Analysis of the various approaches
With regards to project valuation, we were presented with four different approaches. In the end, we decided to value the project using Approach 4. The reason for this is because out of all 4 approaches, Approach 4 adequately takes into consideration of the following factors: the fact that an independent entity (i.e. NESA) is taking on this project rather than New Earth Inc., the special financing package, and the high rate of return that equity investors (i.e. shareholders of New Earth Inc.) require on this project. Approach 1 unfortunately does not take into consideration that a separate entity is i s undertaking the investment, and so the usage of New Earth’s corporate WACC (14%) to discount the project
cash flows does not seem applicable. Approach 2 is more conservative than Approach 1 with the addition of an expected return premium of 10% (resulting in a WACC of 24%), but adding a premium does not justify that the modified WACC accurately reflect the cost of capital for f or NESA. Approach 3 is better since it factored the items that the previous two approaches left out. However, it does not take the financing package into consideration. Therefore, when discounting the future cash flows and debt repayment, it will likely omit the firm’s prepayments, thus not providing an accurate NPV to reflect the firm’s finance plan.
Under Approach 4, the cost of equity was estimated to be approximately 24%, which is a reasonable rate due to the risks that this investment brings to New Earth Inc. Since the WACC was not provided, it needs to be calculated. The calculated WACC is 9.45%. (Exhibit 1) Valued added by the design of the financing package
The calculated NPV of the project can determine the value added b the financing package. The NPV of the project is estimated to be $197.53 million (Exhibit 2). The NPV of this project is positive, thus the design of the financing package adds positive value to New Earth Inc. Financing Package’s Effects on Return
Though prepayment of debt is part of the convent, it is not a necessary course of action from the perspective of the debtholders (page 3 and 4). Since no principal needs to be paid till then, the present value of cash flows will be higher in earlier periods of the project, thus increasing the overall positive NPV of the project. Through the internally generated pro forma analysis, the investment promises strong cash flows. The U.S. banks do not require interest payments in the first two years of investment with no interest compounding. This will reduce pressure for NESA in the first few years y ears regarding interest payment, thus increasing NPV due to higher cash flows in early periods. In addition, without compounding interest obligations, this will further reduce interest payment pressure for the company. Third, $40 million equity financing from New Earth Inc. will relieve some of the pressure for debt repayment on this project (page 4). Though T hough equity financing is only 20% of total financing, it does not incur interest or require repayment at later stages of the project. Financing Package’s Effects on Risk
This financing package also has a couple of effects on risks. First, the project is financed mostly by debt and the cost of capital is quite high. At a debt/value ratio of 80%, with $160 million milli on financed by debt holders (page 3), the project will be under strong pressure to generate the forecasted cash flows in order to meet debt obligations. o bligations.
Second, the prepayment convent that NESA proposed (page 4) could increase the risk of the project. The banks and Chinese debtors did not explicitly request early prepayment of debt. Therefore, proposing such a prepayment factor on debt repayment will increase pressure on the firm if actual future cash flows cannot cover all interest and principal repayment costs, then the firm will be at a deficit early on. Third, the relatively high interest i nterest rates that debtholders are requesting adds to the risk of this project (page 3). The U.S. bank loan, at an interest rate of 10%, payable in 7 years is quite high. With such high interest rates, debt repayment would be difficult given the uncertainty of future cash flows.
