Corporate Finance Analysis

Corporate Finance Analysis

Subjects Covered in Corporate Finance Modelling Exercise
Introduction to Corporate Modelling Difficulties in Corporate Finance Modelling Value Drivers and Predicting Changes in Rate of Return in Corporate Finance Reconciliation of ROIC and Project IRR Measuring the Rate of Return is not Easy Cash Flow Forecasting and Evaluating Key Risks Analysis of Multiples When to Use DCF and When to Use Multiples Alternative Approaches to Measuring Cost of Capital WACC Issues – Target Capital Structure, Tax Effects, Debt Beta DCF Analysis and Normalised Cash Flow

Chapter 1: Corporate Finance Modelling Introduction

Teaching Style for Modelling
Overall objective is to teach more complex project finance theory and concepts through modelling. Don’t use really big template models. Instead work from blank sheet and understand sophisticated issues. You can find models at Understanding the modelling concepts is much more important than typing formulas in excel. If you find yourself typing formulas instead of understanding the concepts STOP TYPING (you will receive and of the completed model).

Finding Completed Template Models
Search for Corporate Finance Modelling in Google

Review the general finance theory and concepts first.
Teaching Style - 2 Review the general finance theory and concepts first. Do this very quickly with power point slides as many of the concepts have been discussed Do this because modelling is not useful unless understand the project finance concept After discussing the modelling concept, add issues into a simple model. Many issues are much better analysed with a simple demonstration in excel rather than a big model with 30 sheets.

Financial Modelling Religion and FAST
Various organisations have rules for modelling. One good technique for modelling (and maybe for your life) is FAST. (General conflict between Structure and Flexible) F Flexible: Different timing, scenarios, financing techniques. A Accurate or appropriate. The balance sheet must balance S Structured. Separate financing from operations. T Transparent – short equations.

My Rule Find the Laziest Way
There are many ways in excel to do things. Find the fastest and easiest way to do it. Often use short cut like Alt,E, IS Sometimes use the mouse Use entire row or column when you can Use TRUE/FALSE instead of IF: =1=1 is TRUE True is 1 False is 0 Find the Laziest Way

Transparency Keep the formulas simple No excuse at all for long formulas because it makes the concepts difficult to explain to somebody not familiar with the model. Long formulas come about because you do not exactly understand what you are doing.

Excel Functions We will use short-cuts, excel enhancements, TRUE/FALSE switches and only four functions. The functions should be used in a way that you are probably not used to. INDEX LOOKUP (not VLOOKUP or HLOOKUP) SUMIF (or AVERAGEIF or COUNTIF) EDATE MAX and MIN for Waterfalls (not IF)

Files to Use and Open Generic Macros Read PDF to Excel
Shift, CNTL, R to copy to the RIGHT CNTL, ALT, C to colour and format Must Enable Macros Should say CNTL,ALT,C on the bottom of excel Generic Macros Should say SHIFT, CNTL, A on the bottom Enable Macros Use Acrobat Use Google Chrome Read PDF to Excel Files to Use and Open

Example of INDEX Function
We will make scenarios for things like: Variation in traffic for infrastructure projects Variation in price for commodity projects Difference in availability for availability projects Example of Index Function

Use of LOOKUP Function Don’t use VLOOKUP, HLOOKUP or INDEX/MATCH with models that have a time line. Instead, use the LOOKUP function with an entire row as illustrated below:

Use of AVERAGEIF, SUMIF, COUNTIF
These functions are useful in project finance model for: Converting periodic data by month to sum for a year Checking errors Counting TRUE’s or FALSE’s

Chapter 2: Difficulties in Corporate Finance Modelling

City is Like a Corporation/Project is Business
Individual Business or Family is like project Finance

Family is Like Corporation, Person is Like Project Finance
Person is the project Entire Family is the Corporation

General Concepts in Corporate Finance versus Project Finance
Evaluate entire life of project Use investors target equity IRR as the cost of capital. IRR measures the true economic return from the asset. Credit analysis from cash flow analysis with DSCR, LLCR, PLCR. Analysis all directly from cash flow and multiples such as P/E or EV/EBITDA not generally used. Corporate Finance Stop at some point and compute terminal value. Terminal value is subjective. WACC is a subjective black box coming from a mysterious potion. ROIC and ROE are affected by timing of capital expenditures and do not measure the true economic return. Credit analysis has a lot of judgment as to whether the balance sheet is strong enough for re-financing. Multiples used to measure long-term value.

Use of Project Finance Ideas in Corporate Finance
Understanding of Projects and IRR that makes-up Corporate Return Understanding how Rate of Return can Fluctuate due to Age of Projects Understanding Risk Changes and IRR in Corporate Finance (e.g. Synergies Risk Different from Base Assets) Notion of Cost of Capital as Minimum Required IRR

Valuation and Magic Potion
Calculation of Cost of Capital with CAPM and Expected Market Risk Premium Adjustments to WACC for Tax Deduction on Interest and Debt Beta Use of Valuation Formula: Value = Income x (1- g/ROIC)/(WACC-g) Assumption that a Company will suddenly become a stable company in equilibrium Myriad of adjustments for political risk, liquidity, beta mean reversion, small company risk … Methods to Normalise Cash Flow in Terminal Period

Cost of Capital in Same Transaction
Top is buy side (if negotiating would want high cost of capital). Bottom is sell side.

Effect of WACC on DCF Variation in value from the cost of capital with the two cases. Note: Two way data tables are better with macro.

WACC Craziness

Corporate Finance Ideas for Simple Company
Lets say you can find the following: A company with some fluctuations in return, but not too much. A company that grows at about the same rate in real terms as the population (e.g. a food company). An industry where P/E multiples and EV/EBITDA multiples are stable across companies and stable over time. An industry where there is quite a lot of competition and assets are not very capital intensive.

Companies Used in McKinsey Book and Typical Examples
Fed Ex UPS Heiniken Disney Walgreens General Mills

For This Simple Company you Can Make an Elegant Financial Analysis
First, start reading a lot of historic financial data from financial statements with read pdf or with workbooks.open or with sec read. Start Next, project variables from actual data – you can even use the historic revenue growth. Project After that, create nice pictures of the historic and future return on invested capital. Create Finally, apply multiples or a fancy formula like (1-g/ROIC)/(WACC-g) to evaluate the terminal value. It doesn’t matter very much because you get the same answer Apply

Example of Classic Company
In this case, keep ROIC in sight when make a valuation.

Contrast Two Companies in Evaluation of Corporate Finance
Classic Company Mature Company with capital expenditures used to make investment. No large write-offs, re-structuring's or asset sales. Multiples are similar across companies in the industry and over time. Value to Investment (price to book) ratios are stable and can be used to evaluate company management and cost of capital. Return earned on assets invested in the past is similar to return on investment on new assets. Tricky Situations Investment in the form of research, operating losses and software. Balance sheet affected by gains on asset sales, write-offs, re-structuring charges. Multiples change a lot over time for individual companies and across a cross- section of companies. Value to investment have little meaning as historic investment was very small compared to new investment. Return on historic investments change as plants age and conditions change in an industry.

But, What happens if … Rate of return (it could be ROIC, ROCE, ROE or any other measure), is not very relevant because: Returns are distorted (i.e. very high) because of large writeoffs that the company took a couple of years ago Invested Capital is high because of because of asset sales that resulted in gains and a higher equity. Businesses like construction and contracting carry risks and therefore earn returns, but little or no capital is invested, so how can you compute ROIC, ROE etc. Investment is in the form of research and development or operating expense to keep quasi monopoly going (e.g. Apple, Google etc.) Return on new investments very different from return on historic investments (e.g. Amazon investment in food delivery versus investment in websites).

Also, What Happens if … A company has been growing fast and it cannot keep growing forever, but you don’t really know how long the growth will last. If a company grows fast and its return is greater than its cost of capital, the P/E ratio and the EV/EBITDA ratio can be very high. Do you really think you can predict the length of time the company will continue to grow. If you claim that you know how fast the company can keep growing you are a fraud. A company has been experiencing high return on invested capital because of low capital spending, but it will eventually have to replace its capital.

Were the “New Economy” Ideas Not So Stupid
The new economy concepts were that real options could be created if a company gains scale. These ideas were laughed at. But after 20 years, maybe some of the ideas were not so silly. For example, “the extraordinarily high anticipated profits represented by stock prices during the Internet bubble never materialized, because there was no ‘new economy.’” Get data from the comprehensive stock price file. The real thing that happened during the dot.com bubble was with telecom companies Use Amazon, Priceline, Pay Pal, EBAY

Comprehensive Stock, Commodity and Index File
You can evaluate the performance and variation in different stocks and make statistical analysis using the comprehensive stock file.

Example of Indices S&P Index since 1950 is base.
IRR is final value (149.5) divided by initial value (1.0), raised to years – 1 (67.8 years). Returns and volatility is affected by the time period.

S&P 500 and DAX This illustrates how you can compare different indices and adjust for exchange rates.

Stock Prices of New Economy Stocks versus Old Economy Stocks
During the Internet bubble, managers and investors lost sight of what drove return on invested capital (ROIC); indeed, many forgot the importance of this ratio entirely. Many executives and investors either forgot or threw out fundamental rules of economics in the rarefied air of the Internet revolution. The notion of “winner take all” led companies and investors to believe naively that all that mattered was getting big fast, and that they could worry about creating an effective business model later. Increasing-returns logic was also mistakenly applied to online pet supplies and grocery delivery services, even though these firms had to invest (unsustainably, eventually) in more drivers, trucks, warehouses, and inventory when their customer base grew. When the laws of economics prevailed, as they always do, it was clear that many Internet businesses did not have the unassailable competitive advantages required to earn even modest returns on invested capital. unassailable competitive advantages = addiction to products or creating a monopoly

Comparison of Priceline to Old Economy Stocks
Now, begin to look at what were called “New Economy Stocks”. Begin with Priceline. It had no “unassailable” competitive advantage.

Now Add eBay The case of eBay is more extreme.

Amazon needs a lot of infrastructure and employees
Amazon dwarfs the other companies.

Telcos and the Dot.com Bubble
As shown in the graph, the stocks of the telecoms were more variable.

Cost of Debt Capital and Compensation for Future Default

Corporate Finance Valuation from Fundamental Value Drivers – You are Only Really Seeing What Happens to the Future Return Compared to Current Returns

Fundamental Valuation Ideas
Objective is to get monopoly profit and then to grow these profits (not making judgment about capitalism here). Value depends on the return from your investment. ROIC Growth Cost of Capital There is no question about theses basic ideas and one can think of valuation as forecasting movements in these three variables. The most difficult thing to think about is what will happen to the rate of return. If you do not make an investment, use of ROIC does not work anymore.

Analytical framework for Valuation – Combine Forecasts of Economic Performance with Cost of Capital
Competitive position such as pricing power and cost structure affects ROIC In financial terms, value comes from ROIC and growth versus cost of capital P/E ratio and other valuation come from ROIC and Growth

Of Course You Should Invest when Return Exceeds Cost of Capital – This is NPV Rule
The interaction between growth and ROIC is a key factor to consider when assessing the likely impact of a particular investment on a company’s overall ROIC. For example, we’ve found that some very successful, high- ROIC companies in the United States are reluctant to invest in growth if it will reduce their ROICs. One technology company had a 30 percent operating margin and ROIC of more than 50 percent, so it didn’t want to invest in projects that might earn only 25 percent returns, fearing this would dilute its average returns. But as the first principle of value creation would lead you to expect, even an opportunity with a 25 percent return would still create value as long as the cost of capital was lower, despite the resulting decline in average ROIC.

Fundamental Idea about Investment Necessary to Generate Return
If you don’t make an investment, you cannot improve your life. If you don’t make capital expenditures, you cannot get EBITDA. If you don’t pay for a stock, you cannot get dividends. Even when you gamble, you must put some money down on the table. But, what about: Uber: drivers make investment and all Uber has is a bit of software Services: You make money from your reputation (Deloitte, Cap Gemini, GE, Siemens, Law Firms, etc.) Construction contracts: You make money by constructing a plant and the investment in tractors etc. is very minor.

Quote from McKinsey Valuation Book
We (McKinsey) explain the two core principles of value creation: (1) the idea that return on invested capital and growth drive cash flow, which in turn drives value, and (2) the conservation of value principle, which says that anything that doesn’t increase cash flow doesn’t create value (unless it reduces risk). Led to ideas about measuring all performance with return versus cost of capital and books on (ROIC-WACC) * Capital Charge

Two Basic Equations Equation 1 Equation 2 Value = CF(1)/k (No Growth)
Value = CF(1)/(k-g) (Growth) This is just math (integral from 0 to ∞) Equation 2 Growth = ROE * Retention Rate Growth = ROE * (1-Payout) Payout = 1 – G/ROE

For Equity, All you Have to Do is Substitute
Start with Basics Value = D1/(k-g) Simple calculus DPO = (1-g/ROE) Fundamental growth D1 = E1 * DPO Earnings Value = E1 * (1-g/ROE)/(k-g) For P/E Ratio Value/E1 = (1-g/ROE)/(k-g) For P/B Ratio E1=Book Value * ROE1 Value = Book Value * ROE * (1-g/ROE)/(k-g) Value/Book Value = (ROE-g)/(k-g)

Growth Implication If the growth is zero, the level of the return does not matter in the valuation formulas This is not really true when growth rate changes. A change in return makes a big difference in any case.

Problems with These Formulas
McKinsey Discussion of the Formula: This formula underpins the discounted-cash-flow (DCF) approach to valuation, and a variant of the equation lies behind the economic-profit approach (i.e. monopoly profit)….You might go so far as to say that this formula represents all there is to valuation. Everything else is mere detail.” However, the formula is really not very good: Only works when ROE and g and k are constant. It does not work with inflation, because the value of the investment increases over time due to inflation. It does not work if the return on new investments is different from the return on existing investments in cases such as high technology.

Case 1: Valuation with Constant ROE
Very simple case of valuation: Return on equity and growth constant No adjustment for inflation (assume no inflation) In this case, you can use the valuation formula: Value = E x (1-g/ROE)/(k-g) You can also use the formula to evaluate implied cost of capital from P/E ratio, growth and assumed return on equity. Silly to worry about ROE versus ROIC at this point. For now, can assume an all equity company with no net debt.

Valuation Sensitivity in Simple Case
Keep discount rate constant at 6% (the discount rate or the expected IRR is the biggest variable) A graph of the data table demonstrates that the combination of variables makes the valuation change dramatically.

Sensitivity Graph with Macro Data Table
Demonstrates that the value has higher variability with respect to ROE with higher growth rate. There is a strong inter-relationship.

Case 2: Constant ROE with Inflation
Theory of inflation: if no growth except for inflation and constant nominal return that includes inflation, then income includes the rate of return with inflation as well as P/E = [(ROE-g)/(k-g)] * [(1+inf)/(ROE-inf)] This formula gives you the “real” P/E ratio from nominal inputs. V=[(ROE-g)/(k-g)] * [(1+inf)/(ROE-inf)] x E Proof and implication of this formula with inflation later.

With Inflation, the Sensitivity is more extreme
This graph shows the data table with and without inflation. Need to have growth more than inflation to create value. Difficult to evaluate interactions non-linear interactions of variables.

With Inflation, the Sensitivity is more extreme
There is more sensitivity to ROE in the inflation case and the case with zero growth results in value that declines.

Case 3: Changing ROE, Changing Growth and Changing Inflation
Cannot grow in long-term much faster than the economy. Demonstrates the that the real issue is whether ROIC above the cost of capital can continue. When ROIC expectations decline, then the P/E ratio falls. To make this analysis, you cannot use the simple formula. Instead, In the terminal period, use the version of the formula that starts from the book value of the investment. Use the formulas for dividend payout as a function of growth. Use the INTERPOLATE LOOKUP function to gradually change Return.

Reasonable Estimates of Growth – Is this Graph Reasonable
The short term Based on best estimate of likely outcome The medium term transition to tranquillity Assessment of industry outlook and company position ROIC fades towards the cost of capital Growth fades towards GDP The long run – tranquillity and equilibrium Long run assumptions: ROIC = Cost of capital Real growth = 0% Much of valuation involves implicitly or explicitly making growth estimates – High P/E comes from high growth Reference: Level and persistence of growth rates

Illustration of Assumptions with Changing ROE
Set-up assumptions with increase or decrease in ROE and construct model using the market to book value formula. Set-up data for the Interpolate Lookup function.

Valuation Model and Sensitivity
The valuation model is structured with switches and a sensitivity analysis is set-up.

Sensitivity Analysis – Use Tornado Diagram
Tornado Diagram with Alternative Cost of Capital and Terminal Value. Low cost of capital increases importance of growth. Longer terminal value means slower change in ROE.

Case 4: ROIC instead of ROE
First, assume invested capital is only plant and equipment Second, assume that invested capital includes working capital changes Key variable is deriving the net plant depreciation rate from the growth rate and formula: Cap Exp/Depreciation = g/Net Plant Depreciation rate + 1

Derivation of Formula Earlier, we developed the relationship between the investment rate (IR), the company’s projected growth in NOPLAT (g), and the return on investment (ROIC): g = ROIC × IR Solving for IR, rather than g, leads to: IR =g/ROIC Now build this into the definition of free cash flow: FCF = NOPLAT * (1 −g/ROIC)

Better Derivation of Formula
To derive the formula with free cash flow and ROIC begin with the formula for free cash flow: FCF = EBITDA – Cap Exp – Tax – WC change Now you can reconcile the FCF and NOPAT: NOPAT = EBITDA – Dep – Tax FCF = NOPAT – Cap Exp + Dep – WC change Invested Capital Increase = Cap Exp – Dep + WC change +/ other items like deferred tax Need Formulas for Cap Exp – Dep and for WC change to derive growth Growth in WC = WC/EBITDA * g/(1-g)

Application of Formula
Growth in WC change = WC/EBITDA * g/(1+g) For the growth amount of capital expenditures, you can use a formula: Growth = Depreciation Rate on Net Plant x (Capital Expenditures/Depreciation – 1) You can re-arrange the formula if you have the net depreciation rate you can compute the capital expenditures to depreciation. Capital Expenditures/Depreciation = Growth/Net Depreciation Rate + 1 If you now have the depreciation expense, you can compute capital expenditures.

Evaluation of Net Plant Depreciation Rate and Capital Expenditures to Depreciation
The example below demonstrates how the plant ratios stabalise after a plant cycle.

Ratios of Net Plant to Depreciation and Capital Expenditure to Depreciation with Longer Life
Note how the Cap Exp to Depreciation is defined as g/Net Plant Depr + 1

Demonstration of (1-g/ROIC)/(WACC-g) Formula
The formula can be demonstrated by using working capital ratio and net plant depreciation.

Apply Ratios to Demonstrate Model
Note how valuation result is the same as the formula (1-g/ROIC)/(WACC-g)

Reasons for More Complex Formulas with Cap Exp to Depreciation, Working Capital etc.
Demonstration of EV/EBITDA ratio with different asset lives, tax rates and working capital ratios Demonstration of how the value changes when growth and ROIC changes. When ROIC changes, the net cash flow changes and different amounts of money must be plowed back into the company.

Return on New Capital and Return on Existing Capital
Technically, we should use the return on new, or incremental, capital, but for simplicity here, we assume that the ROIC and incremental ROIC are equal. Technically, this formula should use the return on new invested capital (RONIC), not the company’s return on all invested capital (ROIC). What crap: when oil prices go down, you cannot say that existing projects still maintain their existing ROIC. When Uber destroys the taxi industry, you cannot say that only new taxies earn a lower return. When the internet kills advertising for newspaper companies, one cannot say that it is only new investments that suffer.

Cases where ROIC may be Different – Purchase of Companies in High Tech
Note the increase in goodwill from Elon Musk’s Pay Pal:

Use of Formula in DCF The value after the explicit forecast period is referred to as the continuing value. Formulas derived from discounted cash flows using several simplifying assumptions can be used to estimate continuing value. One such formula that we recommend is as follows Where NOPLAT=Net operating profits less adjusted taxes (in the year after the explicit forecast period) ROICI = Incremental return on new invested capital g = Expected perpetual growth in the company's NOPLAT WACC = Weighted average cost of capital

Another Silly McKinsey Comment
We will show that high-ROIC companies typically create more value by focusing on growth, while lower-ROIC companies create more value by increasing ROIC. Comment: Everybody of course wants high ROIC, which is just another word for monopoly profit and which is the driver of capitalist economies. If you are valuing a company you must assess the ability of a company to maintain or grow its monopoly position.

Consultant Slide on Value Creation

The Value Matrix - Stock Categorisation
What is the economic reason for getting here and how long can the performance be maintained Throwing good money after bad Give the money to investors Try to get out of the business

Crazy Idea that ROIC = WACC in Long Run
According the McKinsey: Many forecasters assume that the rate of return on new invested capital equals the cost of capital in the continuing value period, but that the company will earn returns exceeding the cost of capital during the explicit forecast period.

Case Study of First Solar
Changes in ROIC drove the collapse

Analysts Did Not Project Changes in ROIC
Forecasted Price of more than 400.

Reconciliation of IRR and Return on Investment (Project IRR versus ROIC or Equity IRR versus ROE)

Companies present the ROE and the ROIC to investors (IRR cannot be computed on an actual basis until after you are dead). Companies make investments using and IRR criteria (academics say project IRR and real investors use equity IRR). If you present a new investment to the board of directors, the ROE will be below the Equity IRR in the early years of the investment. Some companies still believe they can somehow apply the formula ROIC – WACC to assess different investments and divisions using EVA. Should you use ROIC or project IRR. Fundamental Question

Basic Idea of Reconciliation
Weighted average rate of return is the same as the IRR, if: The rate of return is weighted by the PV of the investment balance, and; The discount rate applied to the year by year investment balance is the IRR itself. This is analogous to the fundamental IRR problem where intermediate cash flows are assumed to be re-invested at the IRR itself.

Weighted ROIC versus MIRR
If the cost of capital is measured by something different from the IRR, the weighted average return will be different. If the return is higher than the cost of capital, the weighted average return is higher than the IRR If the return is lower than the cost of capital, the weighted average return is lower than the IRR Use of MIRR does not solve the problem Weighted ROIC versus MIRR

Illustration of IRR and Rate of Return Reconciliation
Computation of PV of Investment weight Use of Sumproduct with entire line Weight from Investment Balance x PV Factor The basic problem is depreciation. This is aggravated by inflation.

The return calculations that depend on depreciation are shown below
Mechanics of Reconciliation – Compute Return and Weight PV of Investment The return calculations that depend on depreciation are shown below

Mechanics of Reconciliation -
Compute the PV factor and then multiply the PV factor by the investment balance (beginning of year). Then use the PV of investment for computing the weighted average ROIC with the SUMPRODUCT. Works when discounting at the IRR (could argue that different discount rates are appropriate for providing management with ROIC given IRR).

Why Use Investment Weighting – Portfolio of Assets with Different Ages
The excerpt below illustrates why you should weight the ROIC by the investment balance. When you have old investments, the lower investment balance means the ROI is less important than the new assets.

Use of Economic Depreciation
You can compute an alternative depreciation rate and then the ROIC will equal the IRR If you use the economic depreciation, you can use a discount rate that equals the IRR. You could theoretically use the economic depreciation rate and then evaluate the performance of an project finance investment over time.

Use of Economic Depreciation to Reconcile
Computation of economic depreciation without inflation Use PPMT function with the IRR as the cost of capital Computation of economic depreciation with inflation Use of PMT in period of investment and then inflate.

How Economic Depreciation Makes IRR = ROI with and without Inflation
The excerpt below shows calculation of economic depreciation for a single investment. The depreciation rates can be used with a depreciation function. The depreciation is structured to write-off the whole plant and to result in a constant return on investment

Implications of Economic Depreciation
There is no way companies will implement economic depreciation and allow measurement of true returns Without economic depreciation it is very difficult to measure the true economic return The true return can be used to evaluate the value of a company. The PV of cash flows at the true IRR as the discount rate is zero. The IRR for a corporation is like the yield to maturity on a bond. Valuation could be computed as the [Investment x Yield]/Disc Rate

Difficulty in Measuring Return: IRR and ROIC in Corporate Case – No Growth
When an asset is simply replaced over a long period of time, the ROIC (or ROE) will be low in early years and then high in later years. This is due only to the investment balance declining, in the example, the asset is replaced and the ROIC with SL depreciation goes down. The flat line shows the ROIC when economic depreciation is used.

With different asset lives the difference is bigger.
Difficulty in Interpreting Return Compared to Underlying IRR – Cases with Different Lives With different asset lives the difference is bigger.

Valuation in Case with No Growth and Lumpy Investments
Due to timing of the next investment different methods of valuation produce different answers. The most correct is using the project IRR and the investment balance from economic depreciation.

Different Valuations with Alternative Timing
These charts show ranges in value compared to the true valuation from 400 year analysis.

Case With Growth In this case assume that you start with some capital expenditures, and the capital expenditures continue to increase each year. In the first case assume that the EBITDA generated by the investment does not increase. Looking for ROIC = IRR after constant growth, but this does not happen If apply Value = Income x (1-G/ROIC)/(WACC- g), what level of ROIC should you use – the ROIC or IRR. If apply Value/Investment = (ROIC-g)/(WACC- g) what level of investment and ROIC should you use.

Mechanics of Model with Growth
Retirements are replaced with similar assets (no inflation). Begin with project IRR and economic depreciation on a single asset.

ROIC and Retirements in Model
See if the ROIC converges to the IRR

Project IRR is not Observed with SL Depreciation
You change the growth and asset life and the IRR, and you do not get convergence. At first there the ROIC is below the IRR and then it is above. The shorter the life and the lower the growth the closer to the IRR.

Valuation, IRR and ROIC Now move to the valuation with IRR and ROIC.
As in other cases, make a proof valuation with a long- term model.

Demonstration of Errors
Say a company just finished embarking on a large expansion. In this case, the return will be low and it will look like the company is earning less than its cost of capital.

Case Study – Kitty Hawk Freight Airline Company
Summary of Case Company embarking on purchase of new planes Even though assets new, the return on equity was high Basic question: How could you continue to earn high returns in a very competitive business.

Measuring the Return on Invested Capital is not Easy

Arrogant Statement about U.S. Companies by McKinsey
The median large U.S. company earned a 19 percent ROIC in 2013, while the median large Asian company earned 8 percent. But for the most part, Asian companies historically have focused more on growth than profitability or ROIC, which explains the large difference between their average valuation and that of U.S. companies. Comment: Everybody of course wants a high monopoly profit. Very smart people are hired to create monopoly profits through marketing strategies (or making children and adults addicted to a product).

Use of Return on Invested Capital to Assess Model
The big question is what really goes into calculation of the invested capital. The most obvious point is that surplus cash should not be in invested capital because the income associated with surplus cash is not in NOPAT.

General Idea of Acquiring History in Corporate Finance Models
Forecasts from History The most effective way to destroy people is to deny and obliterate their own understanding of their history.” Forecasts from History and Manipulating History in Financial Models “Day by day and almost minute by minute the past was brought up to date. In this way every prediction made by the Party could be shown by documentary evidence to have been correct; nor was any item of news, or any expression of opinion, which conflicted with the needs of the moment, ever allowed to remain on record. All history was a palimpsest, scraped clean and reinscribed exactly as often as was necessary.”

What happened to return on capital
Vestas Case What happened to return on capital Write-offs Service business Aging plant

Use of Multiples

A leading sell-side analyst recently told us that he uses discounted cash flow to analyze and value companies but typically communicates his findings in terms of implied multiples. For example, an analyst might say Company X deserves a higher multiple than Company Y because it is expected to grow faster, earn higher margins, or generate more cash flow. Earnings multiples are also a useful sanity check for your valuation. In practice, we always compare a company’s implied multiple based on our valuation with those of its peers to see if we can explain why its multiple is higher or lower in terms of its ROIC or growth rates.

Case Study of Constellation Energy

When to Use DCF and When to Use Multiples

Need to Understand why Multiples are Different

Forecasting Cash Flow and Fundamental Analysis of Risks and Value in Corporate Finance

Price Levels and Return
Need to Answer Fundamental Questions about Demand Growth, Prices and Cost Structure Demand Growth Volatility of demand growth Implications of demand volatility and capital intensity Implications of demand volatility and fixed operating cost Example: Airlines versus Retail Price Levels and Return How can sustain prices that lead to high return Types of products (solar panels and cell phones) First mover and scale (Disney and merchant electric plants) Creating Loyalty (Coke and Fiber Optic Cable)

Problems with Analysis
Need to Answer Fundamental Questions about Demand Growth, Prices and Cost Structure Cost Structure Fixed and Variable Costs Comparison of Costs with Competitors Sustainability of Cost Advantage Example: Shale Gas and High Cost of Replacement Problems with Analysis Very difficult to measure – some companies have sustained high ROIC Product life cycle shortening – how long can maintain returns from innovation Problems of obsolescence, changes in taste, fashion etc.

Still Volume and Price, But …
Have volume history from financial data, but need long-term data that covers business cycles. Surplus capacity analysis may require knowledge of competitor capacity additions – there is no historic financial data that can be used for this. Demand volatility is aggravated by operating leverage. It is difficult from financial statements to separate fixed and variable cost. Example of airlines and auto companies after 2000 and

No History and Problems with Volume Forecasts
Without volume history from financial statements, predicting revenues is extremely speculative. In this case, that occurred around the dot com bubble, a venture financed by Motorola had a dramatic crash. The interesting thing was that how the investment bankers bought the marketing projections hook line and sinker.

Understand Marginal Cost and Surplus Capacity Risk
High marginal cost shale gas and shale oil producers and bankruptcy because of break- even oil price.

P/E, EV/EBITDA and Growth
S&P P/E Ratio

Obsolesce, Fashion, Uber
Very difficult to predict sudden changes in cost structure and/or price in an industry driven by new technology. Stock price of company that finances medallions in New York.

Cost of Capital

Cost of Equity Capital Methods
Implied Cost of Capital from P/E or EV/EBITDA Implied Cost of Capital from Market to Book Ratio

Sensitivity Analysis with Given Cost of Capital
Valuation can be measured with P/E. Growth and return in combination have combined effects on the P/E ratio. Need both variables and cannot use data table when making graphs.

Scenario Analysis with Cost of Capital Derivation
Can make data table and evaluate how the three variables affect the implied cost of capital. Start with simple case and use macro for the data table with a goal seek. Note that data table does not work.

Case 2: Constant ROE with Inflation
Theory of inflation: if no growth except for inflation and constant nominal return that includes inflation, then income includes the rate of return with inflation as well as P/E = [(ROE-g)/(k-g)] * [(1+inf)/(ROE-inf)] This formula gives you the real P/E ratio from nominal inputs. Observe P/E ratios that are understated in places with high inflation, because: The E and the P are not measured at the same date – the E is a forward number and the P is today’s price. When the E is reduced, the true P/E is higher. The E does not measure the loss in value from assets that are measured at book value and must be replaced at market value. When the E is adjusted to reflect the increase in value, the observed P/E is less than the corrected P/E.

Simple Proof that P/E should Reflect Values Adjusted for Inflation – Real Values
Say you have a company operating in a high inflation country and you measure returns, dividends and value. Then, you simply re-state the earnings, cash flow and dividends into a hypothetical country where there is no inflation. The re-stated dividends and the cost of capital for the no-inflation country provide the true P/E ratio. You can compute all of your returns, dividends and book value for the inflated currency, but after you translate back with a Purchasing Power Parity exchange rate, the value of the dividends should be the same.

Inflation Can Be Tricky
The value driver does not work if there is inflation – even a little inflation. Steps Adjust the earnings for loss in investment value Adjust the earnings for inflation Use nominal ROE and Cost of Capital Example: P/E for S&P 500 is 25 Inflation is 2% Book Value per Share is 12.5 EPS is 2 ROE is 16% Then the adjusted P/E for the analysis is: First, adjust for loss in investment value 12.5 * .02 Second, adjust for earnings in real terms When you are finished, the corrected P/E

Observed and Computed P/E
Let’s say you observe a P/E ratio for a particular company or for the entire market or for a particular industry. This P/E ratio will be distorted by inflation. When you put in your ROE, growth and cost of capital, you will come up with this distorted P/E ratio. You could adjust the ROE, the growth rate and the cost of capital to real values and then you would come up with a higher P/E ratio that is correct. Or, you could adjust the P/E ratio for inflation and re-derive the cost of capital.

Inflation Indexed Bonds and Inflation Expectations
Source of data from FRED

Case 3: Changing ROE, Changing Growth and Changing Inflation
Background on inflation expectations

Inflation’s most value-destroying impact is not obvious
Inflation’s most value-destroying impact is not obvious. Though companies may increase prices, most cannot or do not increase them enough to cover not only their higher operating costs (salaries and purchased goods) but also the higher cost of future capital expenditures. As a result, they fail to maintain profitability in real terms.

Weighted Average Cost of Capital

DCF Model Application and Terminal Value

Valuation Diagram – DCF from Free Cash Flow
Valuation using discounted cash flows requires forecasted cash flows, application of a discount rate and measurement of continuing value (also referred to as horizon value or terminal value) Continuing Value Cash Flow Cash Flow Cash Flow Cash Flow Discount Rate is WACC Enterprise Value Net Debt Reference: Private Valuation; Valuation Mistakes Equity Value

Terminal Value in Corporate Model
Year after explicit period to establish stable cash flows Gordon’s CFt x (1+g)/ (WACC-g) History Terminal Value Explicit Forecast Period EV/EBITDA that Reflects Long-term Growth Rate and ROIC PV of Cash Year t Infinity Step 2: PV from Year t to current year Step 1: PV to year t – End of period t, so Gordon’s method must use t+1 cash flows Market to Book Ratio that Reflects Long-term ROE Make sure Cash Flow in period t reflects realistic ROIC, Working Capital that reflects long-term growth and realistic capital expenditures Valuation Date

Equity Cash Flow, Debt Cash Flow, Free Cash Flow and Cost of Equity, Cost of Debt and WACC
Equity Cash Flow and Value of Equity : Dividends less Equity Issued Value of Equity PV of Cash Flows at Cost of Equity + + Debt Cash Flow and Market Value of Debt : Net Interest plus Net Debt Payments Value of Debt PV of Cash Flows at Incremental Cost of Debt = = Free Cash Flow: EBITDA – Op Taxes – Cap Exp – WC Chg Value of Enterprise PV of Cash Flows At WACC

Problems with DCF – Range in Values
Note the range in values in the analyst report The range is less when a terminal value is used, but the range is still very high The high range exists even though there is a tight range in discount rates

Old Value Line vs Internet
History in Corporate Analysis

Value of a Stock

ROE and ROI Changes when Grow a Business

Depreciation Changes with New Investment

Valuation Metrics in Project Finance and Corporate Finance
Project Finance Investment Equity IRR Project IRR Equity NPV Project NPV Project Finance Debt DSCR LLCR PLCR Liquidity Debt Service Reserve Corporate Finance Valuation P/E Ratio EV/EBITDA Projected Dividend and Earnings Free Cash Flow Corporate Finance Debt Times Interest Earned Debt to EBITDA Debt to Capital Corporate Finance Liquidity Current Ratio; Quick Ratio

DCF Analysis with Terminal Value

Debt Sizing - Introduction
Detailed analysis of the term sheet and loan agreements begins with debt sizing. Difference in sizing debt on the basis of: maximum debt-to-capital ratio: from cost and sources and uses minimum DSCR: from financial model Notion of negotiated base case and downside for evaluating DSCR. Limit the debt to assure equity is in project and the value of the project is above the debt

Debt Sizing – Key Philosophical Question
Debt to Capital Ratio – Trust sponsor to be smart enough to not invest in a bad project. Make sure the sponsor is taking downside risk. With no cash invested in the project, there is only upside potential and the sponsor will not care about downside evaluation. The test is historic investment and do not have to look forward. The notion of DSCR implies that you are smart enough to make a forecast. If you really believe your forecast and even variation around your forecast, you can back into the debt from the DSCR. This is the notion of negotiated base case and downside for evaluating DSCR. Limit the debt to assure equity is in project and the value of the project is above the debt

Illustration of DSCR and Debt to Capital Constraint
Lower DSCR results in too high debt to capital ratio. Need to constrain the debt. Discounted Red Area (using the interest rate) is the Value of the Debt. DSCR sizing means you believe your forecast.

Which Constraint is in Place
Items have an effect on whether the debt to capital constraint or the debt to capital constraint applies: Need to Understand that NPV of Debt Service is Loan Value High Project IRR  More Likely Debt to Constraint; Long Tenor  More Likely Debt to Capital Constraint; Sculpting  More Likely Debt to Capital Constraint; Low Interest Rate  Morel Likely Debt to Capital Constraint. Low Project IRR  More Likely DSCR Constraint; Short Tenor  More Likely DSCR Constraint; Level Payment  More Likely DSCR Constraint; High Interest Rate  More Likely DSCR Constraint

Evaluation with Geometry and NPV Formula

Model with Debt Sculpting
Input Minimum DSCR Compute Target Debt Service Compute PV of Debt Service Use PV of Debt Service as Debt in Sources and Uses Compute PV of CFADS LLCR for Max Debt to Cap is PV of CFADS divided by Cost * Debt/Cap

Sculpting Equations - Basic
One of the main ideas about the repayment process in project finance is that the modelling is much more effective when you combine formulas with other excel techniques. If you try and solve these things with a brute force method that uses a copy and paste method or goal seek things will get very messy. Formulas used for repayment and debt sizing are listed below: The fundamental two sculpting formulas are: (1) Target Debt Service Per Period = CFADS/DSCR (2) Debt Amount at COD = PV(Interest Rate, Target Debt Service) Non-Constant Interest Rates However this is by no means the only formula you should use when working on repayment. In cases when the interest rate changes, a simple present value formula cannot be used. Instead, an interest rate index can be created that accounts for prior interest rate changes as follows: (3) Int Rate Index(t) = Int Rate Indext-1 x (1+Interest Rate(t)) (4) Debt Amount at COD = ∑ Debt Service(t)/Interest Rate Index(t)

Sculpting Equations with Debt to Capital Constraint
Use of LLCR when there is a Target Debt to Capital constraint that drives the amount of the debt. If the debt is being sized by the debt to capital ratio, a higher DSCR must be used. This raises the issue of how to compute sculpted debt repayments when debt is sized with the debt to capital ratio and the DSCR is not from the DSCR constraint. When the Debt is Sized by Debt to Capital the LLCR can be used to size the debt, because with sculpting, the DSCR = LLCR. Formulas in this case include: (5) Target Debt Service(t) = CF(t)/LLCR (6) LLCR = NPV(Interest Rate, CFADS)/Max Debt from Debt to Capital (7) DSCR Applied = MAX(Target DSCR,LLCR with Max Debt)

Sculpting Equations with LC Fees
Adjusting Sculpting Equations for Debt Fees: Debt fees such as the fee on a letter of credit is part of debt service. To include the fees in the sculpting equations, you should subtract the fees when you compute the net present value of debt, as the fees reduce the amount of debt service that can be supported by cash flow. To make the sculpting work you should also make the repayment lower by the fees as shown below: (14) Repayment = CFADS/DSCR - Interest - Fees (15) Debt = NPV(Interest Rate, Debt Service-fees) Debt = NPV(rate, Debt Service) - NPV(rate, Fees) Note Debt Service in the above equation means debt service without fees and debt is reduced by PV of fees Adjusting LLCR for Debt Fees: The sculpting analyses include calculation of the LLCR to evaluate whether the debt to capital constraint is driving the constraint. In this case the PV of CFADS is not the correct numerator for the analysis. Instead, the PV of the LC fees should be added to the denominator of the LLCR as follows: (16) LLCR = PV(CFADS)/(Debt + PV of LC Fees), where (17) Debt = Project Cost x Debt to Capital

Sculpting with DSRA as Final Payment
Sculpting and Changes in the DSRA balance including Final Repayment After working through letters of credit for the DSRA, taxes, interest income and other factors that cause difficult circular references, the final subject addressed is using the DSRA to repay debt. A similar result occurs when changes in the DSRA are included in CFADS. Incorporating these changes in a financial model without massive circularity disruptions can be tricky, but it can be solved by separately computing the present value of changes in the DSRA. Changes in the DSRA can be modelled using the following equations: (18) Debt Adjustment = PV(Interest Rate, Change in DSRA/DSCR) (19) Repayment = Repayment from Normal Sculpting + Change in DSRA/DSCR

Part 6: Debt Sizing: Including Items in Project Cost (such as development fees and owners cost) that do not Involve Cash Outflow to Increase Returns

Reconciling Debt to Capital with DSCR
Cash Flow results in too high DSCR meaning that you have debt to cap constraint Increase the project cost WITHOUT spending money on things like land value Yes After you are finished with the term sheet it looks like the DSCR constraint and the debt to capital constraint give you the same answer. This could be because of the process. No Try to increase tenor to reduce increase the DSCR

Effects of Non-Cash Increases in Project Cost
When does asset increase matter and when does it not Importance of paying cash or not paying cash Examples of non-cash increases in project cost Development fees Owner costs Some development costs Contingencies Value of Land allocated to project EPC profit if EPC is sponsor Games with EPC profit Items that can increase the cost of a project affect returns primarily when the debt to capital constraint applies and have less or no importance when the DSCR drives debt capacity.

Debt Sizing: Including Items in Project Cost that do not Involve Cash Outflow
Accounting allocations to the project can have large effects on the equity IRR through debt sizing derived from the debt to capital ratio. If the DSCR drives debt sizing, the accounting allocations, fee allocations and other adjustments have no effect on the equity IRR. Accounting allocations and non-cash contributions can change the structure of returns when multiple investors are involved in the project. If one party is allowed to include non-cash allocations as the basis for his investment, his return is much higher. Depending on the manner in which project costs are accounted for, multiple investors pay debt service and receive dividends, but the investor who did not invest as much cash effectively borrows less relative to the cash investment.

Debt Sizing: Profits from EPC Contractors or O&M Contractor when Investor is also Contractor
If the EPC profits do not affect the debt size and there is only one investor, placing profits at the EPC contractor level or the investor level does not influence overall returns (i.e. if DSCR drives debt size). Depending on whether the debt to capital constraint applies or there are multiple investors, EPC profits can increase equity IRR (by increasing the debt size). Cash Flow Waterfall and issues associated with including profits in O&M contract rather than in SPV cash flow. Profits on the O&M contract versus including O&M costs at the SPV level can affect the distribution of dividends as the O&M fee is paid before debt service.

O&M Contractor is Sponsor
Off-taker: Korea and Japan Utility Companies: Want strong off-taker with inactive to honor contract Profits to O&M Reduce the SPV Cash Flow. O&M paid before debt service Off-take Contract with minimum supply but no fixed price Special Purpose Vehicle: Bond Rating of A- O&M Contractor O&M Agreement Sponsors: Want strong sponsor: Mobil State Loan Agreement Lenders: Issued bonds and debt with long tenor and low rates

Illustration of Non-Cash Accounting

Development Fee Theory
Development fees can be a percent of project cost or a multiple of the amount spent on development. This yields big profits to developers when the notice to proceed occurs and can be a cash outflow for the sponsor. The big profit accounts for the low probability of success during development. If the developer and the sponsor are the same, this profit is not a cash outflow from the perspective of the project. Better to put development fees into cost with debt to capital constraint

Case Study - Funding Enron - Subic Bay, Philippines
Equip’t Cos. Philippines Government Warranties Enron Power Operating Co. Completion Guarantee Fluor Daniel EPC Enron Power Phils. Op’g Co. Enron Corp. 15-year BOT Concession Turnkey Construction Contract Performance Undertaking Enron Subic Power Corp O&M Agreement Supply Fuel Free Napocor 113MW Subic Power Corp. Enron Power Philippines Corp Ground Lease 65% Buyout Rights 35% Philippine Investors Capacity Charge O&M Charge Energy Charge PPA Insurances US$105 million, 15-year Notes

113 MW Diesel Generator Power Station Subic Bay, Philippines
Sources of Funds: Notes $ 105 M Subordinated Note 7 Equity of Sponsor 28 Working Capital 2 TOTAL $ 142 Uses of Funds: Turnkey Contractor $ 112 M Bonus to Turnkey Contractor 7 Development and other related costs and Fees 14 Pre operating, Start-up and Commissioning Costs 3 IDC 4 Working Capital Loan 2

BOT/PPA Contract 15 year BOT and toll process
NAPOCOR (government owned generation company) to supply fuel & take electricity - no fuel availability risk Capacity fee $21.6/kW/month on available capacity Capacity fee is dollar denominated – no direct foreign exchange risk, overseas a/c O&M fixed fee and energy fee is in Peso - $4.56/kW/Month heat rate penalty & bonuses buy out NPV capacity fees- late payment, change of BOT law, war, etc.

Add Development Fee to Model
Add Development Fee to Sources and Uses Adjust the Equity IRR for Development Fees Received Adjust Model to have Debt to Capital Constraint Use Goal Seek to Compute Development Fees

Part 9: Debt Repayment Structure: Sculpted Repayment and Nuanced Issues associated with Debt to Capital or DSCR Constraints Combined with Repayment Patterns

Debt Structuring - General
The structure of debt (the draw down and term to maturity) can SEEM to have more important impacts on the value of a project than the size of the debt and certainly more than the interest rate on the debt. Average life is the general way in project finance to measure the length of the debt although duration is a is better way in theory to measure the effective term of the debt. The debt structure should depend on the economic characteristics of a project such as the revenue and expense contracts. But it may be able to re-finance debt.

Multiple Capacity Charges and Optimisation of Debt Repayment
For some countries and financial institutions, DSCR constraints and debt repayment patterns are given. In these cases, synthetic sculpting can be developed with alternative tariff structures that have a step down element (Malaysia, Pakistan). In other cases a flexible maintenance contract can be used to create synthetic sculpting (Brazil). Incentive issues associated with step-down tariffs where sponsors can have an incentive to walk away from the project and techniques to measure the cost and benefits of alternative maintenance structures will be addressed as part of the session.

Example of Repayment (Bullet Not Shown)
Loan tenor is explained by the repayment period is still within the PPA terms (i.e. 20 years from PCOD), giving a one year tail, and the project is a Build, Own and Operate (BOO) and a BOOT.

Sculpting versus Equal Installment with DSCR Constraint
Note the big increase in IRR with the DSCR constraint – because of the larger debt size. Recall that can effectively make the DSCR constraint be in place

Sculpting versus Equal Installment with Debt to Capital Constraint

Alternative Repayment Patterns
Given a DSCR constraint and the formula that the present value of debt service equals the amount of debt at COD, use geometry to maximize debt. The general idea of maintaining a constant DSCR over the life of a project in sculpting when the risks can increase over time. Contrasts to the requirement that banks must increase capital with longer terms and that an implicit assumption of constant credit spreads is increasing risk over time. Sculpting versus alternative methods in the context of different revenue patterns (indexation, flat fee-in tariffs, tax depreciation, etc.)

Complex Sculpting Issues
Complex sculpting issues can involve: Letter of credit fees Balloon payments as a percent of the loan amount Interest income on sweeps for balloon payment Taxes and net operating losses DSRA as final debt payment To resolve these issues use equations and some fancy excel. Do not try to use brute force.

Example of Synthetic Sculpting with O&M Payments

Borrowing Base and Resource Transactions
Computation of borrowing base Debt repayment and borrowing base – must pay- off debt that is below the maximum borrowing base Rational for borrowing base Rate of production extraction Problems with borrowing base Declining prices and acceleration of loan repayments Increasing prices and reduction of loan re-payments Modelling of borrowing base

Equity IRR without Balloon
Data table with structuring – need to use macro instead of basic data table

Equity IRR with Balloon
This case assumes large balloon payment at the end of the life – 20%. Note how the equity IRR increases.

Part 12: Interest and Fees: Step-up Credit Spreads, Swap Rates and Hedging

Discussion of Interest and Fees
Consistent with the discussion of debt as having five components, interest and fees between the time debt draws occur and debt is fully repaid is the next topic. Interest rates consist of credit spread and base rate. Debt IRR is the money the lenders receive including fees, relative to the amount funded by lenders Credit spreads can include step-ups – why they are present in many transactions and what they mean in terms of re-financing. Loan agreements often require hedging and interest rate swaps.

Example of Interest Rates
NRG Yield presented a table with the margin earned on interest rates. Most of the project finance transactions had margins between 2% and 2.5%. The longest tenor in the table is the year 2038 implying a remaining term of 23 years.

Expected Loss Can Be Broken Down Into Three Components
Borrower Risk Facility Risk Related EXPECTED LOSS $$ Probability of Default (PD) % Loss Severity Given Default (Severity) % Loan Equivalent Exposure (Exposure) $$ x x = What is the probability of the counterparty defaulting? If default occurs, how much of this do we expect to lose? If default occurs, how much exposure do we expect to have? The focus of grading tools is on modeling PD

Comparison of PD x LGD with Precise Formula -- LGD and Multiple Years

Target Rating and Credit Spreads – Why the target is BBB- in Project Finance

Credit Spreads, PD, LGD and RORAC
Credit spreads have to cover loss given and default as well as loss given default. They also should cover the capital that a bank puts up and the administrative expenses.

Probability of Default
This chart shows rating migrations and the probability of default for alternative loans. Note the increase in default probability with longer loans.

Use of Floating Rate Debt
Project Financings are generally funded on a floating- rate basis due to the necessity for: Flexibility in the timing of draw downs Flexibility in early repayment. Floating rates computed as the LIBOR average for the prior six months. 86% of Project Finance Loans are floating rate. But the floating rate loans can be fixed with interest rate swaps. Because of flexibility in take downs and repayments, there would be significant interest rate risk with fixed rate transactions. Extension risk Contraction risk

Swap Settlements Bank financing in project finance generally uses floating interest rates rather than fixed rates (e.g. LIBOR plus basis points). Because floating rate financing can create risks particularly in projects with tight debt service cover such as PFI, projects often use interest rate swaps to convert floating rates to fixed rates. Swaps that convert floating rate to fixed rate debt involve: Establishing a notional amount that corresponds to the face amount of the loan; Paying interest on the floating rate loans; Receiving settlements on the swap if the floating interest rate rises so that the effective interest rate is fixed; Paying settlements on the swap if the floating interest rate declines so that the effective interest rate is fixed. The net value of the swap is generally zero when the swap is established.

Floating versus Fixed Rate Debt
Premium for fixing rates is very expensive because of expected inflation.

Pre-payments Maturity Extensions from Fixed Rate Debt
If fixed interest rates are in the transaction and rates are high, the borrower wants pre-payment option and the lender does not. There can be a set of defined pre-payment penalties. Pre-payments can come from a “divorce” clause were the borrower pays back the loan instead of taking some action. Maturity Extensions If cannot meet the required maturity payments from cash flow, the loan agreement allow the maturity payments to be extended

Contraction Risk from Fixed Interest Rates (Declining Interest Rates)
Borrower Perspective When interest rates decrease, if the loan is at a fixed rate, the borrower will want to re-finance but the lender will not want this. Prepayments accelerate (people re-finance). Lender Perspective From the lenders perspective, the high interest rates are lost and the lender must issue loans at lower rates. Form the borrowers perspective, the proceeds will be re-invested at a lower rate and that bonds will be more expensive. The results are like selling a call option for debt holders -- the upside is limited but the downside is not limited.

Total Rate assuming BBB Spread with 10 year Swap Rate
Note the low credit spread before the financial crisis

Example of Pricing and Changing Credit Spreads

Part 8: Repayment Tenure: Length of Debt Repayment, Mini-perms, Bullet Repayments and Re-financing

Re-financing, Corporate Finance and Project Finance
In corporate finance, debt is re-financed continually and the debt to capital is developed on a market value basis. In project finance, the initial assumption is that debt to capital reduces and for a portion of the project life the total financing can come from equity. In reality, if a project is performing well, it will be sold and/or re-financed. Continual re- financing can result in a similar outcome a very long-term debt.

Debt Repayment Structure and Risk
A project's debt amortization schedule often influences the rating, more so than the degree of leverage. Front-loaded principal amortization schedules that capitalize on the more predictable project cash flows in the near term may be less risky that those with whose delayed amortizations seek to take advantage of long-term inflation effects. Flexible re-payment structures can be developed where the project has irregular cash flows.

Debt Tenure and Return It seems that the debt tenure is more important than the interest rate (depending on the relationship between the project return and the interest rate). You can try some different debt amounts and interest rates and see how the length of the debt is an crucial element (two way data tables). The problem with this is that it does not account for re-financing.

Statistics on Project Finance Debt Tenor
Commercial Bank Market Up to 15 years Private Placement Market Up to 20 years Rule 144A Up to 30 Years Requires investment grade rating Project Finance average maturity 8.6 years PF loans more likely to be fixed rate loans (14% of loans are fixed rate loans)

Fundamental Effect of Debt Tenure with Debt to Capital Constraint

Re-financing Changes Everything
There is a fundamental philosophical and strategic issue about re-financing in project finance. The above charts are somewhat distorted because of the assumption that there is no re- financing. With re-financing, the effect of the debt tenure is much less if not reduced. Assuming no re-financing is a very negative assumption (like and oil price of zero because we cannot predict everything).

Debt Length and the Interest Rate
The table below illustrates the relationship between the length of the debt and the interest rate in terms of equity IRR. Note that the length makes more difference than the interest rate.

Debt Length and the Interest Rate
The table below illustrates the relationship between the length of the debt and the debt to capital ratio in terms of equity IRR. Note that the inter-relationship between the length of the debt and the leverage.

Mini-perms Matching the tenor of repayment to the life of the project and even considering terminal value in the repayment in the context of both achieving a higher DSCR and an improved equity IRR. Problems with multi-lateral agencies that allow long- term maturity can be contrasted with commercial banks and bond financing that may be more flexible and sometimes could have lower costs. Specifically, the effects of hard and soft mini-perms on the profitability of a project along with the difficult problem of required re-financing assumptions. How the DSRA could be used to re-finance debt at end of loan life and how potential terminal value can be used to justify partial bullet repayment at end of loan.

Mini-Perm and Re-financing Assumption

Credit Analysis of Mini-Perm
To evaluate the effects of being unable to re- finance a cash sweep assumption can be used. You can then see how low a variable can go before the loan will not be re-paid.

Part 7: Debt Funding: Nuanced Issues with Pre-Commercial Cash Flow and Equity Bridge Loans

Issues with Funding In general, debt funding is difficult without some kind of support from outside of the project. If the project return is above the interest rate, equity return increases when the equity is contributed later and debt earlier. From bank perspective, the equity should be put in first and the loan in last. Specific Issues: Funding of equity first or pro-rata Capitalisation of interest Pre-operating cash flow Interest on sub-debt or shareholder loan Equity bridge loan

Draw Request and Funding - Introduction
When a borrower uses cash during construction, the funding request includes: Notice of Borrowing Payment and draw details Construction certificate Schedule of construction costs and cumulative amounts Insurance certificates Financial reports and other documents

Project Finance Loans – Drawdown during Construction (Reference)
Prior to satisfying the options conditions, it is the usual practice for the financiers to: be able to rely on other contractual or financial resources (recourse or some kind of support from sponsors) to repay that funding [if the project fails to be completed]; If equity is not up-front may require letter of credit, sponsor guarantee or really strong EPC contract; and, to roll up the capitalized interest-during-construction (“IDC”) into the financing (i.e. capitalizing interest). During the construction phase, equity and debt funds are used to finance the project construction with funds generated from the project cash flow covering the operation period.

Capitalised Interest and Interest Capitalised During Construction for Accounting (IDC)
Interest (and fees) can be paid during construction or capitalized to the debt balance (not paid now, but paid later). If interest is capitalized and the debt is the same percent of the project cost, the capitalizing of interest does not make any difference. Whether the interest is paid or capitalized, it is recorded as part of the project cost as interest during construction (IDC). Note there is no capitalization of the equity cost of capital in a manner similar to debt.

Nuanced Issues with Pre-Commercial Cash Flow
The effects of accounting for pre-commercial cash flows as either equity or reduction in project cost. In terms of accounting, pre-commercial cash flow is income and should be part of equity. Alternatively, one could call the pre-commercial cash flow a reduction in the cost of the asset. Related issues include the issue of government grants and early production. With an extreme case the labelling the pre- commercial cash flow as equity results in improved returns but from banker’s perspective is not “skin in the game.”

Illustration of Accounting for Pre-commercial Cash Flow
Note the operating cash flow is included as equity. More than the Paid in equity.

Equity Bridge Loans and Recourse Debt
In some projects, equity holders provide loans to the project from their balance sheet instead of equity. Example A project finance transaction is structured with equity first financing (i.e. equity put in to finance construction before debt). The sponsor secures a separate loan to finance its equity requirements, meaning it does not put any equity when you count the corporate side. The loan will be re-paid in a bullet (with interest capitalised) at the end of the construction period or maybe even later. When the loan is re-paid, the sponsor provides equity to finance the loan. The equity bridge loan must have a parent guarantee.

Nuanced Issues with Equity Bridge Loans
In pure project finance, equity should be contributed before debt during the construction period to assure that equity does not walk away from the project during construction. Pro-rata debt and equity contributions or equity bridge loans require some kind of sponsor support and can in theory distort the equity cash flow. An equity bridge loan requires parent support, the cost of which is not included in the equity IRR. The effects of IDC on equity bridge loan on project taxes and the effects of equity bridge loans in different interest rate environments and on different types of projects will be discussed. Issue Should the equity bridge loan be included in computing Equity IRR. The loan uses resources of the parent and must be guaranteed by the parent

Issues with EBL If there are multiple sponsors, one of which provides a guarantee, how should the benefits of the EBL be allocated The IDC increases the cost of the project and increases other debt capacity if there is a debt capacity constraint

Nuanced Issues with IDC on Shareholder Loans
Shareholder loans seem to have no effect on senior debt. All of the covenants and waterfall issues occur after the senior debt is paid. If senior debt limits the dividends to shareholders, it will also limit the shareholder loan payments Equity IRR should consider the shareholder loan and any other equity as combined cash flows The shareholder loan may affect taxes which will increase the cash flow (and cause a circular reference problem).

Standby Loans for Construction Cost Over-run and the Issue of Cost Under-run
With a cost over-run facility, the commitment fee can increase the cost of the project. If the debt is subordinated to senior debt the over-run facility is similar to shareholder loans. If there is a cost under-run and the debt has been committed with and EBL or pro-rata, a question arises as to whether the debt should be reduced or whether the proceeds should accrue to shareholders.

Evaluation of Delays in Construction
In evaluating delays in construction, it is generally better not to change the S-curve but rather to assume there is dead time. After accounting for the reductions in PPA revenues, the liquidated damage can accrue to reduction of debt to maintain the DSCR.

Complex IDC Calculations with Portfolios
The IDC calculations can be complex if some parts of the project are completed while others are continuing to be constructed. This is a typical problem in real estate and solar roof-top To resolve the problem: Keep track of plant in service and construction work in progress in separate accounts Allocate interest from the ratio of CWIP to (CWIP + Plant in Service) IDC itself will also be in CWIP and Plant in Service

Draw-downs and Management of Disbursement of Funds
The strict control of fund disbursements can provide a mechanism to maintain leverage over contractors and thus help to minimize construction risk in the better rated projects. Loan documents typically give lenders the right to closely monitor construction progress and release funds only for work that the lender's engineering and construction expert has approved as being complete. Third-party trustees, acting in a fiduciary capacity, will generally manage disbursement of funds to protect debtholders' interest in the project. (Multiple Investors)

Draw-downs and Retention of Funds
Retention of all debt-financed funds in a segregated account by a trustee experienced in management of power project construction, preferably an experienced bank or other lender for these projects; Payment structures that retain a small portion of each amount payable, about 5%, until the project reaches commercial completion; Disbursements made only for work certified as complete by an independent project engineer retained by the construction trustee solely for approving disbursements; Right to suspend or halt disbursements when the trustee concludes that construction progress is materially at risk (reversals or revocations of necessary regulatory approvals or changes in law or cost outside the levels anticipated by the budget and schedule) Authority to approve all change orders or authority to limit change orders to a pre-determined amount (example MCV)

Credit Enhancements - Introduction
Various added provisions that are included in loan agreements to provide additional protection to lenders. These provisions that can include: DSRA’s MRA’s Cash sweeps Dividend lock-up covenants While the credit enhancements can be the subject of intense negotiation, they cannot change a failed project into a good project from a lender perspective. Instead, they can only either limit dividends or reduce the amount of effective net debt associated with a project.

Part 12: Credit Enhancement: DSRA, MRA, Cash Flow Sweeps and Covenants

Financial Enhancements – Alternative Definition
Cash flow capture (dividend lock-up, cash trap) covenants Cause debt to be re-paid early or debt service reserves to be built-up if debt service coverage ratios are low. Bad time covenant. Cash flow sweep covenants Cause debt to be re-paid early or debt service reserves to be built-up if cash flow is high (or low). Good-time covenant. Debt service reserves Assure debt service can be paid if market prices or other risks cause cash flow to be low for an extended period of time. Subordinated debt and mezzanine finance Protects the cash flow coverage of senior debt instruments. Contingent equity or sponsor guarantees Provide for additional equity funding in downside cases.

Investors Need Some Dividends Before All Debt is Paid Off
The timing of debt service (i.e. loan interest payments and principal repayments) is one of the biggest factors that drives the rate of return for equity holders in a project. If the debt service is structured to allow no dividends until all debt is paid, return will be lower. This will generally be unacceptable to sponsors. The faster investors in a project are paid dividends, the better their rate of return. Investors therefore do not wish cash flow from operations of the project to be devoted to lenders at the expense of these dividends. Lenders, on the other hand, generally wish to be repaid as rapidly as possible. Striking a reasonable balance between these conflicting demands is an important part of loan negotiations.

Example of Covenants Minimum Senior DSCR of 1.20x in Base Case Minimum Senior DSCR for the previous 12 months to be greater than 1.10x for distribution Minimum Senior DSCR of 1.05x for Event of default Senior Debt not to exceed 80% of the total project costs

Covenants and Structural Enhancements Cannot Make a Bad Project into a Good Project
The most important aspect of the underwriting process is determining whether the plant is economically sound. This means that the cost structure and the technology of the plant must be viable. However, once a plant is determined to be economically viable, the credit quality of a transaction can be enhanced by various structural features – covenants, debt service reserves, liquidation damages, subordinated debt, contingent equity etc. The potential for structural enhancements to improve the credit quality of a transaction is described in the statement by Standard and Poor’s below: Project structure does not mitigate risk that a marginally economic project presents to lenders; structure in and of itself cannot elevate the debt rating of a fundamentally weak project to investment-grade levels. On the other hand, more creditworthy projects will feature covenants designed to identify changing market conditions and trigger cash trapping features to project lenders during occasional stress periods.

Cash Flow Waterfall A cash flow waterfall defines the priority of uses of cash flow that is received for a project. The import of a cash flow waterfall is what happens if there is not enough cash flow to pay all expenses, debt service and debt service reserve requirements. If sufficient cash is available to pay dividends, the cash flow priority defines how and when a distribution can be made.

Example of Cash Flow Priority
All revenues accrued on and after the Commercial Operation Date will be deposited with the Trustee into the Operating Revenue Account. The Trustee will withdraw amounts on a monthly basis and make deposits in the following priority, but only to the extent funds are then available in the Operating Revenue Account: (1) the operations and maintenance expenses for the Project for such month, subject to certain limitations; (2) the Tax Equalization Account (3) (A) an amount that will not be less than the amount of interest on the Bonds to become due on such Interest Payment Date, and (B) an amount that will not be less than the amount of principal or sinking fund payment to become due on such principal or sinking fund payment date; (4) an amount, if any, sufficient to cause the amount on deposit in the Debt Service Reserve Account to equal the Debt Service Reserve Account Requirement; (5) an amount, if any, sufficient to pay amounts due pursuant to the Working Capital Facility; (6) an amount, if any, sufficient to pay the operating and maintenance expenses related to any transfer station which is acquired by the Partnership. (7) an amount sufficient to repay amounts advanced pursuant to the Waste Supply Support Facility or the Waste Supply Support Facility Guaranty; and (8) an amount equal to the balance of the Operating Revenue Account shall be deposited into the Surplus Account and will be transferred monthly to the Operating Revenue Account.

Example of Cash Flow Priority and Distributions
Amounts in the Surplus Account will be annually transferred on the first business day of January to the Distribution Account and distributed to the Partnership within 90 days thereafter if: the Debt Service Coverage Ratio for the Project is equal to or exceeds to 1.00 for the calendar year preceding the distribution date and is projected to be equal to or exceed 1.20 to 1.00 for the current calendar year; the Partnership does not have knowledge, or could not reasonably be expected to have knowledge, of the occurrence and continuance of an event of default under the Lease Agreement or an event which, with the passage of time, would constitute an event of default under the Lease Agreement, which event of default or event, in any case, would cause a Material Adverse Effect; Full Performance of the Facility under the Construction Contract has been achieved; and Working Capital Facility and the Waste Supply Support Facility have been fully restored. If not so distributed, amounts in the Distribution Account shall revert to the Surplus Account.

Risk Reduction from Cash Flow Sweeps
The model should assess the effectiveness of covenants that sweep cash flow to moderate risk. If the project experiences a high level of cash flow, the covenant restricts the ability to pay dividends because in the next year cash flow may be low. This type of covenant only really makes sense in situations where the cash flow is volatile and/or there are potential downward trends in prices. As with cash flow traps, to assess the effectiveness of the covenant, cases that incorporate realistic price volatility and potential price trends must be run in the model. It may be the case the covenant is only valuable in extreme circumstances. In this case, alternative structural enhancements should be evaluated to assess risk.

Modelling of Cash Flow Waterfall
Set-up Cash Flow from EBITDA to CFADS Take away senior debt service assuming that debt service is paid Use a lot of sub-totals for cash flow after debt service, cash flow before default, cash flow before use of DSRA etc. Use MAX(number,0) or Max(-number,0) to test for what to do when sub-total is positive or negative Use MIN(subtotal, opening balance) to limit the amount of sweep, DSRA use, repayment of default etc.

Example of Risk and Return Analysis for Cash Flow Sweep
Sweeps really help when there is a sudden decline in cash flow – when you would have paid dividends otherwise. Dividends

Economic and Financial Analysis of Cash Sweeps, Reserve Accounts and Covenants
Cash sweeps, reserve accounts and covenants can have negative effects on the equity IRR of a project. Methods to consider the risk benefits to the bank versus the costs to sponsors are addressed. Mechanics of cash sweep with different triggers and theory of what kinds of transactions would be relevant for cash sweep (e.g. hydro but not solar because of volatility) are addressed. The theory of what kind of triggers make sense (Debt/EBITDA but not DSCR and operational triggers). Contrast between cash sweeps and cash trap covenants. As with other issues, the effects of cash sweeps on equity returns should be addressed with and without re- financing assumptions.

Importance of Re-financing Analysis with Cash Sweep
Cash Sweeps seem to dramatically reduce the cash flow But after the sweep, the project can be re- financed You can even lock-in interest rates

Debt Service Reserve Language
On the Closing Date, an amount equal to 10% of the original principal amount of the Bonds will be deposited in the Debt Service Reserve Account of the Debt Service Reserve Fund from the proceeds of the Bonds. The amounts in the Debt Service Reserve Account will be used only for the purpose of making payments into the related Interest Subaccounts, the Principal Subaccounts and Sinking Fund Installment Subaccounts for the Bonds Debt Service Reserve Accounts may be established in the Debt Service Reserve Fund in connection with the issuance of Additional Bonds. In lieu of the required deposits of Revenues into a Debt Service Reserve Account, or in lieu of funds already on deposit in a Debt Service Reserve Account, the Partnership may cause to be deposited into a Debt Service Reserve Account one or more Debt Service Reserve Account Facilities in an amount equal to the difference between the applicable Debt Service Reserve Account Requirement and the sums then on deposit in such Debt Service Reserve Account. If a disbursement is made under a Debt Service Reserve Account Facility, the Trustee shall apply amounts transferred from the Operating Revenue Account to the applicable Debt Service Reserve Account to either cause the reinstatement of the maximum limits of such Debt Service Reserve Account Facility. The Trustee will apply moneys on deposit in a Debt Service Reserve Account prior to any drawing on any Debt Service Reserve Account Facility. In the event that any amount shall be withdrawn from a Debt Service Reserve Account for payments into an Interest Subaccount, Principal Subaccount or Sinking Fund Installment Subaccount or there exists a deficiency in a Debt Service Reserve Account which is to be reinstated, such withdrawals shall be subsequently restored from Revenues available on a pro rata basis (based on the respective aggregate principal amounts of each series of Bonds Outstanding secured by a Debt Service Reserve Account) after all required payments have been made into such Interest Subaccount, Principal Subaccount and Sinking Fund Installment Subaccount, unless restored by the reinstatement of amounts available under the Debt Service Reserve Account Facility.

Part 13: Other Project Finance Subjects: IRR problems, Risk and Value Changes over Life of Project, Resource Analysis and Debt Sizing

A Little Theory about Valuation and Risk of Projects
Valuation theory with respect to projects generally involves risk reduction as a project progresses through phases. In Europe, there are many stories (but not much data) about how insurance companies purchase existing projects with operating history and are willing to accept equity IRR’s as low as 5-6%. The idea behind a low cost of capital for mature projects is the following: During the development stage, expenditures occur with large risks associated with permitting, problematic wind studies, construction cost over-runs, ability to secure tariffs etc. The required equity IRR during the development stage can be 15% to account for the project not being successfully methods. Once the development is finished or in late stages, the risk is reduced by a large margin. However there are still risks associated with successfully completing construction at budget and on time. The reduced risk during the construction phase may reduce the required equity IRR to something like 12% After construction, the remaining risk for a project with a fixed price contract is that the estimated wind production will not be met. Given this risk, the discount risk is still above the cost of capital for bonds and may be in the range of 8-10%. Once operating history is available, the risk is not much higher than the debt cost or the interest rate on long-term bonds. With bonds yielding below 3%, a return of 6% provides a good premium for risk.

Re-financing and Early Project Sale
Timing strategies and sales value. How different types of projects have differences in risk reduction over time, and why wind projects probably have more of a risk reduction than other electricity projects. Show how the effects of changing risk and selling to a Yieldco can be demonstrated with measuring IRR over time with changing buyer IRRs. Demonstrate how optimal holding periods can be computed with various IRR hurdle rate assumptions.

Verification of Cost of Capital from Published Data in Yieldco Reports
As part of this task we have reviewed detailed financial data of Yieldco’s including prospectuses and annual financial reports. One of the last companies that we investigated was Brookfield Renewable Energy Partners (BEP). In its notes to financial statements, discount rates that are applied to both contractual cash flows and non- contracted cash flows in asset valuation are presented. It is assumed that the cost of capital represents after tax cost of capital although this is not specified in the report.

Equity Returns and Re-Financing

Transaction Multiples from Yieldco IPO’s
For valuation of assets the most relevant multiple is the EV/EBITDA ratio. This is because the EBITDA is not affected by financing and because the EV/EBITDA ratio can be computed from IPO’s of Yieldco’s. For Yieldco projects that have minimal capital expenditures and small or no growth in cash flow, the EV/EBITDA can be used to derive an implied pre-tax IRR and an overall cost of capital (this is further explained in the appendix). The IRR’s from this analysis are lower than the low case pre-tax cost of capital assumption.

Equity Returns for Tollroads
The following slide shows equity returns over time and how they have come down

Part 3: Creating or Destroying Value through Contract Provisions Including Liquidated Damages, Penalty Provisions and Efficiency Incentives

General Notion of Back to Back Contacts
Begins with Project Contract (Concession Contract, PPA Contract, Availability Contract). Back to back contracts follow the Project Contract Fixed Price EPC Contract from Fixed Availability Payment Transfer Delay Risk with Liquidated Damage Transfer O&M Risks with Incentives and Penalties

Economic Efficiency of Contracts in Project Finance
Notion of allocating risks to IPP that can be controlled Incorporation of different risks in multipart tariffs The general idea that risks which can be accepted at a reasonable cost should be allocated to IPP versus the off-taker. Nuances of whether risks should be allocated. Notion that penalties and bonuses should reflect off- taker costs combined with SPV costs Use of marginal cost analysis in measuring availability benefits and costs in different periods Calculation levelized prices in PPA contracts

Example of Delay Damage in PPA Contract

Example of Delay LD in EPC Contract

Theory of Risk and Return in Project Finance
Different parties in project finance including EPC contractors, O&M contractors, insurance companies, financial institutions and sponsors are paid for taking risk. The general idea that if parties are paid too much or too little for accepting risk, the off-taker will pay too much for the service and/or sponsors will not receive an adequate return will be demonstrated. Off-taker economics as well as the technical aspects of the facility must be fully understood to effectively negotiate project finance terms. The theory and practice of computing delay liquidated damages, availability penalties, target heat rates and other items through the central idea of minimizing the sum of off-taker costs and IPP costs.

Contracts Off-taker EPC Contractor PPA Contract Four Part Tariff
Fixed Capacity Charge at Fin Close LD Penalty for Delay Risk Contract O&M Charge Contract Heat Rate Availability Penalty Fixed Price Contract with LD Fuel Supply Fuel Index Fuel Supply Contract with Index Corresponding to PPA Special Purpose Vehicle Contract with Guaranteed Heat Rate and Availability Penalty and Fixed Fee O&M Contractor Shareholder Agreement Loan Agreement Sponsors Lenders Letter of Credit for Equity Cash

Example of O&M Contract

Tradeoff Between Cost and Availability

Optimisation and Minimum Cost
In Theory, Minimum is where replacement cost change = maintenance cost change

Quote from McKinsey Book Quote from Damoradan Book
Fundamental Ideas Objective is to get monopoly profit and then to grow these profits (not making judgment about capitalism here). ROIC Growth Cost of Capital Quote from McKinsey Book Quote from Damoradan Book

Underlying Philosophy – Pickerty vs McKinsey
You can make simple accounting for GNP the way you can make a sources and uses analysis: Sources = Uses or in the case of GNP – Spending and Saving Spending in Economy Consumption Government Spending Investment by Corporations (Cap Exp) Sources of Funds Salaries Taxes Profit Earned by Corporations

Now, Evaluate the Sources and with Growth
In theory, growth comes from population growth and increase in productivity driven by new innovation. Say the real growth in the economy is 2.5% from these two factors. (Of course, it is just about impossible to define productivity growth). Growth in Spending in Economy Consumption Government Spending Investment by Corporations (Cap Exp) Growth in Sources of Funds Salaries Taxes Profit Earned by Corporations If the growth in profit earned by corporations exceeds the growth in the economy, then somebody has to be worse off. If growth is compounded, the situation keeps getting worse.

Finally, Consider the Case where Returns Exceed the Cost of Capital and Keep Growing
Say the growth in the economy is 2.5%. If profits are 8%, then we can start with a base year where everything is somehow magically stable and move forward for 10, 20 and 100 years. The little analysis demonstrates what happens when the cost of capital is over-stated by people getting MBA degrees from Columbia or Harvard. Of course, there is a profit incentive necessary to provide incentives and grow the economy. But the question of who gets paid for risk is much more difficult.

Now, Evaluate who Takes Risks in an Economy
Using fundamental principles that risk can be allocated but not prevented, the basic economic equation can be presented in terms of risk: Growth in Spending in Economy (Defined Level of Risk) Consumption Government Spending Investment by Corporations (Cap Exp) Growth in Sources of Funds (Same Level of Risk) Salaries (Value Reduced with Risk) Taxes Profit Earned by Corporations (Returns Increase with Risk) If the growth in profit earned by corporations exceeds the growth in the economy, then somebody has to be worse off. If growth is compounded, the situation keeps getting worse.

Corporate Finance Analysis

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