Presentation Transcript

1. L5: Raising Finance EC10: Commercialisation &

Innovation How to build structures and deliver results
for stakeholders.
2. Raising Finance Outline • Seeking Venture Capital
• Financial Support • Due Diligence • Venture
Finance Strategies 5. Raising FinanceL1: Team
Building
3. 1. Seeking Venture Capital EC10 Innovation &
Commercialisation
4. The Route to Commercialisation Development
Prototype Into To Market Market Penetration Idea
Research Testing Active Sales Market Identification
Source Scottish Enterprise - Commercialisation 1997
5. Raising Finance
5. Seeking Venture Capital (1) • Target a Venture
Capital Partner • Does the VC team have experience
with this sort of technology applications? • Do they
take an active or passive role in the management of
the new venture? • Are there competition
technologies in the portfolio? • Are the personalities
on both sides of the table compatible? • Does the VC
firm has syndication ties with other institutions for
 additional funding rounds? • Can they provide access
to supporting technologies, supply chains and
customer groups? After PricewaterhouseCoopers 5.
Raising Finance
6. Seeking Venture Capital • Write the Plan • Is the
management team capable of growing the business
rapidly and successfully? • Have they done it before?
• Is the technology fully developed? • Is the product
unique, and what value does it create so that buyers
will want to purchase the product or service? • Is the
market potential large enough? • Does the team
understand how to penetrate the market? • Do
significant barriers to entry exist? • How much
money is required and how will it be utilized? • What
exit strategies are possible? • Prepare for
Negotiations • Prepare & Adjust Financials 5. Raising
Finance
7. Sequential Model development and
funding Based on research by Lewis Branscomb and
colleagues – quoted from Harrison 2004 5. Raising
Finance
8. Based on Branscomb – Harrison, Edinburgh Uni,
Inaugural Lecture 2004 5. Raising Finance
9. 2. Financial Support
10. Short term overdraft short term loans trade
credit hire purchase leasing factoring invoice
discounting credit cards (company and/or personal)
Long term initial equity retained profits long term
 loans external equity business angel funding venture
capital Types of Finance 5. Raising Finance
11. Stages of Sources of Finance (adapted
from Weston & Brigham, 1979) • Personal funds +
overdraft + trade credit + (possibly grant, short term
loans, leasing/hp, factoring) • Retained funds + long
term loans (debt) • External equity (e.g. floatation
(IPO), venture capital) • Decline (only internal funds)
• Consider balance between short and long term
sources at different stages….. • Evidence suggests
many SMEs never get beyond stage 1. 5. Raising
Finance
12. Internal Finance • Includes issued share
capital, retained profits • Long term : no redemption
(does not have to be paid back) • Dependent on
(could be constrained by) • wealth of owner
managers • profitability of firm • Young firms (and
young owner managers) are more likely to face an
internal equity constraint 5. Raising Finance
13. External Equity • Includes new shares issued
privately (e.g. founding team) or publicly (e.g. Initial
Public Offering (IPO) • Is long term with no
redemption and from firm’s point of view less risk of
liquidation than debt • Initial flotation and ongoing
costs of compliance can be high so IPO not suitable
for smaller amounts • In 1931, the MacMillan
Committee identified an equity gap for firms seeking
less than £200,000 (equivalent today = £4m) •
Evidence suggests an aversion to external equity by
 entrepreneurs who would rather constrain the growth
of the firm than lose any control 5. Raising Finance
14. Business Angels (Informal VC) • Individuals
who invest in particular firms • Smaller amounts than
formal VC (£10k - £100k) • More if invest as
syndicate (e.g. £2million) • Source of advice/
expertise • May require involvement e.g. seat on
board • For firm, finding an angel is difficult • Need
to find high net worth individuals • Matching may be
through intermediary • e.g. bank or business angel
network • High return required so only high growth
firms 5. Raising Finance
15. External Equity • All forms of external equity
require current owners to give up part of the
ownership and control of the firm, which many owner
managers are averse to - the firm is their baby •
External equity is permanent finance: gives stability
• Costs inevitably lead to minimum thresholds •
Providers require high returns which only very high
growth SMEs can achieve 5. Raising Finance
16. Debt Finance • The major source of external
finance for all firms • Includes bank debt (overdrafts,
short and long term loans) and negotiable debt (e.g.
bonds, convertibles) • Amounts required by SMEs too
small for negotiable debt (issue costs) • Evidence
shows SMEs rely heavily on short term bank debt. For
example: Overdrafts • Gives flexibility but risk of not
being able to renew • Long term assets should be
financed with long term sources of finance. Evidence
 suggests SMEs use overdrafts and trade credit for
long term assets e.g. plant /machinery 5. Raising
Finance
17. Asset Based Finance • Includes hire purchase,
leasing, factoring • Finance is for a specific asset e.g.
van, office equipment, debtors • Widely available to
all sizes of firms and frequently used by SMEs •
Security provided by asset mitigates problems in risk
assessment of SME 5. Raising Finance
18. Trade Credit • Trade credit is a very expensive
form of finance if SMEs are foregoing early payment
discounts. • Paying late can put a strain on
relationships with suppliers • Suppliers are in effect
financing their customers’ operations • Chasing
outstanding debt is time-consuming and expensive •
Uncertainty inherent in late payment makes it
difficult to plan cash flows • And yet 84% of small
firms pay late • The majority say that it is a
necessary part of managing cash flow 5. Raising
Finance
19. Questions • Consider whether the high use of
short term sources of finance is because SMEs
cannot get any other type of finance (because they
are at the mercy of bigger players i.e. finance
providers) or do they choose/prefer to juggle short
term sources? • Is it reasonable to assume
technology businesses will behave differently from
(say) family business? OR 5. Raising Finance
20. 3. Due Diligence Failure and the opportunities
that en2020sue.
21. Assessing the Team • Is the management
team capable of growing the business rapidly and
successfully? • Have they done it before? • Is the
technology fully developed? • Is the product unique,
and what value does it create so that buyers will
want to purchase the product or service? • Is the
market potential large enough? • Does the team
understand how to penetrate the market? • Do
significant barriers to entry exist? • How much
money is required and how will it be utilized? • What
exit strategies are possible? 5. Raising Finance
22. Business Valuations • Stage 1: • Ventures
have no product revenues to date and little or no
expense history, usually indicating an incomplete
team with an idea, plan, and possibly some initial
product development. • Stage 2: • Ventures still
have no product revenues, but some expense
history, product development is underway. • Stage 3
• Ventures show product revenues, but they are still
operating at a loss. • Stage 4 • Companies have
product revenues and are operating profitably. 5.
Raising Finance
23. Why Businesses Fail • Management Controls •
Accounts • Stock • Liabilities • Funding • Overheads
• Borrowings • Credit-control • Market Conditions •
Competition • Market Trends • Selling • Management
 • Staff • Equipment • Warranties & Liabilities 5.
Raising Finance
24. Types of Failure • Cessation • harvesting •
succession • change of identify • Living Dead •
Disposal • Throwing in Towel • Buy-outs, But-ins •
Withdrawal of Backers • Banks • Private Investors •
Trade creditors • Legal • Take-over • Reconstruction
• Mergers • Involuntary Discontinuance of Business.
5. Raising Finance
25. Exit Routes Merger Maturity Steady- State
Assets Accumulation Closure Growth Reversal
Steady- State Closure Growth Reinforcements Merger
Generate Resources Closure Merger Mobilise
Resources Steady- State Access to resources Closure
Time 5. Raising Finance Understanding Enterprise,
p6.3, Bridge,O’Neill & Cromie, Macmillan, 1998
26. Emerging Industries • Newly formed or
reformed industries, created by technology
innovations, shifts in relative cost relationships,
emergence of new consumer needs or economic and
social changes. • The rules are that there are no
rules. The Environment: • Technological uncertainty,
strategic uncertainty, initial high costs but steep cost
reduction • Adoption rates Buyers of emerging
technology are inexperienced. • Need to induce
substitution, inform about functions and overcome
perceived risks. • Short time planning horizons
Porter, Competitive Strategy, Collier Macmillan
Publishers, 1980, pp237 -253 5. Raising Finance
27. Planning Problems For Early Entrants •
Inability to secure supply lines & maintain quality •
Escalation of material prices & labour costs •
Absence of infrastructure – channel, servicing,
complementary products • Absence of
standardisation and regulatory framework •
Perceived likelihood of obsolesce • Image credibility
with Financial Community • Response of
(entrenched) companies • Cost of Failure •
Introduction of incentives to switch costs 5. Raising
Finance Porter
28. Strategic Opportunities for New Entrants •
Shaping Industry Structures • Managing Externalities
• Changing Role of Suppliers & Channels • Changing
the mobility/transferability barriers • Timing Entry 5.
Raising Finance
29. Recovery Positions • Non-recoverable •
Technology or cost advantages have been lost. •
Retrenchment • retrenchment strategy is
successfully implemented but cannot be sustained in
the longer term. • Sustained Survival • the
turnaround is achieved and the business is able to
protect its existing position in the market. •
Sustained Recovery Slatter (1984) 5. Raising Finance
30. Recovery or Retrenchment • Galvanisation •
Team recognise they are no longer able to manage
the situation. • Management changes required for
the business to survive and thrive. • Business will be
required to raise extra financial resources from
 external sources and this may result in a change of
ownership and moving control away founding
entrepreneurs. • Simplification • clear focus of
direction is defined and resources are allocated and
targeted to build a strong and sustainable core
business. • Competency Building • The business then
builds new competencies and competitive
advantages into its business model. In a recovery
situation there will be pressure on resources that are
available and this is likely to create internal
challenges. • Leaverage • New Team buys in
competencies and diversifies into new products,
services, markets and opportunities. 5. Raising
Finance
31. Disinvestment • Alternative to organisational
changes and the financial changes. • Business
focuses on its core profitable business. • It discards
new ventures, subsidiaries and/or sites. •
Technologies or assets sold off to raise money that
can be reinvested into strategies to strengthen the
core business. • Disinvestment strategies divide
between those that are internal to the organisation,
such as the closure of a plant, and external, such as
sale of the business. • Not usually part of a long-term
strategy but reaction to trading conditions or cash-
flow crisis. • Disinvestment decisions are less well
thought through in terms of their long term impact of
the business. Thompson, J, 2002 5. Raising Finance
32. 4. Venture Finance Strategies
33. Access to Finance • According to the Bank of
England (Finance for Small Firms 1999), 39% of SMEs
are financed through (internal) debt funding. • This
indicates that smaller firms are either adverse to
external borrowing or else they are excluded. • This
is the “funding gap”. 5. Raising Finance
34. Trajectories • Bootstrapping • founders, friends
& family (the "3Fs" • business angels • venture
capital (VC) • initial public offering (IPO) or mergers
& acquisitions (M&A) 5. Raising Finance
35. Venture Capital • Long term equity finance •
VC firm manages fund which is invested in portfolio
of other companies • Usually £500,000 minimum,
average investment = £3.5m (1999) • Rigorous
assessment of proposal and monitoring of
investment • High return required so usually only
high growth (and high risk) SMEs 5. Raising Finance
36. Venture Capital • Typically only 1 in 40
proposals is funded • VC may insist on appointing a
non-executive director • VC redeems investment at
exit e.g. by IPO or trade sale 5. Raising Finance
37. Raising Equity Plan • Purpose and Objectives
• Proposed Financing • the amount of money needed
from the beginning to the maturity of the project
proposed, how the proceeds will be used, how you
plan to structure the financing, and why the amount
designated is required. • Market-place • a
description of the market segment the firm controls
 or plans to get, the competition, the characteristics
of the market, and marketing plan (with costs) for
getting or holding the market segment being
targeted.. • History of the Firm • a summary of
significant financial and organisational milestones,
description of employees and employee relations,
explanations of banking relationships, recounting of
major services or products the firm has offered
during its existence. • Product or Service • a full
description of the product, process or service offered
by the firm and the costs associated with it in detail.
5. Raising Finance
38. Raising Equity • Financial Statements • for the
past year and pro forma projections (balance sheets,
income statements, and cash flows) for the next 3-5
years, showing the effect if the project is undertaken
and if the financing is secured. • Should include
analysis of key variables affecting financial
performance, showing what could happen if the
projected level of revenue is not attained.) •
Capitalisation • a list of shareholders, how much is
invested to date, and equity/debt. • Biographical
Sketches • the work histories and qualifications of
key owners/employees. • Principal Suppliers,
partners and Customers • Problems Anticipated and
Other Pertinent Information • a candid discussion of
any contingent liabilities, pending litigation, tax or
patent difficulties, and any other contingencies that
might affect the project. • Advantages • a discussion
 of what's special about product, service, marketing
plans or channels that gives the project unique
leverage. 5. Raising Finance
39. Types of Entrepreneurs • Studies have
revealed that different types of entrepreneurs exist
(Smith, 1967; Westhead, 1990, 1995; Birley and
Westhead, 1994; Woo et al., 1991). • Nascent
entrepreneurs: individuals considering the
establishment of a new business. • Novice
entrepreneurs: individuals with no prior business
ownership experience as a business founder, an
inheritor or a purchaser of a business. • Habitual
entrepreneurs: individuals with prior business
ownership experience. • Serial entrepreneurs:
individuals who have sold / closed their original
business but at a later date have inherited,
established and / or purchased another business. •
Portfolio entrepreneurs: individuals who have
retained their original business but at a later date
have inherited, established and / or purchased
another business. 5. Raising Finance
40. Habitual Entrepreneurs • No accepted
definition (Starr and Bygrave, 1991). • A wider
definition of 'habitual' founders was used by Birley
and Westhead (1993, p.40) who suggested: •
"...'habitual' founders had established at least one
other business prior to the start-up of the current
new independent venture". • Hall (1995) divided
habitual entrepreneurs into serial and portfolio
 entrepreneurs. • Westhead and Wright (1998a) have
claimed that habitual entrepreneurs are individuals
who have established, inherited and / or purchased
more than one business. • They suggested that serial
entrepreneurs have sold / closed their original
business but at a later date have inherited,
established and / or purchased another business. • In
the United States, it is widely reported that many
entrepreneurs have established / owned several
businesses before they established / owned a
successful business (Ronstadt, 1982). 5. Raising
Finance
41. Portfolio & Novice Entrepreneurs • Portfolio
entrepreneurs • Individuals who own two or more
businesses at the same time. Entrepreneurs building
a portfolio of ventures may dispose of some of them
over time thus introducing a serial element to their
behaviour. Westhead and Wright (1998a) • Rather
than becoming involved in further ventures as
controlling owners, individuals use wealth from initial
ventures to acquire minority stakes in ventures
controlled by other entrepreneurs (business angel)
(Scott and Rosa, 1996b). • Novice entrepreneurs •
individuals who own one business and have no prior
business ownership experience as a business
founder, an inheritor or a purchaser of a business.
Westhead and Wright (1998a) • Novice Founders in
this novice category may themselves at a later date
 become serial or portfolio founders (Hall, 1995). 5.
Raising Finance
42. Habitual Entrepreneurs & Angels 5. Raising
Finance
43. The Firm as the Unit of Policy Support •
Business support agencies provide financial,
managerial and technical support and assistance
towards new and existing businesses rather than
entrepreneurs. • These agencies have encouraged
individuals to make the transition from being nascent
entrepreneurs (Carter et al., 1996), that is in the
position of considering starting a business, to
actually establishing new businesses (Reynolds,
1997). 5. Raising Finance
44. Influence of Financial Institutions • Financial
institutions and professional advisers view some
types of customers as more ‘risky’ than others. •
Financial institutions and professional advisers may
be prepared to provide additional advantage to
customers (i.e., habitual entrepreneurs) who have a
proven track record of success. • Financial
institutions and professional advisers require
additional information surrounding the assets and
liabilities associated with prior business ownership
experience. 5. Raising Finance
45. Financing Ventures • A Habitual
entrepreneur’s background and can have a profound
influence on the types of finance used during the
 launch period of surveyed businesses. • Habitual
entrepreneurs, if previously successful, may be
expected to have greater access to funds than
novice entrepreneurs. • Funds from private business
sales may be used by serial (and portfolio) founders
to invest in subsequent ventures. 5. Raising Finance
46. Funding Serial Entrepreneurs • Serial
entrepreneurs who have successfully exited from
their initial venture may generate funds to use
personal resources to finance their subsequent
venture(s). • Serial founders who have relinquished
their equity stakes in previously owned businesses
have no trading partners to leverage-up. • If serial
entrepreneurs are not successful in their first
venture, they may be able to raise funds, as venture
capitalists seek evidence of an ability to succeed the
next time around and not just previous experience
per se (Wright et al., 1997b). • To achieve ownership
of a larger business, serial entrepreneurs may
purchase or buy into rather than establish their
second venture. 5. Raising Finance
47. Funding Portfolio Entrepreneurs • Portfolio
founders who have not exited from their earlier
venture(s) may be able to lever up resources from
the existing business and may make use of finance
from existing customers and suppliers. Further, they
may be able to lever up funds for a portfolio business
from venture capitalists who (in the UK at least)
appear to be reluctant to fund completely new start-
 ups (Murray, 1995). • Habitual entrepreneurs may
also have developed more sophisticated skills in
searching for finance. • The sources of start-up
financed used by novice, portfolio and serial
entrepreneurs with surveyed businesses, located in
rural areas in Great Britain, were explored by
Westhead and Wright (1998b). 5. Raising Finance
48. Suggested Reading • Freel, M, 2003,
Entrepreneurship and Small Firms, Sources of
Finance, McGraw Hill, Chp 5-6, p115 - 165
Presentation Transcript

1. Project Finance Campbell R. Harvey Aditya Agarwal

Sandeep Kaul Duke University
2. Contents • The MM Proposition • What is a Project?
• What is Project Finance? • Project Structure •
Financing choices • Real World Cases • Project
Finance: Valuation Issues
3. The MM Proposition “The Capital Structure is
irrelevant as long as the firm’s investment decisions
are taken as given” Then why do corporations: • Set
up independent companies to undertake mega
projects and incur substantial transaction costs, e.g.
Motorola-Iridium. • Finance these companies with
over 70% debt even though the projects typically
have substantial risks and minimal tax shields, e.g.
 Iridium: very high technology risk and 15% marginal
tax rate.
4. Contents • The MM Proposition • What is a Project?
• What is Project Finance? • Project Structure •
Financing choices • Real World Cases • Project
Finance: Valuation Issues
5. High operating margins. Low to medium return on
capital. Limited Life. Significant free cash flows. Few
diversification opportunities. Asset specificity. What
is a Project?
6. 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
7. What Does a Project Need? Customized capital
structure/asset specific governance systems to
minimize cash flow volatility and maximize firm
value.
8. Contents • The MM Proposition • What is a Project?
• What is Project Finance? • Project Structure •
Financing choices • Real World Cases • Project
Finance: Valuation Issues
9. What is Project Finance? Project Finance involves
a corporate sponsor investing in and owning a single
purpose, industrial asset through a legally
independent entity financed with non-recourse debt.
10. 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 larger than
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
11. Total Project Finance Investment • Overall
5-Year CAGR of 18% for private sector investment. •
Project Lending 5-Year CAGR of 23%.
12. Lending by Type of Debt
13. Project Finance Lending by Sector • 37% of
overall lending in Power Projects, 27% in telecom. •
5-Year CAGR for Power Projects: 25%, Oil & Gas:21%
and Infrastructure: 22%.
14. Contents • The MM Proposition • What is a
Project? • What is Project Finance? • Project
Structure • Financing choices • Real World Cases •
Project Finance: Valuation Issues
15. Project Structure • Structure highlights •
Comparison with other Financing Vehicles •
Disadvantages • Motivations • Alternative approach
to Risk Mitigation
16. Structure Highlights • Independent, single
purpose company formed to build and operate the
project. • Extensive contracting • As many as 15
parties in up to 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.
17. 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 from
sponsoring firms. • Extremely high debt levels •
Mean debt of 70% and as high as nearly 100%. •
Balance of 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.
18. Comparison with Other Vehicles
19. Disadvantages of Project Financing • Often
takes longer to structure than equivalent size
corporate finance. • Higher transaction costs due to
 creation of an independent 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.
20. Problems: High levels of free cash flow.
Possible managerial mismanagement through
wasteful expenditures and sub-optimal investments.
Structural solutions: Traditional monitoring
mechanisms such as takeover markets, staged
financing, product markets absent. Reduce free cash
flow through high debt service. Contracting reduces
discretion. “Cash Flow Waterfall”: Pre existing
mechanism for allocation of cash flows. Covers
capex, maintenance expenditures, debt service,
reserve accounts, shareholder distribution.
Motivations: Agency Costs
21. Problems: High levels of free cash flow.
Possible managerial mismanagement through
wasteful expenditures and sub-optimal investments.
Structural solutions: Concentrated equity ownership
provides critical monitoring. Bank loans provide
credit monitoring. Separate ownership: single cash
flow stream, easier monitoring. Senior bank debt
disgorges cash in early years. They also act as “trip
wires” for managers. Motivations: Agency Costs
22. Problems: Opportunistic behavior by trading
partners: hold up. Ex-ante reduction in expected
 returns. Structural Solutions: Vertical integration is
effective in precluding opportunistic behavior but not
at sharing risk (discussed later). Also, opportunities
for vertical integration may be absent. Long term
contracts such as supply and off take contracts:
these are more effective mechanisms than spot
market transactions and long term relationships.
Motivations: Agency Costs
23. Problems: Opportunistic behavior by trading
partners: hold up. Ex-ante reduction in expected
returns. Structural Solutions: Joint ownership with
related parties to share asset control and cash flow
rights. This way counterparty incentives are aligned.
Due to high debt level, appropriation of firm value by
a partner results in costly default and transfer of
ownership. Motivations: Agency Costs
24. Problems: Opportunistic behavior by host
governments: expropriation. Either direct through
asset seizure or creeping through increased
tax/royalty. Ex-ante increase in risk and required
return. Structural Solutions: Since company is stand
alone, acts of expropriation against it are highly
visible to the world which detracts future investors.
High leverage forces disgorging of excess cash
leaving less on the table to be expropriated.
Motivations: Agency Costs
25. Problems: Opportunistic behavior by host
governments: expropriation. Either direct through
asset seizure or creeping through increased
 tax/royalty. Ex-ante increase in risk and required
return. Structural Solutions: High leverage also
reduces accounting profits thereby reducing local
opposition to the company. Multilateral lenders’
involvement detracts governments from
expropriating since these agencies are development
lenders and lenders of last resort. However these
agencies only lend to stand alone projects.
Motivations: Agency Costs
26. Problems: Debt/Equity holder conflict in
distribution of cash flows, re-investment and
restructuring during 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 investment
distortions/conflicts are negligible. Strong debt
covenants allow both equity/debt holders to better
monitor management. Motivations: Agency Costs
27. Problems: Debt/Equity holder conflict in
distribution of cash flows, re-investment and
restructuring during distress. Structural Solutions: To
facilitate restructuring, concentrated debt ownership
is preferred, i.e. bank loans vs. bonds. Also less
classes of debtors are preferred for speedy
resolution. Usually subordinated debt is provided by
sponsors: quasi equity. Motivations: Agency Costs
28. Why Corporate Finance Cannot Deter
Opportunistic Behavior ? • Does not allow joint
 ownership. • Direct expropriation can occur without
triggering default. • Creeping expropriation is
difficult to detect and highlight. • Multilateral lenders
which help mitigate sovereign risk lend only to
project companies. • Non-recourse debt has tougher
covenants than corporate debt and therefore
enforces greater discipline. • In the absence of a
corporate safety net, the incentive to generate free
cash is higher.
29. Problems: Under investment in Positive NPV
projects at the sponsor firm due to limited corporate
debt capacity. Equity is not a valid option due to
agency or tax reasons. Fresh debt is limited by pre-
existing debt covenants. Structural Solutions: Non
recourse debt in an independent entity allocates
returns to new capital providers without any claims
on the sponsor’s balance sheet. Preserves corporate
debt capacity. Motivations: Debt Overhang
30. Problems: A high risk project can potentially
drag a healthy corporation into distress. Short of
actual failure, the risky project can increase cash
flow volatility and reduce firm value. Conversely, a
failing corporation can drag a healthy project along
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,
sponsors can share project risk with other sponsors.
Pooling of capital reduces each provider’s distress
 cost due to the relatively smaller size of the
investment and therefore the overall distress costs
are reduced. This is an illustration of how structuring
can enhance overall firm value. That is, contradicting
the MM Proposition. Motivations: Risk Contamination
31. Problems: A high risk project can potentially
drag a healthy corporation into distress. Short of
actual failure, the risky project can increase cash
flow volatility and reduce firm value. Conversely, a
failing corporation can drag a healthy project along
with it. Structural Solutions: Co-insurance benefits
are negative (increase in risk) when sponsor and
project cash flows are strongly positively correlated.
Separate incorporation eliminates increase in risk.
Motivations: Risk Contamination
32. Motivations: Risk Mitigation • Completion
and operational risk can be mitigated through
extensive contracting. This will reduce cash flow
volatility, increase firm value and increase debt
capacity. • Project size: very large projects can
potentially destroy the company and thus induce
managerial risk aversion. Project Finance can cure
this (similar to the risk contamination motivation).
33. 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 either hard to
get or expensive. Debt is the only option and project
 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 in
project finance.
34. On or Off-Balance Sheet Professor Ben Esty:
Your question regarding on vs. off balance sheet is a
good one, but not one with a simple answer. I do not
know of a good place to refer you to either.
35. On or Off-Balance Sheet The on/off balance
sheet decision is mainly a function of both ownership
and control. Project finance for a single sponsor with
100% equity ownership results in on-balance sheet
treatment for reporting purposes. But....because the
debt is a project obligation, the creditors do not have
access to corporate assets or cash flows (the rating
agencies view it as an "off credit" obligation--in other
words, not a corporate obligation). Even though
people refer to PF as "off-balance sheet financing" it
can, as this example shows, appear on-balance
sheet. A good example is my Calpine case where the
company has financed lots of stand alone power
plants. In the aggregate, the company showed D/TC
= 95% on a consolidated basis.
36. On or Off-Balance Sheet With less than 100%
ownership, it gets a lot trickier. Many projects are
done with 2 sponsors each at 50%. In this case, they
both can usually get off-balance sheet treatment for
the debt and the assets. Instead, they use the equity
method of reporting the transaction (with even lower
ownership, they use the cost method of reporting).
All of this changes if they have "effective control"
which is a very nebulous concept. (with 40%
ownership but 5 out of 8 directors you might be
deemed to have control). Even if you do not have to
report the debt on a consolidated basis, there are
often lots of obligations that do need to be disclosed.
For example, if you agree to buy the output of a
project, that should be disclosed as a contingent
liability in the footnotes to your annual report. There
are differences between tax and accounting
conventions.
37. Alternative Approach to Risk Mitigation
38. Alternative Approach to Risk Mitigation
39. Contents • The MM Proposition • What is a
Project? • What is Project Finance? • Project
Structure • Financing choices • Real World Cases •
Project Finance: Valuation Issues
40. Financing Choice • Portfolio Theory • Options
Theory • Equity vs. Debt • Type of Debt •
Sequencing
41. 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 distress
which increases with combined variance. • Project
finance is preferred when joint financing (corporate
finance) results in increased combined variance. •
Corporate finance is preferred when it results in
lower combined variance due to diversification (co-
insurance).
42. 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 and fees on loans. • The underlying asset
(project) and the option provides a payoff similar to
that of call option.
43. Financing Choice: Options Theory • The put
option is valuable only if the Sponsor might be
able/willing to exercise the option. • The sponsor
may not want to avail of project finance (from an
options perspective) because it cannot walk away
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
firm’s reputation and ability to raise future capital.
44. Financing Choice: Options Theory •
Derivatives are available for symmetric risks but not
for binary 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 an option on a portfolio.
45. 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) are low
due to less investment opportunities. • Debt provides
a governance mechanism.
46. 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.
47. Financing Choice: Sequencing • Starting with
equity: eliminate risk shifting, debt overhang and
 probability of distress (creditors’ requirement). • Add
insider debt (Quasi equity) before debt: reduces cost
of information asymmetry. • Large chunks vs.
incremental debt: lower overall transaction costs.
May result in negative arbitrage.
48. Contents • The MM Proposition • What is a
Project? • What is Project Finance? • Project
Structure • Financing choices • Real World Cases •
Project Finance: Valuation Issues
49. Real World Cases BP Amoco: Classic project
finance Australia Japan cable: Classic project finance
Poland’s A2 Motorway: Risk allocation Petrolera
Zuata: Risk management Chad Cameroon: Multiple
structures Calpine Corporation: Hybrid structure
Iridium LLC: Structure and Financing choices Bulong
Nickel Mine: Bad execution
50. Case : BP Amoco Background: In 1999, BP-
Amoco, the largest shareholder in AIOC, the 11 firm
consortium formed to develop the Caspian oilfields 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.
51. Case: BP Amoco Structural highlights: • Risk
sharing: Increase the number of participants to 11
and decrease 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 reduce
expropriation risk. • Staged investment: 2nd phase
($8bn) depends on the outcome of the 1st phase
investment. Improves information availability for the
creditors and decreases cost of debt in the 2nd
phase.
52. Case : Australia Japan
Cable Background:12,500km cable from Sydney,
Australia to Japan via Guam at a cost of $520m. Key
sponsors: Japan Telecom, Telstra and 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
53. 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 station owners 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
revenue waterfall. Enforces Management discipline. •
Short term debt allow for early disgorging of cash.
54. Case : Poland’s A2 Motorway Background:
AWSA is an 18 firm consortium with concession to
build and operate toll road as part of Paris-Berlin-
Warsaw-Moscow transit system. Seeking financing
for the € 1bn deal (25% equity). Is being asked to put
in additional € 60-90m in equity. Concession due to
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.
55. Case : Poland’s A2 Motorway Structure for
allocation of 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.
56. Case : Poland’s A2 Motorway Structure for
allocation of Risk • Political Risk: • Best controlled by
Polish Government and AWSA. • Assignment of
revenue waterfall to government: Taxes, lease and
profit sharing. • 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.
57. Case : Petrolera Zuata, Petrozuata
C.A. Background:$2.4bn oil field development
project in Venezuela consisting of oil wells, two
pipelines and a refinery. It is sponsored by Conoco
and Marvan who intend to raise a portion of the
$1.5bn debt 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 be investment grade? •
How can the project structure best address the
associated risk?
58. Case : Petrolera Zuata, Petrozuata
C.A. Operational Risk Management • Pre Completion
Risk • Includes resource, technological and
completion risk. • Resource and technology not a
 major factor ( 7.1% of resources consumed and
proven technology). • Sponsor’s guarantee to
mitigate completion risk. • Post Completion Risk •
Market risk and force majeure. • Quantity risk is
mitigated by off-take agreement with CONOCO.
However price risk 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.
59. Case : Petrolera Zuata, Petrozuata
C.A. 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 at higher cost and time delay. •
Uncovered Bank Debt: Greater withdrawal flexibility
at a fee. Shorter maturity, size and structure
restrictions, variable interest rate. • 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.
60. Case : Calpine Corporation Background:
$1.7bn company with 79% leverage seeking over
$6bn in financing to construct 25 new power plants.
Changing Regulatory Environment allows for selling
of power at wholesale prices over existing
transmission systems with no discrimination in price
 or access. Firm wants to change from Independent
Power Producer (IPP) to Merchant power provider.
Key Issues: • Seizing the initiative and exploiting first
mover’s advantage. • Possible alternative sources for
finance. • Limited corporate debt capacity.
61. Case : Calpine Corporation Options for 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
of Calpine 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.
62. Case : Calpine Corporation Comparison of
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 of Corporate 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 for Calpine Corp.
63. Case : Iridium LLC Background: A $5.5bn
satellite communications project backed by Motorola
which went bankrupt in 1999 after just one year of
operation. Had partners in over 100 countries.
Issues: • Scope of the project: 66 satellites, 12
ground stations around the world 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.
64. Case: Iridium LLC Structural highlights: •
Stand alone entity: Size, scope and risk of the project
in comparison to 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 high D/V
ratio. • Agency theory best explains the D/V:
Management holds only 1% of equity and the project
has projected EBITDA of $5bn resulting in high
agency cost of equity. Also, since Iridium has no
other investment options, risk shifting and debt
overhang do not increase agency costs of debt. •
Partners participating through equity and quasi
equity to deter opportunistic behavior and align
partner incentives.
65. 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.
66. Case: Iridium LLC Contention: The structuring
and financing of Iridium was faulty and partially
responsible for its demise. Reality: Since Iridium was
incorporated as an independent entity and not
corporate financed, its prime sponsor Motorola is still
solvent inspite of Iridium’s bankruptcy. Moreover, the
bank loan default which seemingly triggered the
bankruptcy also avoided fresh capital from being
ploughed into what was essentially a technologically
doomed project.
67. Case : Bulong Nickel Mine Background:In July
1998 Preston Resources bought the Bulong Nickel
Mine in the pre-completion phase and financed it
with a bridge loan. The bridge loan was financed with
a 10 year project bond in December 1998. Within
one year, Bulong defaulted on the notes 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 forward contracts.
68. Case: Bulong Nickel Mine Structural /
financing 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 of completion guarantee results in
project exposure to technology risk. • Project Bonds
instead of bank loans: Motivation is flexibility in
future investment (Preston has a similar project on
the cards which it wants to “facilitate” with Bulong
cash flows). However bonds limit flexibility during
restructuring and delays it by 2 years.
69. Contents • The MM Proposition • What is a
Project? • What is Project Finance? • Project
Structure • Financing choices • Real World Cases •
Project Finance: Valuation Issues
70. 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
71. 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 negative cash flows followed by uncertain
positive cash flows.
72. Failure of Traditional Valuation • Usage of
Corporate WACC is inappropriate: • Different risk
profile of the project from the sponsor. • Project has
rapidly changing leverage. • Considers promised
return on risky debt and not expected return. •
Traditional DCF method is inaccurate: • Single
discount rate does not account for changing
leverage. • Ignores imbedded optionality. •
Idiosyncratic risks are usually incorporated in the
discount rate as a fudge factor.
73. Non-Traditional Approaches • Using Capital
Cash Flow method which acknowledges changing
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 Monte Carlo Simulations to
incorporate idiosyncratic risks in cash flows and to
value Real Options.
74. 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 equity to
arrive at firm value. • Equity value can be derived by
subtracting risky debt value. • Advantages: •
Incorporates effect of changing leverage. • Avoids
calculation of “debt” discount rate. Assumes tax
shields are at similar risk as whole firm.
75. Discount Rate for Project Finance •
Corporate WACC is an inappropriate discount rate
(discussed above). • Incorporate idiosyncratic risks in
cash flows and account for systematic risks in
discount rate. Avoid double accounting. • Ensure that
discount rate is consistent with the cash flow:
unlevered rate for capital cash flows.
76. 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 equity markets. It is very difficult to
estimate Beta with the World portfolio. • The Beta
with the World portfolio is not indicative of the
sovereign risk of the country (asymmetric downside
risks). E.g. Pakistan has a beta of 0. • Most
assumptions of CAPM fail in this environment.
77. Many Alternatives! Approaches to calculating
the Cost of Capital in Emerging Markets: • World
 CAPM 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
78. Many Alternatives! Many of these methods
suffer problems: • 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. • Confusing bond and equity risk
premia.
79. The Country Risk Rating Model • Erb, Harvey
and Viskanta (1995) • Credit rating a good ex ante
measure of risk • Reasonable fit to data • Fits
developed and emerging markets
80. The Country Risk Rating Model Sources •
Institutional Investor’s semi-annual Country Credit
Rating
81. The Country Risk Rating Model
82. The Country Risk Rating Model Steps: • Cost
of Capital = risk free + intercept - slopexLog(IICCR)
Where Log(IICCR) is the natural logarithm of the
Institutional Investor Country 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 less sovereign 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 given risk in the country
83. The Country Risk Rating Model • Risks
incorporated in cash flows: • Pre-completion:
technology, resource, completion. • Post-completion:
market, supply/input, throughput. • Risks
incorporated in discount rate: • Sovereign risk:
macroeconomic, legal, political, force majeure. •
Financial risk.
84. Valuing Risky Debt • Differentiate between
expected yield and promised 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 of risky
debt, V(D): PV (k,r) – P(k)
85. 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)
86. Effect of Covenants on Debt Value •
Management actions that result in risk shifting,
increase equity value (call) and decrease debt value
(put): • "Bet the firm" on a new technology that may
have a small chance of success. • Pay out large
current dividends to shareholders. The future
collateral of the firm will be reduced. • Get new debt
at the same seniority level and repurchase shares. •
Bank covenants to deal with such actions: • New
investment decisions need prior lender approval. •
“Cash Waterfall”: Pre-determine distribution of cash
flows. • Limitations on new debt and distribution to
debtholders. • Bank covenants limit managerial
discretion and preserve value of debt.
87. Real Options: Generic Types
88. Real Options in Project Finance • Scale up:
Are usually in the form of replication. These also
include contractual real options in the form of leases
etc. Affects project NPV. • Switch up: Affects project
NPV. • Scope up: Affects value of Sponsors
involvement. • Study/start: Affects project NPV.
Critical for stock type projects where precise
estimation of reserves is critical to success.
89. Real Options in Project Finance • Scale
down: Mostly applicable in the pre-completion stage.
Scale down is rarely an option post-completion since
projects are valuable almost exclusively as going
concerns. Affects project NPV. • Switch down: Rarely
an option for a project. • Scope down: Similar to the
 scale down option. • Flexibility option: The option to
switch input or output mix is key to projects and can
help reduce cash flow volatility. Affects project NPV.
90. Real Options: Industry Examples •
Automobile: Recently GM delayed its investment in a
new Cavalier and switched its resources into
producing more SUVs. • Aircraft Manufacturers:
Parallel development of cargo plane 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 option to 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
91. Real Options: Industry Examples • Real
Estate: Multipurpose buildings (hotels, apartments,
etc.) that can be easily reconfigured create the
option to benefit from changes in real estate trends.
• Utilities: Developing generating plants fired by oil &
coal creates the option to reduce input costs by
switching to lower cost inputs. • Airlines: Aircraft
manufacturers may grant the airlines contractual
options to deliver aircraft. These contracts specify
short lead times for delivery (once the option is
exercised) and fixed purchase prices.
92. 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
free rate. • 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 without the option.
93. M&M premise of Structure irrelevance No
transaction Costs No taxes No cost of Financial
Distress No agency conflict No asymmetric
Information Real World situations Very high
transaction costs that can affect the investment
decision. Taxes are mostly positive and high and
results in valuable tax shields. Capital and
governance structure decreases risk thereby
decreasing cost of distress. Behavior of various
parties can be controlled through structure. Type and
sequence of financing can improve information. The
MM Proposition
94. The MM Proposition Since real world
situations do not always fulfill the assumptions of the
MM Proposition, capital structure does affect firm
value in reality.
95. Acknowledgements The content of this
presentation has been derived primarily from the: •
Project Finance course taught by Benjamin Esty at
the Harvard Business School. • Emerging Markets
Corporate Finance course taught by Campbell Harvey
at Duke University. • Advanced Corporate Finance
course taught by Gordon Phillips at Duke University.
We thank the above for their contribution to this
effort. We also acknowledge the usage of content
from Project Finance International and Journal of
Applied Corporate Finance. We thank them for
access to their databases.