Valuing a Greenfield Project

Typically for project valuation the different risk return models of finance help us determine the discount rate to be applied on the expected cash flows. The common practice is to look up the cost of capital of the firm undertaking the project if the project has the same risk profile as the firm’s existing operations. If the project is in a new line of activity we seek the cost of capital for “typical” firms engaged in that line of activity. If using CAPM the almost standard practice is to go for “bottom up beta”.

The cost of capital so obtained is for running firms. Is it justified to take the same cost for green field project? Greenfield projects create facilities from scratch. Even if a project follows a standard, tried and tested technology still such a project should have more risks than established firms in that line.

After all, there can be delays in the start of work, under-estimation of costs and deadlines, uncertainty over climatic and geological conditions, very high initial fixed costs with no guarantee as to when cash flows will be positive, etc. Another important feature of a new project is potentially conflicting relationships with subcontractors. Thus new projects launched in different sectors have the risks associated with those sectors (captured in the cost of capital of established firms) and many other risks that are not captured in capital market data as these risks are not present (as they are now overcome) in the firms which supply those capital market data.

In a recent research, researchers (one from BNP Paribas and the other from ESCP Europe) examined the need of factoring in a specific greenfield risk for projects involving the construction of new facilities. They sought from capital markets data whether firms specializing in creation of new facilities are perceived as being more risky than companies in the same sector that did not invest in new facilities.

If investors are assumed to be diversified, only demanding extra return for the firm specific risks they assume, the beta of greenfield companies should be higher than companies that only replace or upgrade existing assets. They identified such firms in the energy sector - the wind farms and energy transportation segments. Both types of firms operate in same regulatory environment and their risks are comparable at most levels, except for the greenfield risks. Firms in energy transportation have a base of established assets, but wind farms firms will need to build new infrastructures on a massive scale over coming years. This led them to conclude that the wind farm risk is a greenfield risk.

They identified three listed pure play firms in the wind farm segment and four firms active in energy transportation. Using this sample, they extracted the greenfield risk premium. By focusing on firms specialising in wind farms and energy transportation they avoided some of the errors that can arise with wide, multi-sector samples, but on the other hand the sample is perhaps less representative of the risk they are trying to measure..

They found the weighted average cost of capital of wind farm firms is higher than that of energy transportation firms and that the expected additional return from wind farm firms is between 1.85% and 2.28%.

The research has some design limitations- first the sample size is rather small but more importantly the construction risk for wind farms may not necessarily be comparable to the construction risks in other sectors. We must also note that generally there is a wide margin of error when estimating the parameters required for computing the cost of capital.

Notwithstanding these limitations, the researchers recommend using a greenfield premium of between 1.5% and 2.5%, when valuing such projects, which is compatible with their simulations and also consistent with the practices of a number of firms.