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Consistent valuation of project finance and LBOs using the flows-to-equity method


Cooper, Ian; Nyborg, Kjell G (2018). Consistent valuation of project finance and LBOs using the flows-to-equity method. European Financial Management, 24(1):34-52.

Abstract

The flows-to-equity method is used to value transactions where debt amortizes according to a fixed schedule, requiring a formula that links the changing leverage with a time-varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

Abstract

The flows-to-equity method is used to value transactions where debt amortizes according to a fixed schedule, requiring a formula that links the changing leverage with a time-varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:1 January 2018
Deposited On:07 Mar 2019 09:32
Last Modified:07 Mar 2019 09:32
Publisher:Wiley-Blackwell Publishing, Inc.
ISSN:1354-7798
OA Status:Closed
Publisher DOI:https://doi.org/10.1111/eufm.12136
Other Identification Number:merlin-id:15331

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