105
Figure 5.1 ITS Value in the Operational Phase
Source: Own construction
As can be seen from the table above, the project does not pay any tax in the first years, due to the large asset depreciation. Hence the ITS will be carried forward until the project starts to generate a tax, which is then shielded. In our case the last cash flow from ITS will occur in year 2020. The Tax Saving from ITS represent the DCF value of the tax benefits when project financing is introduced and represent the value of the ITS. To adjust for the timing of these cash flows, we add a mid-year factor and get a value of the ITS of 2,155,734 DKK.
106
Figure 5.2 ENPV Calculation Including Debt
Source: Own construction
5.4.2. The Interest Tax Shield in the Real Options Valuation
The issue of financing side effects is treated quite extensively in the standard DCF literature as opposed to the situation in the ROV literature. Instead, the ROV literature typically assumes a Miller-Modgliani world with financing being irrelevant (Bulan 2005: 272). The few exceptions we have found do not treat it for projects under development, but instead for the interaction between operational production flexibility and debt capacity (Mauer and Triantis 1994), optimal investment structure and capital structure (Copeland WP: 1), or leveraged buy-outs of a company (Baldi 2005:
64). Other more practical texts such Copeland and Antikarov (2003), Mun (2002) and Shockley (2007) discount the operational cash flows using a constant WACC – thereby implicitly assuming a constant debt-equity ratio of the underlying asset. Based on these initial considerations, the question is how the value of ITS should be accounted for in our ROV of a wind farm under development.
Before addressing this issue it is necessary with an improved understanding of the ITS’s relationship to the different market states.
The value of the ITS will not be directly correlated with the market state as its value depends on factors such as the amount borrowed, whether the loan can be serviced and the pace at which it is repaid. Although such factors will to some extent be correlated to the market state, it is clear from Figure 5.3 below, where the electricity price is set as a proxy for the market development, that the value of the ITS does not vary much with different electricity prices.
Stage Time Prob.
Stage
Probability of
Construction Cash Flow (t) PV (t=0) Probability Weighted PV
Stage 1: Analysis and Pre-approval 0 50% 100% -100,000 -100,000 -100,000
Stage 2: VVM & Final Approval 0.5 50% 50% -500,000 -491,189 -245,594
Stage 3: Complaints and Compensation 1.5 80% 25% -500,000 -474,029 -118,507
Stage 4: Construction 2.5 100% 20% -61,000,000 -55,811,136 -11,162,227
Value of Operational Phase 3 0% 20% 70,479,996 57,827,251 11,565,450
Value of ITS 3 - 20% 2,155,734 1,789,912 357,982
ENPV (Including Debt) 297,104
107
Figure 5.3 Change in ITS Value from different Electricity Prices76
Source: Own construction
The reason that the ITS is not exactly constant is because at the low electricity prices, the ITS is used very late in the operational phase, partly due to the asset depreciation, leading to a lower present value of the ITS. The high prices lead to the loan being repaid faster, resulting in fewer interest payments, thereby reducing the value of the ITS. These relationships demonstrate both the complexity and the stability of the ITS value in relation to the market state. At the same time, it could be argued that a change in the market state could change the leverage ratio of the project, as banks are willing to lend more money to a good project. If an improved market state leads to a higher leverage ratio, the value of the ITS will increase ceteris paribus. Furthermore, an improved market state is likely to lead to a lower risk premium as the default risk is reduced creating a lower ITS, as shown in the two graphs in the figure below.
Figure 5.4 ITS Value Given Different Leverage Ratios and Debt Risk Premiums
Source: Own construction
76 The electricity price in the figure represents the price when the wind farm is constructed and is fixed for all 20-years of the operational phase. This is supposed to demonstrate the fact that the value of the tax shield is relatively constant. It should be noted, however, that in the case of very low electricity prices the project will default, this means that the value of the tax shield is reduced dramatically. However, in such cases the project would have been abandoned during development and these states can therefore be disregarded.
DKK -DKK 500.000 DKK 1.000.000 DKK 1.500.000 DKK 2.000.000 DKK 2.500.000 DKK 3.000.000
0,27 0,29 0,31 0,33 0,35 0,37 0,39 0,41 0,43 0,45 0,47 0,49
Value of ITS
Electricity Price (DKK/kWh)
Risk Premium DKK
-DKK 500,000 DKK 1,000,000 DKK 1,500,000 DKK 2,000,000 DKK 2,500,000 DKK 3,000,000
Value of ITS
Leverage Ratio
108 These two inverse relationships, combined with the relatively stable value of the ITS towards the electricity price, indicate that the ITS will remain close to constant in most market states. Three such examples have been calculated below. They are not intended to show the exact relationship between the different variables, but illustrate the convergence to the mean, based on a set of scenarios.
Figure 5.5 ITS Value in Different Market States
Source: Own construction
The exact relationship between variables is difficult to ascertain. This is due the fact that both the leverage and the debt risk premium, as discussed in “the cost of debt”, depend not only on the market but also on subjective factors, such as the individual project and the developer’s professionalism, and are beyond the scope of this thesis. Based on the relationship between these variables, it is a fair assumption that the value of the ITS is constant. This assumption will serve as a starting point for the discussion of how the value of the ITSs can be handled in a real options valuation model in the following subsection.
5.4.2.1. Modeling the Value of the Interest Tax Shield in Real Options Valuation
As stated above, we are in this analysis working in a field where very little or no research has been done. This means that our approach should be seen as not only a theoretically meaningful, but also a practical solution for EE and other professional wind farm investors using project finance. The ITSs cannot simply be added to the value of the underlying asset and then follow the up and down movements in the asset value tree, since it is not subject to the same market uncertainty. Thus the question is how the value of the ITS can be added to the value of a wind farm under development?
The value of the ITS will only be obtained if the wind farm is constructed. This is much like a financial call option on a dividend paying stock, where the dividend is only obtained if the option is exercised. The standard way of dealing with such dividends in binomial trees is to subtract the dividend from the value of the underlying stock at the time the dividend is paid out. So the decision is whether or not the option should be exercised to receive the underlying stock and the dividend or kept alive (Shockley 2007: 364-365).
In our case the value of the ITS is only received if the decision to construct the wind farm is taken.
EE can then in the final node decide to either exercise the option to construct the wind farm (and
Down State Normal State Up State
Price 0.30 DKK/kWh 0.3432 DKK/kWh 0.40 DKK/kWh
Leverage 75% 80% 85%
Debt Risk Premium 4.03% 2.50% 2.12%
ITS DKK 2,155,734 DKK 2,155,734 DKK 2,155,734
109
thereby receive the underlying asset and the ITS) or abandon (and receive nothing). Following this argument and the one presented earlier that the value of the ITS is close to constant in all the states where the wind farm is actually constructed, we can add the value of the ITS to the final node in the asset value tree. Doing this leads to a modification of the six step model. The modification can be seen in Figure 5.6 below. We will not perform a sensitivity analysis again, as the dynamics would be similar to the ones shown for the QROV in Figure 4.22, chapter 4.
Figure 5.6 Modified Six Step Model including ITS
Source: Own construction
To implement the proposed method we need to estimate the ITS to be added to the asset value tree.
But since the ITS value calculated in Figure 5.1 is primo year 2013, and the last node in the asset value tree is ultimo Q2 year 2012, we must discount the value half a year back, using the cost of debt:
Formula 5.6 Value of ITS in year 2.5
𝐕𝐈𝐓𝐒,𝐭=𝐐𝟐,𝟐𝟎𝟏𝟐= (𝟏+𝟎.𝟎𝟔𝟒)𝟐,𝟏𝟓𝟓,𝟕𝟑𝟒𝟎.𝟓= DKK 2,089,944 Source: Own construction
We can then add the value to the last node in the asset value tree, as seen in the in the figure below.
Sensitivity Analysis
Step 1
Framing ROV
Justify ROV
Identify relevant options
Step 2
Underlying Asset
Calculate DCF value of operational
phase
Uncertainty Estimation
Step 3
Uncertainty Estimation
Identify events and determine probabilities
Identify and estimate market
uncertainty
Step 4
Determine Option Parameters
Time to maturity Length of time
steps Risk neutral prob.
Build asset value tree
Step 5
Calculate Option Value
Build quadranomial option value tree Estimate and add value of financing
decision Build asset value
tree
Step 6
Identify and test main value drivers
Discuss results Sensitivity
Analysis
110
Figure 5.7 Asset Value Tree (Including ITS) 77
Source: Own construction. Figures in thousands DKK.
Having modified the asset value tree to incorporate debt in the last node as shown in Figure 5.6, we can now calculate the option value tree using the same approach as in the QROV:
Figure 5.8 Option Value Tree (Including ITS)
Source: Own construction. Figures in thousands DKK.
The value of the wind farm under development using the QROV approach (including ITS) is DKK 645,763. This is approximately DKK 214,000 more than the value without ITS. The inclusion of the ITS thereby has a significant impact on the value of the wind farm under development.