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• NEWS: The cost of capital of greenfield projects

• THIS MONTH'S TABLE: 184 years of returns
• RESEARCH: The making of an investment banker
• Q&A: What is a free rider in finance?

N° 43
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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
Next month : more risky than companies in the same sector that did not invest in this type of
project.
- NEWS: Mistakes to
avoid in valuation 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
- TABLE: possible to use the difference in the cost of capital to estimate the greenfield
Breakdown of risk). Assuming that investors are diversified and only pay the systematic risk,
global private the beta of greenfield companies should be higher than companies that only
equity replace or upgrade existing assets.

- RESEARCH: How
fair are fairness
opinion?

- Q&A: Value of
preference shares
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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
N° 43 assets, those specialising in wind farms will be required to build new
infrastructures on a massive scale over the coming years. Accordingly, we can
September 2009 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.

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THIS MONTH’S TABLE: 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.

Annual performance since 1825

N° 43 20 0 7
20 0 5
19 9 4
September 2009 19
19
9
9
3
2
19 8 7
p o s itiv e y e a r s : 129 ( 70% ) 19 8 4
e g a tiv e y e a r s : 55 ( 30 % ) 19 7 8
19 7 0
19 6 0 200 6
19 5 6 200 4
19 4 8 198 8
19 4 7 198 6
19 2 3 197 9
19 1 6 197 2
19 1 2 197 1
2000 19 1 1 196 8
1990 19 0 6 196 5
1981 19 0 2 196 4
1977 18 9 9 195 9
1969 18 9 6 195 2
1962 18 9 5 194 9
1953 18 9 4 194 4 200 3
1946 18 9 1 192 6 199 9
1940 18 8 9 192 1 199 8
1939 18 8 7 191 9 199 6
1934 18 8 1 191 8 198 3
1932 18 7 7 190 5 198 2
2001 1929 18 7 5 190 4 197 6
1973 1914 18 7 4 189 8 196 7
1966 1913 18 7 2 189 7 196 3 199 7
1957 1903 18 7 1 189 2 196 1 199 5
1941 1890 18 7 0 188 6 195 1 199 1
1920 1887 18 6 9 187 8 194 3 198 9
1917 1883 18 6 8 186 4 194 2 198 5
1910 1882 18 6 7 185 8 192 5 198 0
1893 1876 18 6 6 185 5 192 4 197 5
1884 1861 18 6 5 185 0 192 2 195 5
1873 1860 18 5 9 184 9 191 5 195 0
2002 1854 1853 18 5 6 184 8 190 9 194 5
1974 1841 1851 18 4 4 184 7 190 1 193 8 195 8 195 4
1930 1837 1845 18 4 2 193 8 190 0 193 6 193 5 193 3
1907 1831 1835 18 4 0 183 4 188 0 192 7 192 8 188 5
2008 1857 1828 1833 18 3 6 183 2 185 2 190 8 186 3 186 2
1931 1937 1839 1825 1827 18 2 6 182 9 184 6 183 0 184 3 186 2
- 50 % - 40 % - 30 % - 20 % - 10 % 0% 10% 20% 30% 40% 50% 60%

Source : Value Square Asset Management, University of Yale.

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!

3
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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
N° 43 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
September 2009 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.

4
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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
N° 43 banker!

(1) P.OYER, 2008, The Making of an Investment Banker : Stock Market Shocks, Career Choice, and

September 2009 Lifetime Income, Journal of Finance, vol. 63, p.2601-2628.

***

QUESTION & ANSWER: 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
Next month : 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
- NEWS: Mistakes to interest of our individual bank would be to let the other banks, which have
avoid in valuation 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
- TABLE: granted.
Breakdown of
global private For more on free riders, see chapter 31 of the 2009 Vernimmen
equity

- RESEARCH: How
fair are fairness
opinion?

- Q&A: Value of
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