This thesis examines the valuation of Project Finance using a local toll road project as a case. First, it describes the characteristics of Project Finance. The description by the early studies on the Project Finance has been largely limited to the conceptual explanation. This study expands the description in more detail. Then it examines the Project Finance Valuation issue. The most fundamental task in project valuation is the estimation of cash flows.
For the creditors, Debt Service Coverage Ratio (DSCR) is used to evaluate whether the project can generate sufficient cash flows to cover interests and principals each year and throughout the project life. Valuation is necessary to evaluate the economic feasibility of the projects. In practice, two approaches are generally used- NPV and IRR. IRR is popular and appropriate for valuing projects with a relatively stable cash flow such as infrastructure or estate development projects. However, IRR is not appropriate for the project whose cash flow structure fluctuates and does not fit the assumptions implied in IRR. In this case, the NPV with an appropriate discount rate is used.
Two problems in applying discount rates are found in practice. First problem relates to the application of a constant discount rate. Using a constant discount rate could lead to a false signal because capital structure (leverage) and the business risk changes over time in project finance. Second, the constant discount rate is usually a target rate of return determined through negotiation processes according to regulations. This discount rate may not be consistent with the cost of capital determined in the market.
This thesis suggests a variable weighted average cost of capital (WACC) or a variable cost of equity in which the beta is adjusted to changing leverage. The beta is difficult to calculate because it is hard to find a proxy firm. However, using market data in estimating opportunity cost of capital is still important because it can be used as a benchmark in negotiation and therefore, could significantly reduce the cost of negotiation that usually lasts more than two years in Project Finance.
The capital structure of Project Finance is similar to that of a Leveraged Buy Out (LBO), and the adjusted present value (APV) approach can be considered as an alternative measure for Project Finance Valuation. As long as other effects of using debt can be appropriately figured out, the APV method is more preferable because the variable discount rate needs not be calculated. However, the issue of determining an appropriate opportunity cost of equity still remains. Finally, real option can be used for the projects with high-risk such as oil exploration, leisure projects, etc. This should be the subject of the future study.
