Question

You are in the midst of valuing a large, risky investment in an offshore windfarm. You are faced with two options: using generic turbines or using new-technology turbines. Building the wind farm with generic technology is cheaper: a generic wind farm costs 50M while a new technology wind farm has a price tag of 80M. Either option will create $3M in FCF next year that will grow at a rate of 3.2% in perpetuity. To evaluate your project, you find two comparable companies. Your generic technology comparable has an expected equity return of 8%, a constant leverage ratio of 50%, debt currently yielding 12%, and a credit rating of BB. You calculate the unlevered cost of capital of the generic technology comp to be 7%. Your new technology comparable has an expected equity return of 9%, a constant leverage ratio (D/V) of 40%, a yield of 23%, and a credit rating of B+. Additionally, since the technology is completely new it is less easy to sell in the aftermarket, and so debtholders will only recover 45 cents on the dollar in case of default. The average default probability of firms with a BB rating is 20% and the equivalent default probability for firms with a B+ rating is 30%. You are extremely averse to taking on any debt and so, regardless of your choice of technology, you plan on financing your windfarm with no debt whatsoever. Answer the following questions: (a) What is the expected return on debt capital for the new technology comp? (b) What is the unlevered cost of capital for the new technology comp? (c) Which technology would you choose for your windfarm?

Answer 1

Particulars	Generic	New
Cost	50000000	80000000
FCF	3000000	3000000
Growth perpetuity	3.2%	3.2%
equity return	8%	9%
debt return	12%	23%
leverage ratio	50%	40%
credit rate	BB	B+
default prob	20%	30%
Levered Kc	14.0%	18.2%
Unlevered Kc	7%	7%

(a) Expected return on debt in New Windfarm = 23*40%+9 = 18.2%

(b) Unleveraged cost of capital Kc has been calculated for New Windfarm = Generic Kc* leverage ratio = 18.20*40% = 7%

(c) Which Technology will you choose for your windfarm ? this problem can be solve by taking valuation of future cash flows

Generic = 3000000 / (14%-3.2%) = 27777778

New = 3000000 / (18.2%-3.2%) = 20000000.

Valuation in case of generic is better paid off as compare to new windf arm case