Letter number 43 of September 2009


News : The Cost of capital of greenfield projects by Muriel Atias (BNP Paribas) and Franck Bancel (ESCP Europe)

The discount rate used is a key issue to be considered when valuing a firm or a project.  For most projects, the theoretical framework helps us to determine discount rates that will be acceptable to the financial community. However, there are some projects that raise new questions for those involved in business valuation.  This is especially the case for greenfield projects which involve the creation of new infrastructures from scratch and, accordingly, also involve new industrial challenges (technical, technological, logistic, etc.). Firms incur additional risks when they invest in greenfield projects as opposed to standard projects that merely involve replacing or upgrading assets already in place.  These additional risks include delays in the start of work, potentially conflicting relationships with subcontractors, the under-estimation of costs and deadlines, uncertainty over climatic and geological conditions, the amount of investments necessary (often very high), very high initial fixed costs with no guarantee as when cash flows will be positive, etc.  Many greenfield projects are launched in sectors as diverse as energy, transportation or telecommunications and depending on the context of each project, involve very different realities and risks.  So, when valuing greenfield projects, we are systematically confronted with the issue of what discount rate to use.
In a recent research, we asked whether factoring in a specific greenfield risk would be justifiable for projects involving the construction of new infrastructures.  In order to answer this question, we sought to establish whether companies specialising in greenfield projects were perceived as being more risky than companies in the same sector that did not invest in this type of project.
If this is the case, and all other things being equal, “greenfield companies” should have a higher weighted average cost of capital than others (it should be possible to use the difference in the cost of capital to estimate the greenfield risk).  Assuming that investors are diversified and only pay the systematic risk, the beta of greenfield companies should be higher than companies that only replace or upgrade existing assets.
The only sector in which we were able to identify such firms is the energy sector, and more specifically, the wind farm and energy transportation segments of the energy sector.
Firms in these two segments operate in an environment that is homogenous from a regulatory point of view (regulated prices, etc.) and their risks are comparable at most levels, with the exception of the greenfield risk. Although firms operating on the energy transportation market have a base of established assets, those specialising in wind farms will be required to build new infrastructures on a massive scale over the coming years. Accordingly, we can conclude that the wind farm risk is a greenfield risk.
We identified three listed pure players on the wind farm market (EDF Energies Nouvelles, Iberdrola Renovables and Theolia) and four firms active in energy transportation (Enagas, Red Electrica de Espana, Snam Rete Gas and  Terna). Using this sample, we extracted the parameters required for our initial measurement of the greenfield risk premium. We believe that focusing on firms specialising in wind farms and energy transportation has the advantage or avoiding some of the errors that arise when setting up wide, multi-sector samples, but the downside is that it is less representative of the risk we’re trying to measure. 
We showed that the weighted average cost of capital of wind farm firms is higher than that of energy transportation firms. The expected additional return is within a bracket of values estimated at between 1.85% and 2.28%. 
There are a lot of limits to this research and it can only be seen as an initial attempt to measure the greenfield risk. Firstly, our results are based on the study of a very small number of listed pure players. Secondly, the construction risk for wind farms is not necessarily comparable to the construction risk of another infrastructure in another sector. For example, the construction of an oil rig is a very different sort of project from that of developing of a wind farm.  Whether this risk premium should be generally applied to all greenfield projects is thus a question worth asking. Finally, there is generally always a wide margin of error when estimating the parameters required for computing the cost of capital. 
In conclusion, notwithstanding the limits set out above, we recommend using a greenfield premium of between 1.5% and 2.5%, when valuing such projects, which is compatible with our simulations and also consistent with the practices of a number of firms.

Statistics : 184 years of returns

The father of the father of the father of your father was unlikely to be born when stock exchanges were already in business, for example in the USA. Hence this statistic about annual returns on the US stock market since …. 1825.

Does the slope of the graph rings a bell? A bell curve perhaps?
Please notice that there are more positive years than negative ones which explains/reflects the fact that you are richer than was the father of the father of the father of your father. Are you more happy? We hope so. We will come up next year with an updated graph!

Research : The making of an investment banker

Share price performances can have a major impact on the wealth of investment bankers, many of whom have gained first hand experience of this rather unpleasant fact as a result of the current economic crisis. But they can also have a long-term impact on their careers, and on the careers of students who are planning to enter the investment banking business. Paul Oyer of Stanford University shows how market conditions over the period during which students are doing their MBAs modify their choice of career (1). He based his results on a survey of several thousand Stanford MBA graduates in the 1980s and 1990s.
Oyer shows that going straight into investment banking after completing an MBA has a long-term effect on the career of the young graduate. The probability of staying in investment banking is 73% higher than for a graduate who started his or her career in another business (consulting, entrepreneur, retail bank manager, etc.)
There are two possible explanations for this phenomenon:
• Either one is born an investment banker, i.e., some people are pre-disposed to investment banking and have a love and/or talent for it. Obviously, more natural-born investment bankers are likely to start out working in finance and will wish to stay in the business for as long as possible;
• Or one becomes an investment banker through experience. Good market conditions lead students to take more finance courses while they're at university or business school, and then to start their careers in investment banking, which means that early on, they develop the specific qualities that are needed to work in this field.
The results of Oyer’s study argue in favour of the second explanation. When share prices are performing well, students who do not necessarily have a particular interest in or talent for finance are often attracted by the lure of money (investment bankers’ earnings are far higher than average earnings in other sectors during such periods). If only natural-born investment bankers were to enter the field, such opportunistic students would switch fields as soon as there was a downturn in the cycle. Those who start out in investment banking when share prices are performing badly, would be “true” investment bankers, attached to their chosen field. Statistics show, however, that this is not the case. Those who start out in investment banking are just as likely to stay in the business, regardless of market conditions when they started their careers.
The study confirms that more students take finance courses when market conditions are favourable.  Additionally, students who already have some experience of finance before starting their MBAs are more attached to the business than others.  Oyer concludes that it is through experience that one becomes an investment banker. Initial choices made by students have long-term consequences on their careers, and these choices are influenced more by the economic situation at the time they are made than by any innate qualities.
Not only do market trends during the period that future investment bankers are studying have a lasting influence on their careers, they also have an impact on their discounted wealth.  A Stanford MBA graduate working in finance for 6 to 10 years was paid, over the period of the survey, $15,814 per week, which is three times as much as what Stanford MBA graduates working in other sectors earned.  Oyer suggests that students beginning an MBA at a prestigious university or business school, should hedge against a fall in share prices over the time it takes to complete their studies.  Spoken like a true investment banker!
(1) P.OYER, 2008, The Making of an Investment Banker : Stock Market Shocks, Career Choice, and Lifetime Income, Journal of Finance, vol. 63, p.2601-2628.

Q&A : What is a free rider in finance?

The term "free rider" is used to describe the behaviour of an investor who benefits from transactions carried out by other investors in the same category without participating in these transactions himself.
This means, first, that there must be several—usually a large number—of investors in the same type of security and, second, that a specific operation is undertaken implying some sort of sacrifice, at least in terms of opportunity cost, on the part of the investors in these securities.
As a result, when considering a financial decision, one must examine whether free riders exist and what their interests might be.
Below are two examples:
* Responding to a takeover bid: if the offer is motivated by synergies between the bidding company and its target, the business combination will create value. This means that it is in the general interest of all parties for the bid to succeed and for the shareholders to tender their shares. However, it would be in the individual interest of these same shareholders to hold on to their shares in order to benefit fully from the future synergies.
•Bank A holds a small claim on a cash-strapped company that owes money to many other banks: It would be in the interests of the banks as a whole to grant additional loans to tide the company over until it can pay them back, but the interest of our individual bank would be to let the other banks, which have much larger exposure, advance the funds themselves. Bank A would thus hold a better-valued existing claim without incurring a discount on the new credits granted.
For more on free riders, see chapter 31 of the 2009 Vernimmen