The Cost of Capital Calculation in the Project Finance Settings

The paper aims at elucidating and solving the methodological problems around the estimation of the cost of capital in the project finance settings. By convention, capital budgeting analysts evaluate project finance ventures using the free cash flow for equity (FCFE) method, whereby cash flows, including cash, whose distribution is limited by debt covenants, are discounted with the project’s cost of equity. We argue that this approach is erroneous. From the standpoint of the sponsor company, only distributable cash flows should be taken into consideration when evaluating project finance ventures. In turn, the discount rate should be equal to the weighted average cost of capital of the sponsor, which should reflect the financing of the venture from the sponsor’s capital mix. In the case of full recourse to the sponsor, the WACC of the sponsor needs to be adjusted to reflect the change in capital structure as a result of shifting the credit risk to the sponsor’s balance sheet. Failure to adhere to the guidelines outlined in this paper may lead to the undervaluation of investment projects and suboptimal allocation of investment budgets, particularly in large corporations that use their capital invested to inject equity into subsidiary SPVs.