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Consistent valuation of project finance and LBOs using the flows†to†equity method


  • Ian A. Cooper
  • Kjell G. Nyborg


The flows†to†equity method is used to value transactions where debt amortizes according to a fixed schedule, requiring a formula that links the changing leverage with a time†varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

Suggested Citation

  • Ian A. Cooper & Kjell G. Nyborg, 2018. "Consistent valuation of project finance and LBOs using the flows†to†equity method," European Financial Management, European Financial Management Association, vol. 24(1), pages 34-52, January.
  • Handle: RePEc:bla:eufman:v:24:y:2018:i:1:p:34-52
    DOI: 10.1111/eufm.12136

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    References listed on IDEAS

    1. Cooper, Ian A. & Nyborg, Kjell G., 2006. "The value of tax shields IS equal to the present value of tax shields," Journal of Financial Economics, Elsevier, vol. 81(1), pages 215-225, July.
    2. Ian A. Cooper & Kjell G. Nyborg, 2008. "Tax‐Adjusted Discount Rates with Investor Taxes and Risky Debt," Financial Management, Financial Management Association International, vol. 37(2), pages 365-379, June.
    3. Ian Cooper & Kjell G. Nyborg, 2007. "Valuing the Debt Tax Shield," Journal of Applied Corporate Finance, Morgan Stanley, vol. 19(2), pages 50-59, March.
    4. Ian A. Cooper & Sergei A. Davydenko, 2007. "Estimating the Cost of Risky Debt," Journal of Applied Corporate Finance, Morgan Stanley, vol. 19(3), pages 90-95, June.
    5. Schaefer, Stephen M. & Strebulaev, Ilya A., 2008. "Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds," Journal of Financial Economics, Elsevier, vol. 90(1), pages 1-19, October.
    6. Jing-Zhi Huang & Ming Huang, 2012. "How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?," Review of Asset Pricing Studies, Oxford University Press, vol. 2(2), pages 153-202.
    7. Mike Dempsey, 2013. "Consistent Cash Flow Valuation with Tax†Deductible Debt: a Clarification," European Financial Management, European Financial Management Association, vol. 19(4), pages 830-836, September.
    8. Heitor Almeida & Thomas Philippon, 2007. "The Risk‐Adjusted Cost of Financial Distress," Journal of Finance, American Finance Association, vol. 62(6), pages 2557-2586, December.
    9. Miles, James A. & Ezzell, John R., 1980. "The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(3), pages 719-730, September.
    10. Pierre Collin-Dufresn & Robert S. Goldstein & J. Spencer Martin, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
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    Cited by:

    1. Pengran Zhou & Pengfei Zhou & Serhat Yüksel & Hasan Dinçer & Gülsüm Sena Uluer, 2019. "Balanced Scorecard-Based Evaluation of Sustainable Energy Investment Projects with IT2 Fuzzy Hybrid Decision Making Approach," Energies, MDPI, Open Access Journal, vol. 13(1), pages 1-20, December.

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