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Valuing a Project – Approaches & Cash Flow Concepts

Project valuation determines whether a project is financially viable and bankable. Unlike valuing a company, project valuation focuses exclusively on the project's future cash flows.

Key Principle
A project is worth the present value of its future cash flows. In project finance, EVERYTHING is about cash flows!

Why Value a Project?

1. Investment Decision

  • Should sponsors invest equity?
  • What return will they earn?

2. Lending Decision

  • Will the project generate enough cash to repay debt?
  • What is the risk of default?

3. Pricing Decision

  • What tariff/toll rate is needed for viability?
  • Is the project competitive?

4. Negotiation

  • Equity IRR determines how much equity is needed
  • DSCR determines how much debt can be raised

Cash Flow Concepts

Types of Cash Flows

1. Project Cash Flow (Unlevered)

Cash flows before debt service (interest and principal repayment).

Components:

Revenue
- Operating Expenses
- Taxes
+ Depreciation (non-cash, added back)
= Operating Cash Flow

+ Capital Receipts (asset sales, scrap value)
- Capital Expenditure (CAPEX)
- Working Capital changes
= Free Cash Flow to Firm (FCFF)

Usage: Calculate Project IRR - return to the project as a whole

2. Equity Cash Flow (Levered)

Cash flows after debt service - what's left for equity holders.

Formula:

Project Cash Flow
- Interest Payment
- Principal Repayment (Debt Service)
+ New Debt Drawn
= Free Cash Flow to Equity (FCFE)

Usage: Calculate Equity IRR - return to sponsors

Leverage Effect
Debt acts as a lever - if Project IRR > Debt Cost, Equity IRR will be higher than Project IRR. This is why projects use high leverage (70:30 debt:equity)!

3. Lenders' Cash Flow

Formula:

Operating Cash Flow (before debt service)
- Taxes
- Working Capital
- Capex (for maintenance)
= Cash Available for Debt Service (CADS)

Usage: Calculate Debt Service Coverage Ratio (DSCR)

Key Valuation Metrics

1. Net Present Value (NPV)

Definition: Present value of all future cash flows minus initial investment.

Formula:

NPV = Σ [CFt / (1+r)^t] for t=0 to n

Where:

  • $CF_t$ = Cash flow in year t
  • $r$ = Discount rate (Cost of Capital or Required Return)
  • $n$ = Project life

Decision Rule:

  • NPV > 0: Accept project (creates value)
  • NPV < 0: Reject project (destroys value)
  • NPV = 0: Indifferent

Example:

Initial Investment = ₹1,000 crore Annual Cash Flow = ₹200 crore for 10 years Discount Rate = 12%

NPV = -1,000 + [200 × PVAF(12%, 10 years)] NPV = -1,000 + (200 × 5.650) NPV = -1,000 + 1,130 NPV = ₹130 crore ✅ Accept!

2. Internal Rate of Return (IRR)

Definition: The discount rate at which NPV = 0. It's the project's actual return.

Decision Rule:

  • IRR > Required Return: Accept
  • IRR < Required Return: Reject

Two Types in Project Finance:

  1. Project IRR (Unlevered IRR):

    • Uses project cash flows (before debt service)
    • Typically 12-16% for infrastructure projects

  2. Equity IRR (Levered IRR):

    • Uses equity cash flows (after debt service)
    • Typically 16-22% for infrastructure projects
    • This is what sponsors care about!

Example:

Year 0: -₹300 crore (Equity investment)
Year 1-5: -₹0 (Construction, no cash distribution)
Year 6-25: +₹50 crore per year (Dividend to sponsors)
Year 25: +₹100 crore (Equity residual value)

Equity IRR = Rate that makes NPV of above cash flows = 0 = ~18%

IRR Benchmark
Sponsors typically target Equity IRR of 16-20% for greenfield infrastructure projects in India. Lower risk projects (like operational toll roads) may accept 14-15%.

3. Debt Service Coverage Ratio (DSCR)

Definition: The ratio of cash available for debt service to actual debt service required.

Formula:

DSCR = Cash Available for Debt Service / (Principal + Interest Due)

Or more precisely:

DSCR = (EBITDA - Tax - Capex - ΔWorking Capital) / (Principal Repayment + Interest)

Decision Rule (Lenders' Perspective):

  • DSCR > 1.3: Comfortable - project has 30% cushion
  • DSCR = 1.2: Minimum acceptable for most projects
  • DSCR = 1.0: Barely breaking even - risky!
  • DSCR < 1.0: Default risk - cannot service debt

Example:

Cash Available for Debt Service = ₹150 crore
Annual Debt Service (Principal + Interest) = ₹100 crore

DSCR = 150 / 100 = 1.5 ✅

This means the project generates 50% more cash than needed - safe for lenders!

DSCR Over Project Life:

YearCADSDebt ServiceDSCR
1100801.25
2110851.29
3120901.33 ✅
4130951.37 ✅
51401001.40 ✅

Minimum DSCR over project life = 1.25 (Year 1) - need to improve structure!

4. Loan Life Coverage Ratio (LLCR)

Definition: Present value of remaining cash flows divided by outstanding debt.

Formula:

LLCR = PV of Remaining Cash Flows / Outstanding Debt

Usage: More sophisticated than DSCR, accounts for entire remaining life, not just next year.

Decision Rule:

  • LLCR > 1.5: Strong
  • LLCR = 1.3-1.5: Acceptable
  • LLCR < 1.3: Weak

5. Payback Period

Definition: Time taken to recover initial investment.

Simple Payback = Years until cumulative cash flow = 0

Discounted Payback = Years until cumulative discounted cash flow = 0

Example:

Initial Investment = ₹500 crore
Annual Cash Flow = ₹100 crore

Simple Payback = 500 / 100 = 5 years

Limitation: Ignores cash flows after payback period.

Discount Rate Selection

For Project IRR

Use Weighted Average Cost of Capital (WACC):

WACC = (E/V) × Cost of Equity + (D/V) × Cost of Debt × (1-Tax Rate)

Where:

  • E = Equity Value
  • D = Debt Value
  • V = E + D (Total Value)

Example:

Debt = 70%, Cost of Debt = 10%, Tax = 25%
Equity = 30%, Cost of Equity = 16%

WACC = (0.30 × 16%) + (0.70 × 10% × 0.75)
WACC = 4.8% + 5.25%
WACC = 10.05% (~10%)

For Equity IRR

Use Cost of Equity (16-18% typical for infrastructure)

Valuation Approaches

1. Discounted Cash Flow (DCF)

  • Most widely used in project finance
  • Calculate NPV using projected cash flows
  • Requires detailed financial model

Advantages:

  • Conceptually sound
  • Captures time value of money
  • Can handle complex cash flow patterns

Disadvantages:

  • Garbage in, garbage out (sensitive to assumptions)
  • Difficult to forecast cash flows 20-25 years ahead

2. Comparable Transactions

  • Look at similar projects (same sector, size, region)
  • Use multiples: EV/EBITDA, Price/Revenue, etc.

Example:

Recent toll road acquisitions:
- Project A: 12x EBITDA
- Project B: 13x EBITDA
- Project C: 11x EBITDA

Our project EBITDA = ₹100 crore
Valuation = 12 × 100 = ₹1,200 crore

Limitation: Hard to find truly comparable projects

3. Replacement Cost

  • What would it cost to build this project today?
  • Used for insurance valuation
  • Less relevant for financial valuation

Sensitivity Analysis

Projects are sensitive to key assumptions. Must test:

Key Variables to Test

  1. Traffic/Demand: +/- 20%
  2. Tariff/Pricing: +/- 10%
  3. Construction Cost: +/- 15%
  4. Operating Cost: +/- 10%
  5. Debt Cost: +/- 100 bps
  6. Construction Delay: +6 months, +12 months

Scenario Analysis Example:

ScenarioTrafficCapexEquity IRRMin DSCR
Base Case100%100%18%1.35
Optimistic120%90%24%1.65
Pessimistic80%110%12%1.15
Stress70%120%8%0.98 ❌

In stress case, DSCR < 1.0 means project cannot service debt - not bankable!

Lenders Focus
Lenders care most about downside scenarios. They'll analyze pessimistic and stress cases extensively before approving.

Summary

  • Project valuation is based on future cash flows
  • Two perspectives: Project Cash Flow (unlever ed) and Equity Cash Flow (levered)
  • Key metrics: NPV, IRR, DSCR, LLCR
  • Equity IRR (16-20%) is what sponsors target
  • DSCR (minimum 1.2-1.3) is what lenders require
  • Discount rate: Use WACC for project, Cost of Equity for equity valuation
  • Sensitivity analysis is critical - must test downside scenarios
  • DSCR < 1.0 in any scenario = Project not bankable

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