Corporate and Project Finance Modeling

Chapter 17Constructing Flexible Scenario Analysis for Risk Assessment

An alternative to using beta, value at risk, or other statistics to measure the risk of a corporation or a project is to ask bankers how much money they will lend to a company. The debt capacity of a project, an acquisition, or a corporation can be one of the best ways—much better than the Capital Asset Pricing Model—to derive the implicit equity risk. This is because banks in theory should be willing to lend relatively more money to a company that has less volatile cash flow and is not taking dangerous risks. These are exactly the same kind of risks that equity investors should be worried about. The extensive due diligence made by lenders in assessing downsides has so much importance in finance because a banker should in theory have no direct vested personal or psychological interest in completing the project. By putting his stamp of approval on a project and by directly investing money in the project or corporation, the risk analysis made by the banker provides crucial risk information to decision makers. Similarly, the investment will probably not be made if bankers do not approve a loan for the project. If the banker concludes that the project is too risky, an equity investor has a very strong signal that something is fundamentally wrong with the investment and he should probably stay away from the investment. So much for Modigliani and Miller.

In evaluating how much debt can be supported by an investment ...