#StayatHome Financial Modeling : Discount Rate or Opportunity Cost of Capital

Talking about Discount Rate makes me remember the song by Bruce Springsteen…Dancing in the Dark

Even if we’re just dancin’ in the dark
Even if we’re just dancin’ in the dark
Even if we’re just dancin’ in the dark
Even if we’re just dancin’ in the dark


Many times, participants asked me about what discount rate that we need to discount the expected cash flows in your financial model? They mostly understand that WACC (Weighted Average Cost of Capital) should be there. But I don’t want to discuss WACC, too boring.


I get up in the evenin’
And I ain’t got nothin’ to say
I come home in the mornin’
I go to bed feelin’ the same way
I ain’t nothin’ but tired
Man, I’m just tired and bored with myself
Hey there, baby, I could use just a little help

just a little help, yeah…

Instead of answering, like many finance professors, they will answer back with question..there are no hard and fast rules.

Let’s say, you have a business that runs well. You want to expand this business with another project requiring US$ 1 million, and as usual, you go to your banker. Your banker using 5 Cs’ analysis will look into your business, and come up with the conclusion, this is creditworthy, and the bank will charge with 8% interest per year.

Question: Is the project’s cost of capital 8%?

This might sound quite logical, I got the funding bearing interest of 8% per year, and that money all being used to fund the project’s investment?

“Sound” logical, but is it true? You are in hesitation, and coming to my class asking about this?

The confusion comes from the reality that project’s cost of capital is UNOBSERVABLE. There is no way for us to go to the market and find it or any paper or publication will tell us how much in % the cost of capital for our project will be.

However, interest rate on debt is REAL, and OBSERVABLE. Even your banker could tell you straight how much interest the bank will give you the credit.

Again, you need to put your feet on the ground…time for REALITY CHECK.

The loan interest rate might be related to project cash flows, since the project investment will be financed by the loan and the project cash flows will be used as well to service the debt repayment and the yearly interest rate. Though it is RELATED, but here we are talking about the COST OF CAPITAL to discount the PROJECT’S EXPECTED CASH FLOWS. So in this case, we are talking about the RISK OF THE PROJECT. The loan interest rate then is NOTHING TO DO with the RISK OF THE PROJECT.

When the Banker does the assessment of your business expansion business, and comes up with the annual interest rate, that will say about the soundness of the business, and that includes the already-existing business. Which means that the Bank looks into the current cash flows produced by the already-existing business, plus the new incremental cash flows that will be generated by the business expansion project. If the business expansion project’s cash flows and assets were not sufficient to repay the loan principal and service the interest charge, then the Bank has another door to go, that is the bank could demand repayment from the cash flows generated by already-existing business.

Don’t you think the Banker is the smartest people in the world? Don’t forget to remember: Money attracts Brain! Some people trades products but some people trades money.

Hopefully you are still with me.

The loan then is nothing to do with the project’s risk.

The key words every time we are discussing the cost of capital is THE OPPORTUNITY cost of capital. I guess, we need to keep this OPPORTUNITY word in all textbooks, to remind the readers, and reduce any confusion about the cost of capital. Since it is the opportunity that is the key word, then it will implicate something, we need to compare between two investments, in this instance:

(i) Either the money going to finance the project. Let’s say, the project will only come back with the expected rate of return of 12%; OR

(ii) the money be invested to other investment option, let’s say, other stock in the capital market, with equally risk level, which will return the expected rate of 20%.


I don’t think it will make finance sense at all, if the management decide to:

(i) take the loan with interest rate of 8% per year, and then invest the money to the project with the expected rate of return of 12%, if at the same time…

(ii) the company’s shareholder could pick up the loan with 8% annual interest rate and invest the money to capital market which its expected return of 20%.

I hope Readers will see that when it is the OPPORTUNITY cost of capital, then we need to see everything from the SHAREHOLDERS’ EYES.

Don’t ever forget your SHAREHOLDERS!

Comparing the above two ALTERNATIVES or OPTIONS, then we could say that the Project’s OPPORTUNITY cost of capital should be 20% instead of 8%!!!!!!!!!

You will judge the project’s soundness using the cost of capital of 202% and not 8% (interest rate on loan) or 120% (your expected rate), but 20%, since this is the return that you could get from equally risky investment.

If the money from bank could be used to gain 20% return in the capital market, then it will be easily challenged as to why you put the bank loan money into the project that will give back lower rate, that is 12%.

There is something that I said above that you might not really notice. I refer to the capital or stock market when I said that we need to look to the capital/stock market for finding alternative equally risky investment.

Of course we can’t leave the bonds market away.

To find the OPPORTUNITY COST OF CAPITAL, then we need to look to the Bonds Market and Stock Market. As ever I put before in my another writing “Government Bonds with Negative Yield?”, Bonds Market will always be the anchor for all your investment decisions, either you want to put your money in the bank, real estate, stock, you need to check on the Bonds Market, as interest as the Mother of Economics, is formed through demand and supply forces in that market. Even the expected return rate on common equity will somehow factor into it, the bonds yield. This is why sometimes we find that analysts will use bonds-yield-plus-[subjective]risk-premium approach to estimate a company’s cost of common equity. It is logical to think that companies with risky, low-rated, and consequently high-interest-rate debt (which is readily observable in the market) will also have risky, high-cost equity.

I got a question instantly, then what happens to all those WACC concepts that I got from my finance class?

I don’t say WACC is wrong or correct to be used, yet, probably what we learnt so far is just half the story.

I am trying to depict the WACC discussion into what I call Traditional View and Expanded View.

As you can see, and know very well, under Traditional View, with money flowing from Debt-holders and Equity-holders, WACC to fund a project then will be the weighted average of cost of debt and cost of equity proportional to the market value of each fund.
Well, I guess, nobody from finance schools will challenge the above.

However, I am a bit piqued by knowing that the interest rate on loan/debt (how we get the interest rate, that’s different story, some analysts, just use bonds yield, stated interest rate, etc.) is nothing to do with the project risk. The interest rate being requested by the debt-holder will only reflect the soundness or good health of the Company overall, including its existing business. In the case, the new expansion project can’t repay or service the loan, the bank could come to company to demand repayment from the cash flowing from its existing business.
It will sound a bit non-finance sense to borrow, let’s say 8% and invest the money to the project earning 12% if the shareholders could go the Expanded View, where he/she himself/herself borrow the money at 8% and use the money to fund the project and for that, the shareholders require 20%, the return that he/she could get by putting that money to the stock market (big assumption: the project and the stock market investment has equally risky profile of return and risk).
So under the Expanded view, all projects expected cash flows should be discounted at the equivalent rate of return that the shareholders could earn from alternative equally-risky investments. In this example above, 20% to use to discount the project.

In this case, we don’t even need all those WACC calculation.

In a nutshell, either the project is financed with a mix of debt and equity = since the shareholders could borrow by themselves instead of the company making the borrowing, all projects should be discounted at the rate that the shareholders could earn from other equally-risky investment.

My argument, this Expanded view is very feasible, in United States of America, we know there is pass-through company, called S Corporation. A shell company.

What do you think?

Respondent 1 to Karnen:

In short, I think I agree with everything you say; in particular, ” … all projects expected cash flows should be discounted at the equivalent rate of return that the shareholders could earn from alternative equally-risky investments. In this example above, 15% to use to discount the project.  In this case, we don’t even need all those WACC calculation.”  There is excellent theory (originally developed by Modigliani and Miller) to support this view too and it basically says that except when there is either (1) significant transaction cost differences between enterprise / business sale transactions and debt / equity investment transactions, or (2) information asymmetries between enterprise management and debt / equity investors, the project discount rate (on the assets) would be exactly the same as WACC (see Section 5.3. in the attached).  My personal opinion is that, in most cases, it’s very difficult to determine whether (1) or (2) exists; so I tend to assume the asset project rate = WACC and then just avoid estimating WACC on that basis.

And, yes, I agree with your argument and estimation methods that you suggest as well.

Karnen to Respondent 1:

Could you kindly elaborate further when you said:

so I tend to assume the asset project rate = WACC and then just avoid estimating WACC on that basis. 

Will that mean you don’t use WACC? 

May I know what you are doing when you come to estimate the discount rate?

Seems to me this discount rate is a kind of elusive concept. Different people could have a different way to come up with the discount rate. So meaning there is no single rate or even one range of rates that even two people could agree upon.

I guess the issue is (i) we need to infer Ku (unlevered risk) from Ke or even Kd (and this will lead to a long debatable topic), and second, we don’t have at the moment, the theory to calculate directly the project unlevered risk.

Though there are many books out there showing us to unlever and relever Ke, but all of this will really depend :

whether we assume using fixed book-value leverage ratio

whether we assume using fixed market-value leverage ratio

whether we assume using preset debt

whether we assume periodically adjusted debt

what discount rate assumption we use for TS


If we read MM 1958 paper, the authors themselves, never figured out how to calculate the cost of capital and they put there that  question must be deferred to a subsequent paper. Though MM gave us a definition of the company’s cost of capital was the opportunity cost of not putting money into the shares of a different firm in the equivalent return class, however, again, they never really defined what that was supposed to mean.

It is interesting to note that you bring up the Certainty Equivalent Method and risk-neutral pricing. However, I am not too often in practice, to see analysts using this kind of method to do their pricing, and this method seems to me has not gone to the mainstream in valuation.

If you could share the way you calculate your discount rate, that will be great.

Respondent 1 to Karnen:

I’ll try to answer in sequence:

(1) “so I tend to assume the asset project rate = WACC and then just avoid estimating WACC on that basis.  Will that mean you don’t use WACC?”

That’s correct: If I can support the assumptions that (i) there are no substantial information asymmetries between an enterprise’s management and the acquirer (e.g., if the acquirer has done adequate due diligence and the target’s management has incentives to properly disclose all significant matters), and (ii) there are likely no substantial differences in transaction costs between an “all equity deal” and a “leveraged deal,” then it follows that Ra = Rl*FV(LIAB) / FV(ASSETS) + Re*FV(EQUITY) / FV(ASSETS) = WACC. So, I just use Ra; the estimated risk-adjusted rate of return on the assets / project. 

And, I agree, MM (1958) just introduced the concepts / ideas without really working out all the theory.  I worked out the modern theory in my book based on the fundamental economic identity for resources and claims against resources (ASSETS := LIABILITIES + EQUITY), and an application of information asymmetry and transaction cost theory under the no-arbitrage principle (following Ross (2004), etc.).

(2) “May I know what you are doing when you come to estimate the discount rate? Seems to me this discount rate is a kind of elusive concept. Different people could have a different way to come up with the discount rate. So meaning there is no single rate or even one range of rates that even two people could agree upon.”

I agree about the wide variation in practice on estimating discount rates, and I think this has mainly to do with the fact that arbitrage pricing theory (APT, Ross 1976) is still rarely taught in university; mainly because people (even professors) think APT is just the same as CAPM but with additional risk factors.  But APT and CAPM are quite different theories: CAPM is based on a priori assumptions like (i) there is such a thing as an observable risk-free asset and rate, and (2) the capital markets are in equilibrium.  If these assumptions don’t hold, then CAPM’s theoretical predictions would not be valid.  In contrast, APT needs neither of these assumptions.

So, I use either an APT-based estimate of risk-adjusted expected rate of return, or I discount estimated certainty-equivalent cash flows using observable risk-free asset yields. 

(3) Regarding levered and unlevered “beta”

If one actually believes CAPM is valid, then using the Hamada equation to work out the relationship between levered and unlevered beta–and, so, estimated discount rates–makes sense.  But I’ve actually tested CAPM many times on equities that *should basically meet the CAPM assumptions* (e.g., Boeing) and the real world data is almost always inconsistent with CAPM theory.  So, I never have used the Hamada equation for anything; basically because it’s based on CAPM being true. 

And, yes, I agree … some of the many assumptions that need to be made along with CAPM and the Hamada equation seem (to me) to be beyond rational belief.

My valuation friends always say to me “But you have to use CAPM because it’s the only accepted theory there is!”  But the actual history is that APT and certainty-equivalent pricing (“risk-neutral pricing”) were developed in the mid- to late-1970s to solve the problems with CAPM.  So, we do have other accepted theories and methods … and the methods are much simpler as well.  It’s just that university professors like to teach CAPM, and hate to teach APT as it was intended.

I’ve attached an redacted example (from an actual, recent valuation report) of using APT to estimate the risk-adjusted discount rate.  I certainly don’t think any theory or estimation method is perfect, but I do think the APT method is more theoretically valid, simpler, and does not require inappropriate assumptions.

Karnen to Respondent 1:

Can you clarify further, how to operationalize this equation? the formula seems to me is not new, this is exactly WACC formula.


Second, you draw my attention to APT. Yes, APT is a sort of mystery to me even up to now. The corporate finance textbooks give just a glimpse of the APT and its implementation. I believe most of the finance professors just stop after they finished up explaining the CAPM, and shy away from elaborating more on APT. To be honest, I can’t find one good book on putting APT on par with CAPM, meaning the book gives the same proportion as that CAPM. As far as I remember only Financial Theory and Corporate Policy (by Copeland, Weston and Shastri) textbook that is able to explain that to me. Stephen Ross wrote one book : Neoclassical Finance, but it is too technical, I guess, we need one book that could bring this APT concept to more a operational level for valuation analyst to fall in love in using them.

Respondent 1 to Karnen:

On the equation …


… I was trying to show the following, but wasn’t very clear:

(1)  Ra = is the estimated expected risk-adjusted rate of return on the *assets* (“the project”) … maybe estimated using APT.
(2)  WACC := Rl*FV(LIAB) / FV(ASSETS) + Re*FV(EQUITY) / FV(ASSETS) is the definition of WACC; with each component Rl, Re, FV(L), FV(E), FV(A) being an estimate.
(3)  If there is no significant information asymmetry or transaction cost differential, then Ra = WACC, in which case we only need the estimate of Ra (exactly as you said).

And I agree the difference between APT and CAPM is actually very subtle; I think because if there is, in fact, only one risk factor then CAPM and APT result in the same expected rate of return.  Because of this, most professors I know just say something like “APT is just CAPM with more risk factors” … but then they don’t show that there is a difference between a *risk price* and a *risk factor* (I discuss this problem in Section 2.10 of my book).  The difference between risk price and risk factor can by thinking about the following for asset i:

APT:       Ri = Rf + B1i*RISK PRICE1 + B2i*RISK PRICE2 + B3i*RISK PRICE3 + … 

CAPM:   Ri = Rf + B1i*RISK PRICE1 = Rf + Bi*(ERm – Rf)  where (ERm – Rf) is the “capital market portfolio risk premium”

Because CAPM just assumes there is an equilibrium, (ERm – Rf) is the *risk price* for single aggregated *risk factor*.  But CAPM does not tell us how to find / estimate other risk prices, because in the CAPM equilibrium there is only the one risk price, which equals (ERm – Rf).  In contrast, APT shows how to extract risk prices from market data for any risk based on asset return sensitivities to risk factors.

I also agree with you completely with you on “all asset pricing models are about expectation- ex-ante and not ex-post, and the whole matter then revolves around the future.”  My two favorite financial economists are Fischer Black and Stephen Ross, and in my view Black was essentially a theorist and Ross an empiricist … which I think explains the difference between CAPM (Black) and APT (Ross):  In CAPM, there are unobservable / untestable assumptions; in APT there’s basically just one observable / testable assumption.

In my recent blog article, I show an example in Sections 4 and 5 of CE method valuation, and I also show in Section 5 what is most critical in asset pricing: estimating return sensitivity to risk factors.  If there is a *statistically stable* sensitivity of market returns to a risk factor, then we can reasonably make the argument that ex post risk prices can be used to estimate ex ante expected returns … or at least that’s how I think of it.

Respondent 2 to Karnen:

For myself, I guess, all asset pricing models are about expectation- ex-ante and not ex-post, and the whole matter then revolves around the future. Can use historical data to draw a conclusion or even use it to test the future? I gather, all we need is just to rely on a sense of the prob of the future events. Fisher Black once said that we should put our trust only in logic and theory and forget about statistical empirical results. (quoted from Capital Ideas Evolving by Peter L. Berstein. John Wiley & Sons, Inc.. 2007. Page 94.)

My first understanding and reaction is that if the equity holders do what you say and invest in the firm/project, clearly the wacc reduces to Ke.

Karnen to Respondent 2:

Yes. However, my point, since the shareholder could borrow by him/herself to finance the project (in reality, I have seen this before, where the equity fund is indeed coming from bank loan), then computing WACC for the project is not necessary. All project cash flows could hypothetically be discounted at Ke, even for the case, where the company borrows the money directly from the bank.

Respondent 2 to Karnen:

I don’t see clearly why if the financing with debt is done by the firm, you still say that any project could be discounted with Ke. Explain, please…

Karnen to Respondent 2:

What I would like to say is that:

The forecast cash flows of a project should not be discounted at wacc (debt and equity), but by Ke (cost of equity), the required return that the shareholder could earn from other alternative equally risky investment (in this case, I use return from stock market).

WACC becomes irrelevant since the shareholder could borrow by himself to finance the project and flow the bank loan proceeds in the form of equity.

So whether the company or the shareholders the entity that have the borrowings, it is not relevant, and thus the way discount rate is calculated from WACC.

The value of the company that itself obtains the loan (A) and the value of the company that through its shareholder obtains the bank loan proceeds (in form of equity) B)= both companies A and B should have the same value. In other words, Ke is the appropriate discount rate for both Company A and B. Otherwise Arbitrage will creep into.

Respondent 2 to Karnen:

Not sure.

Just a naive question: how would the firm know if shareholders have financed the investment in the firm?

The firm will not know. The firm will “see” that the project/firm will be financed by equityholders only  if they ask the firm pay all debt, and ok, the firm will know that the firm will be 100% by equity.

If the firm keeps debt it will have to pay interest on debt. And it will earn TS. If this is the situation, it is not clear to me why the firm should discount its projects/investments CFs at Ke and not at WACC or even at Ku in case the firm perceives that equityholders has 100% of capital. In the best case of your proposal, it would be a 100% equity funded firm and in that case the DR would be Ku and not Ke. 

In short, if the firm perceives that it is financed X% by debt and (1-X%) by equity, it might discount any project with WACC etc. If there is no debt, the project/firm CFs should be discounted at Ku.

Karnen to Respondent 2:

Let’s give you one example:

Company A: have 50%:50% mix of debt + equity

Company B: 100% equity but behind that equity, the shareholders have a mix of 50%:50% debt and equity

Do you think the value of Company A the same or not with Company B?

If the same, why, and if not why?

That’s my very basic question about this.

Respondent 3 to Karnen:

Clearly, the value of Company A is not the same as that of Company B (assuming their expected FCFs are identical, EBIT>int, no financial distress costs). 

Va=Vu+VTS > Vb=Vu

If we go to compare the wealth of shareholder in A (Wa) and the wealth of a levered shareholder in B (Wb), then with a simple algebra one can see that the conclusion depends on the income tax rates. If the tax rate for the shareholder in B equals the corporate tax rate, then Wa=Wb, otherwise Wa and Wb will differ with the sign depending on which tax rate is higher.

To avoid confusion, one should not mix the value of a project (firm) and the overall wealth position of an investor in the project (firm).

My humble beliefs

A project’s generic risk is the risk of its FCF with the associated required return Ku equivalent to the expected rate of return from an alternative equally-risky investment. 

Rates to discount the project’s cash flows will depend on a composition of claims on project’s assets (i.e. distribution of the project’s cash flow and risk) 

For all equity capital structure (only equity claim exists) the discount rate for the FCF is Ku, and for a mix of debt and equity it is WACC.

One may prefer to value an equity claim on the project directly, and in this case CFE should be discounted at Ke (with a premium to Ku for the risk of having to serve the debtholder claims on the project’s FCF first). 

Where the shareholder obtained funds to invest in the project is irrelevant, a determinant of the discount rate is the risk of the cash flow being discounted.  

Discounting FCF and Ke is visibly inconsistent and produces senseless result

Judgement by comparing the projects return with the borrowing rate makes no sense.

Karnen to Respondent 3:

Thanks for your generous comments.

You said: Clearly, the value of Company A is not the same as that of Company B (assuming their expected FCFs are identical, EBIT>int, no financial distress costs).

How come the value of Company A is not the same with that of Company B as both they are exactly the same company and produce the same forecasted cash flows)?

Pls remove first all discussions on tax, assuming we are living in a perfect MM world.

I put all these hypothetical example (all else remains the same, only the financial structure is different)

Company A: have 50%:50% mix of debt + equity

Company B: 100% equity but behind that equity, the shareholders have a mix of 50%:50% debt and equity

Other information:

  • Alternative equally risky investment return for that project = 15% (I took from stock market if the shareholder put his/her money in the stock market)
  • Borrowing rate (either going to company A or going to shareholder) = 5%

My questions:

For Company A : how much discount rate will you put there?

For Company B : how much disocunt rate will you put there?

Respondent 3 to Karnen:

Sure, sure… if we alter assumptions to a perfect MM world, then Va=Vb and tax considerations are irrelevant. However, other statements remain valid, just WACC reduces to Ku.

Let’s see how it goes in the hypothetical example suggested

An implicit assumption is “project  firm”. If not, discount rates for the firm and project would differ

It’s not clear what 15% return from an alternative equally risky investment is. Since it is said to be a return a shareholder obtains from the stock market, 15% could be Ke, if return comes from investing in a share of a levered firm, or 15% could be Ku, if the firm is unlevered. 

Let’s assume 15%=Ku (either observed directly or obtained by unlevering Ke)

Since we are in a perfect world, cost of debt capital = borrowing rate

Discount rates are as follows:    

Va = Value(Company A) = PV[ FCF at WACC ] = PV[ FCF at Ku ] = PV[ FCF at 15% ] 

Ea (or Ve(A) depending on a choice for notation) = Value(Equity claim in the Company A) = PV[ CFE at Ke ] = PV[ CFE at 15%+(0.5/0.50)(15%-5%) ] = PV[ CFE at 25% ] = 0,5Va

Vb = Value(Company B) = PV[ FCF at Ku ] = PV[ FCF at 15% ] = Value(Equity claim in the Company B) = Eb 

Obviously, Ea=0,5Eb. However, if we look at a shareholder wealth position, then in full compliance with MM  0,5Va =Ea = Wa = Wb = 0.5Eb = 0.5Vb

Indifference of a shareholder wealth position doesn’t imply that ALL cash flows could be discounted at one and the same rate.

Things become a bit more complicated if we introduce taxes

I suppose comments from Respondent 2 above have an underlying idea similar to comments above.

Karnen to Respondent 3:

Yes, under MM super perfect world, WACC = Ku, this will lead to the same valuation of Company A and Company B.

Stock market return, that I put there, that is not specific industry, we could use a portfolio of shares, since I guess, nowadays, nobody only puts his/her eggs in one company’s shares. I heard many times in the discussion with the investors, they just said that they earned such return rate from putting their money in the stock markets, and use that as the benchmark.

In practice, again, I did remember from my very early email exchanges with Ignacio, bringing Ku to the table of discussion, this is hard, since Ku is not observable. And one question to Ignacio, hopefully he still remembered that, is most of the time, (i) we need to infer Ku from Ke or even Kd (and this will lead to a long debatable topic), and (i) we don’t have at the moment, the theory to calculate directly the Ku.

Though there are many books out there showing us to unlever and relever Ke, but all of this will really depend :

whether we assume using fixed book-value leverage ratio

whether we assume using fixed market-value leverage ratio

whether we assume using preset debt

whether we assume periodically adjusted debt

and Ignacio’s favourite topic, what discount rate assumption we use for TS


I just sent you a couple of days before, one paper by Clifford S. Ang, CFA and Andrew Lin, CFA, CAIA : The Valuation Impact of Using the Wrong Leverage Ratio to Unlever Betas (http://quickreadbuzz.com/2020/04/29/business-valuation-ang-lin-the-valuation-impact-of-using-the-wrong-leverage-ratio-to-unlever-betas/, accessed on 3 June 2020)  which gives us conclusion that:

The above analysis shows that using the improper leverage ratio to unlever betas can lead to substantial valuation differentials. In a significant percentage of cases, the valuation differentials can exceed 10%. In some cases, the valuation differentials can exceed 50%. The size of the error rate is likely concerning to most valuation analysts.

Nonetheless, the point that you bring something to me is you are talking about the view from total shareholders’ wealth, which sounds interesting to me.

Respondent 3 to Karnen:

I would admit that the extensive argument you provide didn’t persuade me to give up my view: whatever the pass one takes to settle a hurdle rate for an investment decision, it doesn’t make much sense to discount all cash flows of a project (not to say all projects) at this one rate. I see you smoothly move away from your initial question to a related, but different topic, and this is another story.

Karnen to Respondent 3:

However, I came up with this question when in practice, I see even two analysts valuing the same project (part of a company) could come up with two different single rate or two different ranges of rates. When they structure the financing either the loan going direct to the company or thru the shareholders, this has brought up a different way to come up with discount rate. Again, unlever and re-lever is a painful process to explain away, which one to use and again that another debatable topic.

Again, as I put in early email to this discussion, even if we could get 5% loan, but invest in a project returning 12% while the shareholders could earn 15% from the stock market, then that project still is not feasible to go. Put something to discount rate (either WACC, whatever) for the project’s cash flows, in my practice, brings too much complication to the table.

My proposition, if the shareholder “could” borrow the loan to finance the project and flow it to the project, then he/she could increase their expected return (even higher than 15%) and then use that a benchmark to compare against the IRR of the project’s cash flows. This brings discussions becoming lighter to talk and get across. I am trying to avoid as much as possible, about Ku, re-lever & relever beta (or Ke), target leverage ratio, etc.

Respondent 3 to Karnen:

Ok, let me try to explain the point another way. I don’t see much problem, if any, with discounting at Ke (or whatsoever one may call it) regardless of who is levered, a shareholder or a firm. However, If the shareholder takes a levered position (borrows herself and pours money into the project as equity), then it would be inconsistent (in fact, a common mistake) to discount the project’s cash flow (FCF in this case) at that Ke, or compare the project’s IRR to it.

Karnen to Respondent 3:

Under Company B, all FCFs of the projects flow to shareholders, so that FCF Project = FCF Equity = CFE, and we could compare that to Ke. What is the issue with that?

Something that I need to clear off with you, again back to the stock market return. Hypothetically the money from loan creditor and shareholders, could be invested by the company as well into the stock market return, and let’s say it earns the same rate of 15%. Meaning that this investment in the stock market could be made by the shareholders themselves and by the company itself. Leaving with the option for the company, to put the money into the project (IRR 12%) and put the money into the stock market (15%), then it takes no brainer that the company should not take up that project. If you accept with the above notion, then the company doesn’t need WACC or whatever discount rate for the project. All we need to make assessment is only the IRR of the project, and the benchmark other alternative investment (in stock market or other market).

Next discussion will see what is inside the interest, since interest rates are a key factor being included in determining the cost of capital and it provides benchmarks against which to make financial and investment decisions.

Just pick up the interest rate from the market (Note: since it is relatively easier, since the rate is OBSERVABLE and updated INSTANTLY) without really understand what factors are driving the interest rate (or the yields required to induce investments of various types), it might be like a boy with a hammer, which to him, everything looks like a nail.

Question to Respondent 4:

A project will be funded by debt and equity. If the equity holder obtains his/her fund from the bank (somehow bank wants to finance this long-term equity investment in one project, through the shareholder, instead of directly funding the project. The reason might be that the loan thru the shareholder is guaranteed by other shareholder’s assets) with effective annual rate, let’s say 10%. The equity holder have two options hypothetically, invest the proceeds from the bank loan into the project, or put that into the equally risky stock investment in the capital market, yielding expected return of 15%.

My question, for the expected cost of equity for that project (which fund is obtained from loan), do we use 10% or 15%?

Respondent 4 to Karnen:

Hello Sukarnen,

This is a big issue in project finance.  In particular there is something called an Equity Bridge Loan where equity holders borrow their investment and pay it back later.  My opinion about all of the divisions in equity is that first, the overall equity IRR should be evaluated.  In addition you can compute the distribution of equity and investors that have put less risk in the development should accept a lower IRR.

Unlike corporate finance, you can find real data on the cost of capital from transactions where projects are bought and sold and there is a good estimate of the returns investors are willing to accept.


Effective Annual Interest Rate in Topping Up Your eMoney or eWallet


I am a bit intrigued to think about the top up fee that we need to pay to replenish our eMoney or eWallet, for example, I found the example, where we need to pay Rp 1,000 for each top up transaction. Since this world is driven by interest, which is the mother of economy, then I guess, somehow I should relate this top up fee to interest that I have to pay implicitly.

How to do this?

Let’s say, the case is:

  • we want to top up Rp 300,000 with a top up fee Rp 1,000.
  • we replenish this top up every two weeks, meaning that Rp 300,000 will be used up to buy food, transportation, etc.

So how much is the implicit effective annual interest rate that we need to pay:

The analysis is shown below.

The implicit effective annual interest rate is 8.43%. This seems to me quite high since this is not too far from working capital borrowing interest rate, though we don’t borrow anything from anybody, as that’s pretty much our own money.

I will go further by having sensitivity analysis with one-factor change, that is the replenished amount, and keep the remaining assumption constant.

Sensitivity (1) One Factor : The Replenished Amount (IDR)

The chart below demonstrated that the effective annual interest rate will fly from 62% for replenished amount of Rp 50,000 declining to near to 5% for the replenished amount of Rp 500,000. This will mean that the higher amount that we replenished, then the lower effective annual interest rate that we need to pay for this top up transaction.

How about if we keep all assumptions constant, but the frequency of the top up?

Sensitivity (2) One Factor : The Frequency of the Top Up (in Days)

From the above chart, we could see that the longer days that we do this top up transaction, then the interest will decline from near 30% (if we fill up the top up every 5 days) to near 2% (for every 60 days) with the amount of Rp 300,000 every time we top up the emoney or ewallet.

How about if we make the amount of the replenishment and the frequency of the top up becoming variable?

Sensitivity (3) Two Factors : The Replenished Amount (IDR) and the Frequency of the Top Up (Days)

The above table gave us that the effective annual interest rate is quite far by wide margin. If we top up Rp 50,000 every 5 days, then the interest rate will be 324%…wow is this really what we paid?

If we top up Rp 500,000 every 2 months (+/- 60 days), then the interest is around 1,18%, this sounds very low.

So what we could get something out of this analysis:

  1. All fees that we pay, there is implicit effective annual interest rate that we need to pay to the service provider.
  2. The top up fee of Rp1,000 may sound small money, but when we link that fee to the frequency of the top up transactions and the amount being replenished, that small amount might give us interest rate that shoots through the roof.
  3. The old adage will ring again, watch your spending habits. My two-cents suggestion: drive your car till it drops!

Government Bonds with Negative Yield?


I just read this


I quoted the whole news:

Britain sold a government bond that pays a negative yield for the first time on Wednesday – meaning that Britain’s government is effectively being paid to borrow as investors agreed to be paid back slightly less than they lent.

The bond, which matures in July 2023, sold at an average yield of -0.003%.

While investors will receive an annual interest payment of 0.75%, they paid above face value for the bond so the actual return in cash terms is less than they have lent.

Demand for the bond was low by recent standards, with investors bidding for just over twice the £ 3.75 billion (US$ 4.59 billion) on offer.

The last time a bid-to-cover ratio was below Wednesday’s 2.15 was on March 19, before the BoE announced it would buy an extra 200 billion pounds of assets, mostly government bonds, to support the economy through the coronavirus crisis.

This is interesting news, though it is not really coming as a big surprise.

What does it mean?

It means that UK government bonds carry coupon rate lower than the at-that-time-issued market interest rate, resulting to the market value of that bonds higher than its face value. Let’s say, the face value of that bonds is USD 100, then the investor is willing to buy that bonds at USD 103. In other words, the investor has purchased that bonds at premium.

Under normal condition, coupon rate of bonds will be set at the same rate of that market rate at the time of bonds issuance, giving rise to face value of bonds = market value of bonds.

The big fat question is why the investor is willing to pay the bonds higher than its face value?

Looking forward, the investor might predict that the UK demand in the future will be lower, putting the market interest rate declining in the long term. It might indicate that the demand will not that be strong in the economy, and the economy might be going to be weak. As the long-term interest rate is influenced by the demand vs supply, then from the investor’s perspective, he/she is willing to invest in government bonds with premium, expecting that the long-term interest market rate will be going down to that level lower than the bonds coupon rate.

How about Indonesia?

We need to look at the bonds market.

Source: http://www.ibpa.co.id/ (accessed on 21 May 2020)

Why we need to keep an eye on the bond market, regardless you invest in stock market or real estate.

As we learnt from macroeconomic class, interest rate is the mother of economy. In the bonds market we could find the bonds yield, and as you probably already knew, the interest rates and bonds yields are highly correlated  (though it doesn’t mean that it always move perfectly in step), and oftentimes, even both terms are used interchangebly.

This is why it is so important for the investor to always look to bonds market, as interest is one of the leading economic indicators and bonds market could be considered as a great “predictor” of future economic activity and expected future levels of inflation. Both interest and inflation, as we know, had, is and will always directly affect the price of everything in the economy, running from capital market, real estate market, and domestic household demand.

Back to the bonds yield pattern above, for Indonesia, it is still displaying normal curve, which have expected long-term rate higher than short-term rate. While short-term rate is more driven by the announcement by the Central Bank, yet the long-term rate reflects the market forces, supply vs demand and the underlying expectation. This “expectation” is one key element in the determination of the long-term interest rates that is largely a function of the effect the bond market players believes current short-term interest rates will have on future levels of inflation.

Guided by this bond yields with its a normal yield curve which starts with low yields for lower maturity bonds and then increases for bonds with higher maturity, then the market players foresee that Indonesia demand will still be strong, including its inflation being high in the long-term eyes. To me, this makes economic sense, in view of the large population that Indonesia have.

I’ll give you simple math to see this.

Currently, Indonesia has around 267 million population (with 133 mio of working people). Assuming we take a very floor assumption, which one people will spend around Rp 25,000 per day only for basic needs such as rice, sugar, salt, vegetables, cigarette, coffee, etc.

Then the “real” money flowing will be :

267 mio (I rounded it up to 270 mio for convenience) x Rp 25,000/ day x 365 days = Rp 2,500 Trillion.


This Rp 2,500 Trillion is only for the scenario for the basic needs consumption.

So readers, you could see the real domestic consumption strength in Indonesia, which in statistic, this massive and gigantic domestic demand have support Indonesia GDP growth more than 50% for years. I believe, this carries explicit confidence in the economy growth in Indonesia.

We need to be able to keep our eyes on the forest and not confused by the trees in between.

Though not really apple-to-apple comparison, yet I always remember that in early 2000s when the internet bubble burst out, what we saw it was the financial bubble that burst, but not the internet market. Internet market even continued to make its growth dramatically after that explosive bubbles. Which reminds me that it is always important to see what is going on in substance. With all this covid-19 pandemic outbreak and its short-term shock to Indonesia economy, Indonesia economy will still be there for 270 million people.

Jakarta, 21 May 2020


https://www.cohencpa.com/insights/articles/on-(yield)-curves-and-what-they-mean (accessed on 22 May 2020)

#StayAtHome Financial Modelling (2) Model


From getting a brief introduction to get a head-start on building a financial model, then you’re gonna said “What is NEXT”?

I will say, it depends…

Depends on What?

Depends on what models you are going to build, of course.

In practice, there are at least 6 (six) models that we could cover when we are talking about financial model:

  1. Corporate Model.
  2. Project Finance Model
  3. Acquisition or Leveraged Buyout Model
  4. Merger Model
  5. Financial Institution Model
  6. Real Estate Model

Here I would like to touch on Corporate Model vs Project Finance Model.

Cut to the chase, Corporate Model will involve the company that have a history and as like many corporation, they have longer life, and in many cases, the modeler, will build into the assumption, that that company (and business) could last indefinite (Note> INDEFINITE doesn’t have the same meaning as that INFINITE. Please use your online dictionary to find out the big difference of that two terms.)

Since we have assumed away that that company could last into indefinite years, then it will be much efficient, that we reflect that value of indefinite business into one figure, called or termed as Terminal Value. We could put whatever figures we want into this Terminal Value, as long as we can sell this idea to the investor or reader. For example, the question what does that Terminal Value mean?

We might assume:

The Company being sold (or purchased) = Terminal [Cash/Share Swap] Value

The Company being liquidated (or gone into bankruptcy) = Disposal/Scrap Value

The Company being merged with other company = Selling [Share Swap/Non-Cash] Value

The Company being there forever = Continuing Value

The Company being….. = Horizon Value (I put Horizon Value since I don’t know what term I need to put here…, can we put Probable  or even Future Value, since we have no idea what will happen in the future? Anything could happen.]

You could add your version yourself, but one thing to bear in mind, that you need to check the ROIC, ROE and ROA figures at that point of “Terminal” year as making economic sense. If they are too high…then it could indicate that that year should not be the “terminal” year. How long and how low can it go, then? Some finance scholars and practitioners might say that that ROIC might be not too far to cost of capital in the long-run. Is this correct? What do you think?

Check as well the working capital growth and the capital expenditures level at that point of “terminal value”. Again, remember the adage saying that it takes MONEY to make MONEY. So it will certainly take certain level for the working capital and capex level to sustain high valuation at Terminal Value.

If you believe in the Myron J. Gordon Growth formula for calculating Terminal Value = FCF_t (1+g)/(WACC-g), then be noted, that we could have a wide range of terminal value, just by changing the growth rate (g) and the WACC (cost of capital), two variables that are the most difficult to assess in many valuations, terminal growth rate and terminal cost of capital.

When setting the terminal growth rate, instead of focusing on how much we want to put the % for that rate, I guess, the more important to think is, what spurs that rate. High terminal growth rate will for sure require more capital expenditures to invest in that later years. How much is the growth rate for the capex? You should remember, that it takes Money (and some moderate grain of risk) to make Money. Without this engine, the “imaginary” high growth rate will come to a screetching halt.

Ok, we go back: it means we need a (detailed) forecast of EBITDA and then Cash Flows for the indefinite life of the company.

The key outputs of this Corporate Model is Earnings per Share (EPS), Return on Investments (ROI), and don’t forget your shareholders, which means we need as well ROE (Return on Equity). Making Shareholder’s happy should be your first and foremost goal! They love it when you put something about the measurement of the performance of the management of the company…..but they will be happier if you remember their money being invested into that company, and this will drag you to put ROE always in your model. The shareholders want to know whether their money invested will return return (2 Returns) that high enough to justify finance sense to put their money in that corporation business, compared to being put in the other investments, such as deposit, stock, bonds, etc. (equivalent investment with comparable risk and period.)

Corporate Model indicates explicitly that the search is for the Shareholder Value, which view is ubiquitous in many corporate finance textbook, and its term was first coming from Alfred Rappaport, a business school professor. However, as a side note, in 2019, 181 US Top CEOs signed a one-page declaration, which that ended as follows: “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.” (https://hbr.org/2019/08/181-top-ceos-have-realized-companies-need-a-purpose-beyond-profit). The idea about 3Ps, Profit, People and Planet, or also know as “Triple Bottom Line” has increasingly been getting into the mainstream.

What do you think about Triple Bottom Line? Or is it Impossibility Trinity? Feel free to share your opinion.

However, for the time being, the Corporate Model will talk only the first P, that is Profit. And……it is a general’s command: return cash (dividends) to shareholders when there are no credible value-creating opportunities to invest in the business, earning return higher than its costs. This general’s command is something that we should put at the back of the mind even though the Corporate Model itself will drive the dividends modelling using sort of dividend payout ratio or policy (which again, this is a discretionary decision).

Another thing that I would like to mention is Return on Investment (ROI). Though this ROI sounds very familiar to many people, even from their university time, yet in practice, the way ROI is defined, might be quite different. I found there are so many abbreviations for such way to measure the productivity of capital, to relate profit to invested capital, or cash flow to spending, and to quantify the rate of return earned before or after getting the investors’ money back.

ROIC = Return on “all” Invested Capital,

ROCE = Return on Capital Employed vs Return on Common Shareholders’ Equity

RONIC = Return on New or Incremental Invested Capital

ROA = Return on Assets (and RONA = Return on “Net” Assets or ROC = Return on Capital)

Generally speaking, the rate of return on capital employed (interest-bearing debt + common shareholders’ equity  falls between ROA and ROE)

And the most confusing is the way that for what we put for the numerator and denominator to calculate all the above. For numerator, some put net income, net income before interest expense (net of tax savings) on long-debt, etc. etc.

If you ask my suggestion, if you found such ROI, etc above, the very question you need to look at : ASKING and CHECKING how that ratio is calculated. Moreover, CONSISTENCY in calculation is crucial as well. For example, if we compare Net Income to total Debt and Equity, then I don’t think this is correct. Logically, net income is the residual income after the interest expense is deducted, and then this should only relate to Equity and not to the sum of total Debt and total Equity.

Another people,  instead of using end-of-month or end-of-year balance for Investment, Debt or Equity, will use the average of two period ends. I have no idea which one is correct.

I can’t say which one is correct from all above calculation for ROI. Each author have his/her own argument to defend : McKinsey, finance professor, finance practitioners.

Again, CHECK and always put your feet on the ground. If the number seems too good to be true, then it might be that so. Meaning it is not true.

If you feel the way is calculated, make you confused, probably that’s the intention. Albert Einstein once said:

If You Can’t Explain it to a Six Year OldYou Don’t Understand it Yourself”

My tip, if you see somebody gave you ROI, then back asking him/her, which one you are talking about, left-hand of the balance sheet or right-hand of the balance sheet, as depicted below:

Source: Corporate Finance : Theory and Practice by Pascal Quiry, Maurizio Dallocchio, Yann Le Fur and Antonio Salvi. Fifth Edition. 2018. Page 46.

If he/she can’t really tell you..then better to leave him/her.

Pls keep in mind that:

  • ROA measures the profitability of operations before considering the effects of financing. It will make sense to use ROA if what we are interested in, is the profitability and the efficiency of the firm’s core operations or its operating assets.
  • When somebody is talking about Returns (since Returns matters!) or cash flows, then you need to ask first, returns to whom? To the Firm or to the Capital providers? There is a big difference between this. For example, when we read the Statement of Cash Flows of the Company, then that’s the net cash flowing into or out of the Company.

How about ROE, which is one single ratio that represents the shareholder’s wallet. Well, as the manager of the company, then it is one of his/her job to maximize this ROE, in other words, to maximize the shareholder’s [market] value in the company.

My caveat to you, don’t be too impressed on ROE.

One of many issues with ROE, is in ROE, we can’t find risk element. Again, as you probably already new, RETURNS and RISKS is two sides of the SAME COIN. Under Modern Portfolio Theory, the shareholders do not only concern or care about the RETURNS but also, of course, the RISK.

Another shortcomings, in ROE, we don’t see the second crucial element to consider in all investment performance, that is the SIZE of the investments. In another color, how much money is invested by the shareholders to earn that ROE. Higher ROE, let’s say 50% of US$ 1 mio versus Lower ROE of 25% of US$ 10 mio: Which one you are going to pick up?

Shareholder’s [market] value will always involve the talk about the RETURN, the RISK and the SIZE of the “skin in the game” (read: money put on the table).

G. Bennett Stewart, III in his book “Best-Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value” (John Wiley & Sons, 2013), wrote (p. 86) about what’s wrong with RONA (= ROE)?

RONA and the other conventional return metrics are highly misleading and incomplete performance indicators, for reasons I will explain. And the deficiencies are far from academic. As you will see, companies that have aimed to increase RONA or maintain a high RONA have committed major blunders in strategy and resource allocation. And when RONA is judged
from the bird’s-eye view of how well it performs as an element in a firm’s. overall management system, it fails, or at least it is far inferior to EVA, as I have been saying and will continue to elaborate.

RONA fundamentally fails because it is inconsistent with what is—or should be—the main mission of every firm, which is to maximize the wealth of its owners. It is to maximize the difference between the capital that investors have put or left in the business and the present value of the cash flow that can be taken out of it. In short, the goal is to maximize MVA by maximizing the stream of EVA, as I have said.

Here’s the problem in a nutshell. RONA tells us about the ratio of market value to invested capital, but that is not the same thing as maximizing the spread between market value and invested capital, which is the true goal. A company that aims to maximize RONA will always tend to hold back and underinvest, underinnovate, underscale, and undergrow. It will leave value
and growth on the table, and become vulnerable to a hostile takeover or a toppling by upstart rivals.

I gather that now you are more skeptical about reading high or low ROE.

Always remember:

We can’t buy something using high or low ratio. Instead, it is the difference or the gap between the amount you invested and the amount you get back!

I gather, now we keep going.

Then, we move talking about Project Finance Model.

You said, the finance books that I had back in my finance class, all have title “Principles/Fundamentals/Essentials of Corporate Finance” or “Managerial Finance”, none of them have a title of Project Finance.

I hope you still remember that one of the chapters or sections in many Corporate Finance textbooks, they are talking about Capital Budgeting technique and how to apply that. Some techniques, such as IRR is useful when the model we build is about Project Finance Model.

The Project Finance model is being used to evaluate a project or investment that :

  • have no history of cash flows at all
  • the project have lifetime (like a human, there is a birth date and death date)

As a background for the popularity of Project Finance model, is, in many developing countries, government partners with private sectors to build infrastructures such as roads, hospitals, power plants, etc. Most of those projects are analyzed or financial-model built on project finance concepts.

We can’t bring corporate finance concept into project finance model, since the creditors cannot stand on assets-in-place (since there is no historical balance sheet at all to stand on) to seek remedy. And the risk is so big, considering no history of cash flows at all and no historical balance sheet to stand on in case the project fails),  then risk sharing is the key to this project success.

Accordingly, the project finance model should focus on two things:

(i) Cash flows flowing to lenders

(ii) Cash flows flowing to equity holders and/or sponsors

Those two cash flows are so important to model, as all cash flows generated by the project itself during the entire lifetime of the project will ALL distributed to lenders, equity holders, sponsors, and not be re-invested to the company (the latter is for Corporate Model). Accordingly, key outputs of Project Finance model will be the Project IRR (pre and post tax), and Equity IRR. Again, the latter is to let the shareholders know that you are thinking about their pocket ultimately.


a) If there is pre-tax IRR in the Project Finance model, how about in the Corporate Model? Do we have pre-tax ROI?

Answer: Pre-tax ROI? What I could say, the ratio of EBITDA to Investment (net working capital and net fixed assets) could represent pre-tax ROI. Though this might raise a bit question, since EBITDA is computed BEFORE DEPRECIATION, and when it comes to “Return”, it should be calculated AFTER DEPRECIATION. Nonetheless, EBITDA/Net Investment is commonly being used in the assessment of the Corporate Model.

b) Why do we need to come up with Pre-Tax IRR in the Project Finance model? How about if the resulting Pre-Tax IRR is lower than the market interest rate? How about if the resulting Pre-tax IRR looks higher than the cost of capital? What does it implicate something to you?

Prof. Peter DeMarzo’s comment:

Yes, the lack of collateral can diminish the opportunity for credit.  But indeed, this is not so different from many projects in the corporate sector, if the main assets are in the form of human capital. From the perspective of the cost of capital, again the main driver should be the beta of the project cash flows.   An additional risk may be that of expropriation, which is more likely in bad times.  This expropriation risk would raise the beta. What other factors do you see?

Karnen again:

I believe many project finance assets are not in the human capital. One of the common characterictic of many project finance, they are marked with low tech risks and mostly dealing with predictable market, so having heavy project physical assets still make reasonable finance sense.

About project risks..beta I don’ t think it could reflect all risks being involved in project finance. As I put before, project finance doesn’t depend on soundness and profitability of the company. Mostly will deal with totally new venture. So the soundness and profitability of the venture itself is the main critical factors.

Project finance in most cases will involve very large scale to the company’s current size, sheer higher risk compared to “average” risk that beta could capture, and have potential contamination risk. In view of these risks, project finance will carefully identify the risk during each phase of the project, such as during development phase, construction, completion, operations and maintenance, etc, then allocate that respective risk to the party that could handle that risk the most efficient and effective. This is why we see so many parties being parts to the Project Finance agreement.

This all brings to ascertain the project has low supply risk, low commercial risk as all output will be taken by a single offtaker or a few large buyer or products being consumed by general public, secured long-term concession (sometimes plus monopoly right being awarded), etc.

One classic paper to read is written by Brealey, Cooper and Habib “Using project finance to fund infrastructure investments” Journal of Applied Finance 9 (1996).

Project Finance in many fronts are quite different from Corporate Model, for example, there are different phases over the life of the a project (remember, a project have a date of birth and date of death), they are:

  • development phase
  • construction phase
  • operation phase
  • debt repayment phase
  • debt refinancing phase

The aforementioned different phases will involve different risks to handle, and WHEN THE RISKS CHANGES, THEN THE VALUE WILL CHANGE AS WELL.

From the eyes of the equity contributor, then he key output of Project Finance is Internal Rate of Returns to equity holders, which will mean that this IRR will be calculated from the project cash flows AFTER all debts and its interest have been serviced and paid to the debtholders. Which mean, at the end of the day, all cash flows generated by the project will flow to the last penny to all the contributors to the projects. Since IRR to equity holders are coming AFTER the debt servicing, then this resulting figure (good or bad, or as expected) will be flowing from the PROFIT AND LOSS PERFORMANCE (summarized in the Profit and Loss Statement), then CASH FLOW STATEMENT. Modelling through all these statements, the modeler could see that the following factors will play a role in determining the equity IRR for Project Finance model:

  • the financing size. This first factor is not quite surprising knowing that all project finance is all about funding big fat question, that is how to finance such sizeable project.
  • Once the financing size is answered, then it comes to ABC and the loan tenor. What is ABC? ABC is talking about the Debt repayment, how the project will pay back the loan : “A” Amortising Debt, “B” Bullet Repayment of Debt, and “C” Loan with Interest Capitalized. Here is about the TIMING of the repayment of the debt. Bullet Repayment as it puts there “Bullet”, it means the debt will be paid in one time at the end of the debt term or tenor (this is why possibly the term is called “Bullet” = Bullet to the Head if you don’t pay!), or the pattern of debt principal repayment is akin to the bullet form, so some portion of the debt amount is paid along the duration of the loan.

As you probably know that IRR magnitude is very sensitive to (i) the pattern of the cash flows and (ii) the duration of the project cash flows. This is why IRR is called “INTERNAL”, the calculation of IRR doesn’t need external elements, all it needs is just the CASH FLOWS and the TERM of the Cash Flows. We don’t need even the Discount Rate or COST OF CAPITAL (from market).

You might say, oke, you’re covering the equity IRR. How about the debt contributor? They might take risk as well in the project.

From the perspective of the debt contributor, then the big fat question is always, whether:

  • Can I  get back my debt principal (Return OF debt)?
  • Can I get back my debt interest (Return ON debt)?

So the lender in this case will be quite prudent to see whether the project cash flow has sufficient BUFFER ABOVE the debt service obligations, and here, we are talking about DEBT SERVICE COVERAGE RATIO. You might call this “Margin of Safety”. The higher the DSCR, the more MOS that the lender have. DSCR = 1 will mean that all project cash flows are gone to service the debt and the interest. However, this is not prudent in case there is A SHOCK to the project cash flows, which means that the lender won’t get its repayment as scheduled.

The other factor that the lender would see is comparing the tenor of the debt vs the life of the project. If the project life is longer than debt tenor and could still generate cash flows, even after the forecasted debt repayment, then it means, the lender could have another MOS, in case the scheduled repayments do not happen as forecasted, and needs to come back to the project owner to negotiate for restructuring the loan. Here is called “Cash Flow Tail“. The longer the Cash Flow Tail period, then it is much better for the lender.

Some authors have outlined the difference between Corporate Financing and Project Financing as depicted below.

Source: https://youssef-serghini.weebly.com/project-finance-vs-corporate-finance.html (accessed on 31 May 2020)

Source: Project Finance in Theory and Practice : Designing, Structuring, and Financing Private and Public Projects (2nd edition) by Stefano Gatti. Page 4. 2013. Elsevier Inc.

However, I come to the point that Corporate Finance and Project Finance is an overlapped concept. Project Finance in its far end, like all those big infrastructure and energy projects, they are developing to different world on its own, so it is easy to forget that the concept is coming or shared the same way as that Corporate Finance in many aspects. Project Finance origin should be part of Corporate Finance, (as discussed originally in the capital budgeting sections of many books), but when that projects share no same characteristics as that the average projects that the company has run before, in terms of returns, risk, phase, etc…then this needs parties and partners to share the risk and return, I guess, this is where all the Project Finance books and training try to show us. Sharing risk and return is not something that we discuss at length under Corporate Finance, since the focus is on maximizing the shareholders’ value. Under Project Finance, we don’t always put too much emphasis on MAX shareholders’ value, though we use all the capital project evaluation concepts from CF, such as IRR, NPV, etc.

Respondent to Karnen (10 June 2020):

Corporations are portfolios of projects and the ultimate ROIC should be the aggregate of project IRR’s (with big problems of reinvestment etc.).  Similarly the ROE should correspond to equity IRR’s.


#StayAtHome Financial Modelling (3) William F. Sharpe : It’s Dangerous to Think of Risk as a Number


During this Covid-19 outbreak, what Bill Sharpe, the father of CAPM (pronounced: CAP-EM) and the receiver of the Nobel Prize in Economics in 1990, said in the title above, keeps ringing in my head.

I believe what he said is so true. Though mathematically, pretty much, we could model the risk, but the big fat question, does it work? This Covid-19 case is one of the good example.

When we build our financial modelling for the next 3-5 years (personally, I think even after 3 years, nobody could really have a good crystal clear idea about what will happen). Of course, human will still exist, but what happen to environment, economy, politics, etc…I guess, all we have just a good GUESS-ing. Even for some companies, near-term is the only agenda item they’re concerned about and the rest might be read as peering through the fog of uncertainty.

Normally, we have many cases or scenarios we put into our financial model, in general:

  • Corporate scenario or base scenario
  • Sunny or good scenario
  • Bad or worst scenario

Then where is the Covid-19 scenario?

I did remember one book written by Enrique R. Arzac with the title : Valuation : Mergers, Buyouts and Restructuring (2nd Edition) which he said that it is necessary that in the valuation, we need to do some stress test by assuming the revenue is BIG ZERO.

When I read that a couple of years ago, I didn’t really believe I would like to use that suggestion, and somehow I feel it was too extreme assumption to put into the financial model.

However, in one or two other books on financial modeling topics, the authors will suggest, that one of the testing of the integrity of the model is to assume away extreme figures, such as BIG ZERO REVENUES, and see whether there is something wrong in the model. I’ve never entertaining a thought when reading that such “model test” could actually be put as one of the scenarios to be built. But amidst this Covid-19 pandemic, all these suggestions are worthy noted and used somehow in the model. Good model should also take into factor extreme condition. How about if the company doesn’t have the revenue at all or revenue dropping off more than 50%. We could even say that Covid-19 is one of that “black swan” events. According to Nassim Nicholas Taleb in its beautifully-written book The Black Swan, The Impact of the Highly Improbable, a black swan is a highly improbable event with three principal characteristics: (i) It is unpredictable; (ii) it carries a massive impact; and, (iii) after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was. The question, can we put the impact of the highly improbable into the Model?

By the way, talking about risk and CAPM, the insight I got is not all risks that other people is willing to pay. For example, if you are crossing the busy street recklessly, then I don’t think there is somebody that wants to pay you for taking that risk. In CAPM world, only systematic risks that deserve a (expected) return to ask. Can we call this systematic risk a real risk that an investor is willing to pay?

Another thing to look at investment that give us a payoffs in bad times (for example, during this Covid-19 pandemic) then, logically , it should be valued more higher or more expensive. Since we need to pay more expensive, then it means we are willing to accept the lower expected return compared to investment that will give us payoffs in good times.

My simple question to you:

Loosing US$1,000 when you are in bad financial condition vs Gaining US$1,000 when you are in good financial condition, IS NOT THE SAME, though the money is the same, that is US$1,000.

Loosing US$1,000 when the money is scarce, is a lot painful, and we might call this ‘REAL RISK’.

CAPM is built under Markowitz Modern Portfolio Theory and its main engine is diversification, which will wash away all firm-specific risks, and such risk will not be priced into the expected returns for common equity. Only the risk that can’t be diversified then that investor or shareholders are willing to pay. However, this same rationale could not be brought into the case where the securities have limited upside potential and greater downside potential arising from firm-specific risks. For example, securities such as bonds issued by the company. If the bond issuer is doing well, then the bondholders will only be limited to receive the promised principal and interest coupons. However, if the company is doing bad, then the bondholders might not receive the payments of principal and/or interest coupon as promised. It might be in lesser amount or even part of all principals are never recovered. So for such investment, mean-variance framework will not work.