Final answer:
The most suitable valuation methodology for project finance is typically free cash flows discounted at the weighted average cost of capital (WACC), which includes the costs of both debt and equity financing and accounts for changing risk profiles. The adjusted present value (APV) is also applicable, especially for complex financing structures. Valuation based on equity cash flow requires detailed adjustments for leverage.
Step-by-step explanation:
The most appropriate valuation methodology for project finance is (d) free cash flows discounted at the weighted average cost of capital (WACC). When evaluating the long-term financial viability of a project, WACC takes into account the proportionate costs of both equity and debt financing, encompassing the entire project timeline and various risk factors. Using WACC to discount the free cash flows of a project helps to determine the present value of future cash flows, and is particularly important as project finance often involves significant debt levels, with risk profiles changing over the lifespan of the project.
Option (b), the adjusted present value (APV) approach, is also suitable for project finance, especially if the financing structure is complex and involves layers of debt with different seniorities. APV separately calculates the base-case NPV of unlevered project cash flows, and the NPV of the tax shield provided by debt, allowing for changes in leverage and different financing costs over time.
In contrast, valuations based purely on equity cash flow, such as options (c) and (e), require careful adjustments for leverage, which might make them less straightforward compared to using WACC or APV, especially when the leverage of the project changes over time. Valuation by comparables (option a) can provide a benchmark but is not as tailored to the specific cash flow structure of a given project as WACC or APV.
Every business and governmental decision involving capital investments, like adding safety features to a highway or setting environmental policies, incorporates some form of present discounted value comparison between current costs and future benefits.