# Valuation Analysis in Project Finance Models – DCF & IRR

##### #financialmodeling #projectfinance #valuation #dcf #irr #discountedcashflow #internalrateofreturn

Welcome to the project finance modeling course in this lesson we will talk about valuation discounted cash flow analysis and internal rate of return in order to understand the concept of valuation we will have to learn about the future value of money what is a future value of one thousand dollars deposited into a bank account at five percent interest rate one

Year from now well one thousand times 1.05 is equal to one thousand 50 so the future value is 1050 let’s now reverse the problem and ask ourselves what is the value of one thousand fifty dollars today remember 1,050 will get one year from now at five percent interest rate the value of 1,050 today is one thousand fifty divided by 1.05 which is one thousand so

This concept of bringing future value to value today or to present value is called discounting the interest rate that we used is called discount rate in the context of valuation and the conclusion from our exercise is that money today is worth more than money in the future why because we can deposit the money today into a bank account and earn interest income

Because we may not get the money in the future because we generally prefer to consume and spend money today to save money and defer our consumption to sometime in the future in the context of valuing a company or business or asset we perform valuation based on the cash flows for example shareholders receive cash flows in the future in the form of share capital

Redemption and dividends shareholders cash outflows our equity investments made into the project so after determining cash flows we have to think about what discount rate needs to be applied to those future cash flows first because we are dealing with shareholders our discount rate is related to equity investment which is called a cost of equity cost of equity is

A return demanded by investors who are investing into a business there are two ways cost of equity can be measured first is a formula called capa asset pricing model it is academically sound and extensively used by practitioners especially in the realm of public equities or companies listed on stock exchanges according to capital asset pricing model cost of equity

Is equal to the risk-free rate plus beta times market risk premium risk-free rate is usually a yield on the long term treasuries beta is a measure of a stock’s volatility in relation to the market or in other words it measures the sensitivity of the stock returns to the market returns and market risk premium is the additional return an investor expects to receive

From holding a portfolio of risky stocks instead of risk free assets capital asset pricing model is beyond the scope of this course so let’s leave it here the second method to measure or estimate the equity return is concept of hurdle rate a hurdle rate is the minimum rate of return on a project or investment required by investor where do these hurdle rates come

From they are derived from industry rules of thumb hurdle rates are extensively used in private equity and infrastructure investments so once we determine the discount rate typically we have to convert it into a discount factor which is 1/1 plus the discount rate and raised to the power of year from the valuation date the valuation of an asset is then represented

By net present value which is total cash flows times the discount factor let’s quickly review an exercise on discounted cash flow analysis let’s assume that our project’s life is six years we have our dividends and discount factor based on the discount rate of 15% we then calculate discounted dividends which is dividends times the discount factor we calculate the

Discounted dividends in this fashion for all years then we sum the discounted dividends to get the present value of dividends which in our case is equal to 86 suppose that initial investment was 50 then this simple projects net present value is present value of dividends less the initial investment which will give us 36 so the investment is worthwhile as long as

The net present value is equal to or greater than zero let’s now spend some time on another concept called internal rate of return which is extensively used in private equity and project finance internal rate of return or irr is a discount rate at which net present value of the project’s cash flows is zero if the project’s irr is larger than the required rate of

Return or hurdle rate the investment is worthwhile so going back to our simplified valuation case let’s now assume that our discount rate is 40 percent and based on that we calculate our discount factors we then again calculate the discounted dividends and present value of those dividends which is equal to 50 our initial investment did not change so it is 50 and our