavy and hence would be able to repay their loans by selling assets, keeping realized losses low in the case of a default.
Many investors in project finance transactions also view the risk rating of the off-taker as a hurdle rate for their investment. In other words, if investor XYZ is putting $10,000,000 of equity to work in a project with an off-taker rated BBB+, we can use the observable BBB+ market spread to Treasuries to create a rate of return to which we can say, “I should be making at least THAT much in this deal.” Otherwise, investors could be made better off simply by buying BBB+ assets.
To find the observable spreads to Treasuries, there are a variety of mechanisms available. The easiest to use is a Bloomberg terminal; unfortunately, it’s also the most expensive. If you’re lucky enough to have access to a Bloomberg terminal, type OAS1 and and you should get to a menu that allows you to dissect the spread for which you’re interested (“OAS” stands for “option-adjusted spread”.)
There also exist a variety of other services that can assist here. Some are free (with a deliberate lag in the availability of their information); some might require a subscription. Regardless, it’s important to remember that these are spreads to an underlying reference rate, in this case, Treasuries. Match the tenor of your reference rate to the length of your contract or the average life. The full discount rate is going to involve adding the spread to the reference rate to arrive at the discount rate.
What happens if your off-taker is unrated? One could look at the industry in which the off-taker operates and use the historical non-investment grade spread as a guide. For example, one could use the aforementioned tools to track the non-investment grade industrials, retail, utilities, etc. spreads.
NPV is an essential tool for determining the value of project financing. Using publicly available tools, we can fill in most of what we need to derive a project’s WACC. But what we lack, namely Beta and a robust calculation of the cost of equity, leaves our efforts stranded.
Stepping back and evaluating the true risks to our project, namely the default risk of our off-taker, the provider of our project cash flow, can help us reframe the calculation in a simpler, more holistic way.
