Question

I am financing a $1 million dollar project with equal amounts of equity and non-recourse debt (i.e., project finance). This project generates $50,000 of free cash flow to equity every period in perpetuity. The comps have an average asset beta of 0.60.

Assume a debt beta of .25, a market risk premium of 5.00%, and a risk-free rate of 2.50%. Further assume that CAPM holds. Using an iterative, project-finance-based approach for project value, which of the following is closest to your final estimate of the project's equity?

	A) $400,000
	B) $750,000
	C) There is not enough information to answer the question.
	D) $500,000
	E) $650,000

Answer 1

Asset beta is beta of the assets that is project beta ignoring the capital struture or you can say assuming 100% equity.

Asset beta is also known as unlevered beta.

Asset beta or Unlevered Beta = 0.60

Unlevered Beta = Equity Beta x 50% + Debt Beta x 50%

0.60 = Equity Beta x 50% + 0.25 x 50%

Equity Beta = 0.95

Using CAPM,

Cost of Debt = Risk Free Rate + Market Risk premium x beta

Cost of Debt = 2.5% + 5% x 0.25

Cost of Debt = 3.75%

Cost of Equity = Risk Free Rate + Market Risk premium x beta

Cost of Equity = 2.5% + 5% x 0.95

Cost of Equity = 7.25%

Debt invested in project = 50% of $1,000,000 = $500,000

Annual interest to be paid on debt = $500,000 x 3.75% = $18,750

Annual cashflow from project = $50,000

Annual cashflow to be paid to debt holders = $18,750

Therefore, cashflow available to equity share holders = $50,000 - $18,750 = $31,250

Value of Equity = Cashflow available to Equity Share holders / Cost of equity

Value of Equity = $31250 / 7.25% =$431,034

which is closest to option A) $400,000

Answer is option A) 400,000