Standard Discounted Cash Flow Research Articles

Wealth maximisation and residential energy-efficiency retrofits: Insights from a real options model

The slow adoption of residential energy-efficiency retrofits continues to hamper the energy transition. We study incentives for adoption by proposing a model of optimal investment under uncertainty where the wealth-maximising agent has the option to delay. Stochastic portfolio returns and energy prices are taken into account. An extension of the model where the energy carrier is switched, e.g. from gas to electricity, is also considered. Exercise boundaries for the optimal stopping problem are estimated numerically for recent case studies of German buildings. Investment is generally not optimal at current energy prices and market conditions. Increasing correlation between gas and electricity prices erodes the value of technology switching. Comparative statics reveal that energy-efficiency investments become optimal at relatively lower energy prices as wealth, income, and savings behaviour increase, and portfolio drift and volatility decrease. Consequently, incentive to invest in retrofits is far more heterogeneous along wealth dimensions than standard discounted cash flow analyses suggest. An examination of retrofit subsidies demonstrates how free-riding by wealthier agents occurs when subsidies are not appropriately targeted. We also show that the pursuit of economic efficiency in subsidy design might have regressive effects on the wealth distribution.

Valuation of Wind Energy Turbines Using Volatility of Wind and Price

The limitedness of the nonrenewable local energy resources in Israel, even in the background of the later gas fields’ findings, continues to force the state to devote various efforts towards ‘green’ energy development. These efforts include installations, both for the solar and for wind energy, thus improving the diversity of energy sources. While the standard discounted cash flow (DCF) method using the net present value (NPV) criterion is extensively adopted to evaluate investments, the standard DCF method is inappropriate for the rapidly changing investment climate and for the managerial flexibility in investment decisions. In recent years, the real options analysis (ROA) technique has been widely applied in many studies for the valuation of renewable energy investment projects. Taking into account the above background, we apply, in this study, the real options analysis approach for the valuation of wind energy turbines and apply it to the analysis of wind energy economic potential in Israel, which is the context of our work. We hypothesize that due to nature of wind energy production uncertainties, the ROA method is better than the alternative. The novelty of this paper includes the following: real world wind statistics of the Merom Golan site in Israel (velocity 3.73 m/s, with a standard deviation of 2.03 m/s), a realistic power generation estimation (power generation of 1205.84 kW with a standard deviation of about 0.5% in annual value which is worth about 1.3 M$ per annum), and an economic model to evaluate the profitability of such a project. We thus discuss the existing challenges of diversifying renewable energy sources in Israel by adding wind installations. Our motivation is to introduce a method which will allow investors and officials to take into account uncertainties when deciding in investing in such wind installations. The outcomes of the paper, which are obtained using the method of Weibull statistics and the Black–Scholes ROA technique, include the result that market price volatility adds to the uncertainties much more than any wind fluctuations, provided that the analysis is integrated over a long enough time.

Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance

Many studies have focused on the relationship between companies with strong environmental, social, and governance (ESG) characteristics and corporate financial performance. However, these have often struggled to show that positive correlations—when produced—can in fact explain the behavior. The authors of this article provide a link between ESG information and the valuation and performance of companies, by examining three transmission channels within a standard discounted cash flow model—which they call the cash-flow channel, the idiosyncratic risk channel, and the valuation channel. They tested each of these transmission channels using Morgan Stanley Capital International ESG Ratings data and financial variables. This showed that companies’ ESG information was transmitted to their valuation and performance, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk). The research suggests that changes in a company’s ESG characteristics may be a useful financial indicator. ESG ratings may also be suitable for integration into policy benchmarks and financial analyses. TOPICS: ESG investing, security analysis and valuation, risk management

Discontinuous financing based on market values and the value of tax shields

The tax shield as present value of debt-related tax savings plays an important role in firm valuation. Driving the risk of future debt levels, the firm’s strategy to adjust the absolute debt level to future changes of the firm value, labeled as (re-) financing policy, affects the value of tax shields. Standard discounted cash flow (DCF) models offer two simplified (re-) financing policies originally introduced by Modigliani and Miller (MM) as well as Miles and Ezzell (ME). In this paper, we introduce a discontinuous financing policy that refers to the refinancing intervals, i.e., the maturity structure of the firm’s debt. By deriving APV valuation and beta unlevering equations that allow for this discontinuous financing policy, we show the MM and ME policies to be special cases of the proposed extension. While we document the effect of discontinuous refinancing to be economically significant when leverage is high and refinancing periods are extremely long, our results suggest that for low-levered firms with short refinancing periods, the traditional continuous refinancing-based models (like the Miles/Ezzell model) produce relatively robust value estimates. Combining capital structure and maturity structure choices, our model extends the set of feasible financing policies in DCF valuation models.

Adoption of switchgrass cultivation for biofuel under uncertainty: A discrete-time modeling approach

Production of biofuels from cellulosic sources, such as switchgrass, is being encouraged through mandates, incentives, and subsidies. However, uncertainty in future prices coupled with large establishment costs often inhibit their cultivation. Owing to their inability to incorporate uncertainty and dynamic decision-making, standard discounted cash flow techniques are ineffective for analyzing such investments. We formulate a discrete-time binomial framework to model output prices, allowing us to incorporate price uncertainty, stand age, and variable crop yields into the analytical framework. We analyze the feasibility of investments in switchgrass cultivation under varying price transition paths, evaluate the relationship between risk and profitability, and estimate the value of flexible decision-making options wherein the farmer can alter cultivation choices. We find that switchgrass cultivation is only 32% likely to be profitable in the base model and infer that on-farm management could play an important role in entry and exit decisions. We also find that subsidies are important for project viability and policymakers could consider incorporating payments for ecosystem services to encourage adoption.

The Impact of Default on Tax Shield Valuation

AbstractIn this paper we develop a model to value debt related tax savings and associated yield rates for debt in a setting where future cash flows are uncertain and follow a stochastic diffusion process. By explicitly modeling a default trigger we find that tax shield values in standard Discounted Cash Flow (DCF) valuation formulas are too high as they do not correctly incorporate the risk of default. Furthermore, we are able to endogenously derive risk-adjusted yield rates, while keeping the overall simple and tractable structure of the DCF approach.

Real options decision framework: Strategic operating policies for open pit mine planning

This paper presents a first approach towards the development of a dynamics decision-making tool (DDMT) for open pit mine planning projects. In this paper, a decision framework, the so-called real option decision framework (RODF), is developed based on a real-options approach with practical applicability to a mining investment project. Four strategic operating options namely, deferral options, maintain options, expand options, and shutdown options, are assumed for mining operations. We illustrated the proposed framework and developed methods for a hypothetical gold mine. The standard discounted cash flow (DCF) method was carried out to analyze the project values without options. The real option valuation (ROV) approach was calculated for the deferral and expand options. We used a system dynamics (SD) modeling method to solve real options problems and the discrete-event simulations were used to simulate the potential values of the projects. The findings are that investors are prone to lose an opportunity to invest if relying on traditional DCF-NPV rules as they suggest accepting the project if and only if NPV is greater than zero. However, results obtained from real options suggest that the project has a value to an investor across different time horizons. The insight is that it is of paramount importance to find an optimal time to exercise a strategic option. It is indicated that strategic options such as the deferral option may yield a higher value than the base case (DCF-NPV) mine option because project risks can be hedged, whereas the expand option may also offer additional value to mine operators. However, such extra-additional values can only be captured through managerial flexibility.

The first commercial coal bed methane project in Turkey - reservoir simulation and prefeasibility study for the Amasra coalfield

This study plans and models coalbed methane (CBM) recovery from the Amasra coalfield (the east and the west fields) in Zonguldak Basin, Turkey and compares the results from several operational development scenarios in order to identify the most effective development strategy. The reservoir was modelled using GEM, an advanced general equation-of-state compositional simulator. Vertical and multi-lateral CBM development plans were proposed and the cumulative gas production and gas production rates were estimated. Finally, a standard discounted cash flow analysis was performed. It was found that the vertical and multi-lateral CBM plans would yield positive NPV's - US$ 12,148,498 (IRR - 28.35%) and US$ 11,250,167 (IRR - 27.39%) respectively - only at the west field. Financial analysis showed that none of the alternatives are feasible at the east field. It can be concluded that the vertical CBM development plan with higher IRR (28.35%) would be the best alternative for the west field considering the technical difficulties in drilling operations and much higher capital investment in the multi-lateral CBM development plan. By this way emissions of 2.57 MMtCO2e would be avoided over a 20-year period based on the fact that the coal will be mined and the resulting methane will be liberated. [Received: January 6, 2015; Accepted: March 2, 2015]

Issues in real options with shadow costs of incomplete information and short sales

This paper presents the valuation of real options and the capital budgeting models within shadow costs of incomplete Information and short sales. Shadow costs are sunk costs in the spirit of Merton's (1987) model of capital market equilibrium with incomplete information.The shadow cost includes two components. The first component is the product of pure information cost due to imperfect knowledge and heterogeneous expectations. The second component represents the additional cost caused by the short-selling constraint. Information costs are linked to Merton's (1987) model of capital market equilibrium with incomplete information, CAPMI. This model is extended by Wu, Li and Wei (1996) who propose an incomplete-information capital market equilibrium with heterogeneous expectations and short sale restrictions, GCAPM. This model is used in our paper to provide for the first time in the literature analytic solutions for derivatives in the presence of both shadow costs of incomplete information and short sales.Shadow costs are used in standard discounted cash flow techniques and real options. The justification of shadow costs in real projects is based on the observation that R&D needs to be done before investment decisions. The main results regarding real options and shadow costs of incomplete information and short sales are proposed by extending the analysis in Bellalah (1999, 2000) and Bellalah and Wu (2009).Our results have important implications in terms of pricing derivative assets and different types of real options. In particular, this framework can be easily implemented in investment decisions and the valuation of flexibility embedded in real projects. In fact, several investment decisions under uncertainty can be reformulated and their results can be implemented in the presence of incomplete information and investment constraints.

How Does Value Grow? Chasing Short-Term Income Destroys Long-Term Value

On what does growth in value primarily depend? Is it the magnitude of forecast cash flow, the growth in forecast cash flow, discount rates, or some combination? This article answers these questions. Additionally, the author develops a generalized discounted cash flow (GDCF) model, in which the standard discounted cash flow becomes a special case. The GDCF consists of a single formula for valuing a business. Finally, the author provides recommendations for management of the business that will increase growth in value the most.

(Re-)Financing Policies and the Value of Debt-Related Tax Shields

The tax shield as present value of debt-related tax savings plays an important role in firm valuation. Driving the risk of future debt levels, the firm's strategy to adjust the absolute debt level to future changes of the firm value, labeled as (re-) financing policy, affects the value of tax shields. Standard discounted cash flow (DCF) models offer two simplified (re-) financing policies originally introduced by Modigliani and Miller (MM) as well as Miles and Ezzell (ME). In this paper we show that both policies are special and polar cases of a general model of financing policies referring to the firm's choice of debt refinancing intervals. We derive general valuation and cost of capital equations allowing flexibly incorporating any refinancing sequence. By combining capital structure and maturity structure choices our model extends the set of feasible financing policies in DCF valuation models.

Costs and Survival of Biogas Under EEG Law: A Real Options Approach

Operators of biogas plants, who receive their feed-in tariffs according to the German Erneuerbare Energien Gesetz (EEG), possess a basket of real options, whose payoff structure is similar to put options. The underlying is the main input factor of the plant, field crops. This real option to shut down or abandon the plant under adverse market conditions increases the value for its owner, while it reduces the financial burden for the electricity consumers, whose payoff structure resembles the one of a writer of a digital put option. Using current market prices and technical parameters, we find that the present value of the financial burden of a typical plant is much smaller than determined with a standard Discounted Cash Flow (DCF) method. When taking into account that feed-in tariffs are not inflation indexed, the gap between payoffs measured with DCF and with real option methods widens further. Using Monte Carlo simulation we determine probabilities that biogas plants go out of business. According to our simulations, under current market conditions, the chances that a plant feeds in for the whole guaranteed period of 20 years are less than 25%. We assess by how much aggregation across the idiosyncrasies of the cost structure of individual plants can smooth out the impact of input factor prices which are determined on the world market. Our findings suggest that biogas plants of the same cohort will mostly go out of business in the same or an adjacent year. In our conclusion, we discuss the impact of insecure feed-in on stake-holders of the biogas industry.

A simple correction of the WACC discount rate for default risk and bankruptcy costs

Standard discounted cash flow approaches suffer from a rudimental modeling of the possibility of a default, as the main characteristics such as the default probability and potential bankruptcy costs are commonly disregarded. This paper aims at providing a tractable extension of the well-known WACC approach for both default risk and bankruptcy costs. The corrected WACC discount rate reveals that default risk results in a systematically higher WACC because the tax component is scaled by the survivorship probability and an aditional component for bankruptcy costs must be added. This difference between the classical WACC discount rate and the simple modified WACC rate can be remarkable especially for firms from businesses with high bankruptcy costs and a relevant default probability.

Value Added to Invested Capital (VAIC): New Financial Performance Metric and Valuation Tool

This article introduces a new financial metric for managerial performance evaluation, Value Added to Invested Capital (VAIC), with the cost of unlevered equity as a hurdle rate to calculate the capital charge rather than the widely accepted WACC. VAIC preserves all positive features of the conventional residual operating income and EVA® and has the distinct advantage of computational simplicity and straightforward interpretation. Associated valuation model is equivalent to the standard discounted cash flow approach; this equivalence is formally proved under certain assumptions regarding the risk of tax shields and confirms consistency of the new metric proposed. VAIC can serve as an aggregate financial indicator on the business performance dashboards, and might as well be considered a valid substitute for the established EVA© and ReOI metrics in evaluating managerial performance. Equivalence of the VAIC valuation model to the fundamental approach of valuing a business by cash flow discounting makes this metric not only a robust measure of financial performance but also a full-fledged investment valuation tool.

Análise de um projeto agroindustrial utilizando a Teoria de Opções Reais: a opção de adiamento

O objetivo geral deste trabalho é analisar a viabilidade econômicofinanceira de um projeto agroindustrial, através da Teoria de Opções Reais (TOR). A justificativa para utilização da TOR está centrada no fato de que os métodos tradicionais de análise de projetos (VPL e TIR) ignoram duas características importantes: a) a irreversibilidade e b) a possibilidade de adiamento da decisão de investir. Essas características, junto à incerteza sobre o futuro, fazem com que a oportunidade de investimento seja análoga a uma opção financeira. Com o intuito de aplicar estes conceitos, será realizado um estudo de caso, que consiste em um projeto agroindustrial de processamento de frutas, em que se pretende produzir sucos, polpas, geleias, doces e frutas desidratadas. A avaliação pretende demonstrar o valor das flexibilidades operacionais que esse projeto apresenta, como adiar a implementação do mesmo. Para isso, adotou-se a metodologia proposta por Copeland e Antikarov (2001), que adiciona à avaliação tradicional de Fluxo de Caixa Descontado as Opções Reais que o projeto possui. O resultado obtido para o valor presente líquido expandido do projeto, considerando-se as opções reais, para o quarto ano, foi de R$ 891.877,00, aumento de 207% em relação ao valor presente tradicional.

Start-Up Firm Valuation: A Real-Options Approach

Start-up firms typically produce negative cash flows in the first years after their foundation. As a consequence, standard discounted cash flow methods are not applicable, often forcing practioneers into using theoretically dissatisfying devices like multiples. In this paper, we develop a comprehensive and theoretically more convincing valuation framework for start-up firms. Our analysis is based on a contingent claims approach in an arbitrage-free setting which - due to an alternative process assumption - explicitly allows for the negative earnings typically produced by start-up businesses in early stages of their development. The model allows for the derivation of optimal conditions for exercising the waiting option to invest in a start-up as well as its optimal capital structure upon establishment. Finally, we show how unexercised additional options to invest (growth options) - even if producing negative cash flows at the time of investment - may significantly contribute to the start-up firm's value. The explicit incorporation of additional investment options may serve as an explanation for observable high market values of start-up firms with low or negative current cash flows.

Evaluation of Real Options with Information Costs

This paper presents a simple framework for the analysis, valuation and simulation of several real options in the presence of shadow costs of incomplete information. Information costs can be viewed as sunk costs in the spirit of Merton’s (1987) model of capital market equilibrium with incomplete information. We incorporate these sunk costs in standard discounted cash flow techniques and present the basic concepts of real options. The justification of information costs in real projects is based on the observation that R&D needs to be done before investment decisions. These costs account for all the expenses needed to be informed about an investment opportunity and the management of projects. This analysis extends the models in Bellalah (1999, 2001) for the valuation of real options within information uncertainty. We present valuation procedures and simulations for the values of common real options in the presence of shadow costs of incomplete information.

The capitalisation rate of the Government Superannuation Fund

PurposeThis paper seeks to compare the capitalisation rate offered by the Government Superannuation Fund (GSF) to retiring GSF members with the alternatives of borrowing and sale of the pension entitlements.Design/methodology/approachThe paper uses standard discounted cash flow techniques.FindingsThe principal conclusions are as follows: first, while up to 50 per cent of a GSF member's pension claims can be effectively sold, the restriction that the buyer must be an individual implies a band of possible sale prices with an upper bound equal to that prevailing if sales were unrestricted (present value). Second, borrowing is increasingly favoured over capitalisation as the retirement age declines, and the critical retirement age below which borrowing dominates capitalisation is 64 for men and 66 for women if the GSF member has a spouse at the retirement date and otherwise about three years less. Third, the present value of the pension benefits is well in excess of both the capitalisation rate offered by the GSF and the capitalisation rate implicit in borrowing, implying sale prices even well below present value that are superior to the better of capitalisation and borrowing.Research limitations/implicationsThe analysis treats the retirement age of a GSF member as exogenously determined. However, the analysis also provides insights into the optimal retirement age and this issue is currently the subject of further research.Originality/valueThe paper should provide guidance to GSF members who are contemplating capitalisation of their entitlements.

The appraisal of data centres: deconstructing the cash flow

PurposeThis paper aims to analyse the appraisal of a specialised form of real estate – data centres – that has a unique blend of locational, physical and technological characteristics that differentiate it from conventional real estate assets. Market immaturity, limited trading and a lack of pricing signals enhance levels of appraisal uncertainty and disagreement relative to conventional real estate assets.Design/methodology/approachGiven the problems of applying standard discounted cash flow, an approach to appraisal is proposed that uses pricing signals from traded cash flows that are similar to the cash flows generated from data centres. Based on “the law of one price”, it is assumed that two assets that are expected to generate identical cash flows in the future must have the same value now. It is suggested that the expected cash flow of assets should be analysed over the life cycle of the building. Corporate bond yields are used to provide a proxy for the appropriate discount rates for lease income. Since liabilities are quite diverse, a number of proxies are suggested as discount and capitalisation rates including indexed‐linked, fixed interest and zero‐coupon bonds.FindingsThe application of conventional discounted cash flow approaches to the appraisal of data centres requires information about a wide range of inputs that is difficult to derive from market signals or estimate analytically. In practice, discounted cash flow appraisals of data centre facilities are forced to incorporate non‐market assumptions that are inevitably subjective. Cash flows from data centres tend to be more complicated because of the high levels of current and capital expenditure compared with conventional assets. This requires an understanding of the appraisal of liabilities as well as income. Whilst the use of price information from similar cash flows such as corporate bonds is helpful, there are rarely assets and liabilities that have identical cash flows and risks and some approximation is necessary.Originality/valueThe digitalisation of business and society has produced a different form of real estate asset that is specialised, physically complex and whose operation, maintenance and management require specialist staffing and high levels of current and capital expenditure. The complexity of the cash flows and the lack of active trading create significant appraisal problems. This paper proposes an alternative approach to appraisal that utilises external pricing signals to appraise the various incomes and costs.

Valuing Infrastructure Investment: An Option Games Approach

To understand the recent trend toward privatization of infrastructure assets (e.g., airports), this article proposes a valuation methodology based on real options and game theory analysis that enables assessing when investors might overpay for infrastructure assets over standard discounted cash flow methods and when a premium is justified for their operating flexibility or strategic growth option value. While some infrastructure asset acquisitions may involve financial transactions whose value derives primarily from their expected cash flows, many of these infrastructure investments provide a platform and create the strategic context within which the firm can grow.