Analysis of the various approaches

With regards to project valuation, we were presented with four different approaches. In the

end, we decided to value the project using Approach 4. The reason for this is because out of all

4 approaches, Approach 4 adequately takes into consideration of the following factors: the fact

that an independent entity (i.e. NESA) is taking on this project rather than New Earth Inc., the

special financing package, and the high rate of return that equity investors (i.e. shareholders of

New Earth Inc.) require on this project.

Approach 1 unfortunately does not take into consideration that a separate entity is undertaking

the investment, and so the usage of New Earth’s corporate WACC (14%) to discount the project

cash flows does not seem applicable. Approach 2 is more conservative than Approach 1 with

the addition of an expected return premium of 10% (resulting in a WACC of 24%), but adding a

premium does not justify that the modified WACC accurately reflect the cost of capital for NESA.

Approach 3 is better since it factored the items that the previous two approaches left out.

However, it does not take the financing package into consideration. Therefore, when

discounting the future cash flows and debt repayment, it will likely omit the firm’s prepayments,

thus not providing an accurate NPV to reflect the firm’s finance plan.

Under Approach 4, the cost of equity was estimated to be approximately 24%, which is a

reasonable rate due to the risks that this investment brings to New Earth Inc. Since the WACC

was not provided, it needs to be calculated. The calculated WACC is 9.45%. (Exhibit 1)

Valued added by the design of the financing package

The calculated NPV of the project can determine the value added b the financing package. The

NPV of the project is estimated to be $197.53 million (Exhibit 2). The NPV of this project is

positive, thus the design of the financing package adds positive value to New Earth Inc.

Financing Package’s Effects on Return

Though prepayment of debt is part of the convent, it is not a necessary course of action from

the perspective of the debtholders (page 3 and 4). Since no principal needs to be paid till then,

the present value of cash flows will be higher in earlier periods of the project, thus increasing

the overall positive NPV of the project. Through the internally generated pro forma analysis, the

investment promises strong cash flows.

The U.S. banks do not require interest payments in the first two years of investment with no

interest compounding. This will reduce pressure for NESA in the first few years regarding

interest payment, thus increasing NPV due to higher cash flows in early periods. In addition,

without compounding interest obligations, this will further reduce interest payment pressure

for the company.

Third, $40 million equity financing from New Earth Inc. will relieve some of the pressure for

debt repayment on this project (page 4). Though equity financing is only 20% of total financing,

it does not incur interest or require repayment at later stages of the project.

Financing Package’s Effects on Risk

This financing package also has a couple of effects on risks. First, the project is financed mostly

by debt and the cost of capital is quite high. At a debt/value ratio of 80%, with $160 million

financed by debt holders (page 3), the project will be under strong pressure to generate the

forecasted cash flows in order to meet debt obligations.

Second, the prepayment convent that NESA proposed (page 4) could increase the risk of the

project. The banks and Chinese debtors did not explicitly request early prepayment of debt.

Therefore, proposing such a prepayment factor on debt repayment will increase pressure on the

firm if actual future cash flows cannot cover all interest and principal repayment costs, then the

firm will be at a deficit early on.

Third, the relatively high interest rates that debtholders are requesting adds to the risk of this

project (page 3). The U.S. bank loan, at an interest rate of 10%, payable in 7 years is quite high.

With such high interest rates, debt repayment would be difficult given the uncertainty of future

cash flows.