Valuation of Solar Projects
In Finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks or on liabilities (e.g.,bonds issued by a company). Valuations are needed for many reasons such as investment analysis,capital budgeting merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
In the general composition of the capital structure, prospect of future earnings, and market value of assets is taken into account.Judging the contributions of a company’s management would be more of a subjective valuation technique, while calculating intrinsic value based on future earnings would be an objective technique.
Different methods are being used to determine the value of an asset,a company,or a project:
Now in solar projects, valuation plays a crucial role, because the huge cost in involved initially, and it takes a longer period to get the returns.this results in developing the appraisal of projects.In solar, we value projects based on their returns in the long run. The method to value solar projects typically depends on the Project IRR and Equity IRR. Looking into the expected returns of this concerned project in detailed manner gives a clarity as to which project one should take up. To begin with certain assumptions are taken into consideration,know the generation output. With the help of these figures,a projected profit and loss statement is prepared which helps to determine profit before tax and profit after tax ( Tax as per govt. Regulations). we also prepare a discounted cash flow where record all cash outflows and inflows.The inflows are calculated with the help of supporting financial projections,with various assumptions..Basically based on these statements we project the expected returns in terms of IRR. Here we assume the Minimal Acceptable rate (also the cost of capital) to be 16% due to other debts.Taking this into consideration the IRR which we get from an investment of 80cr is 14%.In this case it is advisable not to invest in solar as the IRR <WACC.A project will not create value if its IRR<WACC.
Lets try to understand with the above graph,the IRR which we got for a project costing is 80cr is 14%(cost of capital to be 16%).it clearly shows that there are other debts which need to be repayed, and investing in solar with a return of 14% at this juncture is not viable.In the second scenario if an angel investor invests a certain sum of money into the investment and the project cost comes to 82cr,the general level of expectations also rise,which results in an increase in the expected returns also.(considering the inflation level) i.e 16%.The third scenario is where the value of a project decreases,this largely happens due to extraneous factors at macro level,which also tend to decrease the expectation level in an investor.threby reducing the return to 14%(Increasing and decreasing value of returns have been assumed).
It is also to be noted that when debt financing is introduced in an investment,the expectation level of investors increases,as it evades tax codes when compared to equity.
Apart from this,there are certain other factors which affects the value of a project.these are the risk factors,Below are listed few of them:
- Construction risk: Risk of property damage or liability stemming from errors during the building of new projects.
- Company risk: Risk affecting the viability of the project developer, for example, risks related to key personnel, financial solidity and technical ability to execute on plans.
- Environmental risk: Risk of environmental damage caused by the solar park including any liability following such damage.
- Financial risk: Risk of insufficient access to investment and operating capital.
- Market risk: Risk of a cost increase for key input factors such as labor or modules, or rate decreases for electricity generated.
- Operational risk: Risk of unscheduled plant closure due to the lack of resources, equipment damages or component failures.
- Technology risk: Risk of components generating less electricity over time than expected.
- Political and regulatory risk: Risk of a change in policy that may affect the profitability of the project, for example changes in levels of tax credit or RPS targets. Also, this includes changes in policy as related to permitting and interconnection.
- Climate and weather risk: Risk of changes in electricity generation due to lack of sunshine or snow covering solar panels for long periods of time.
- Sabotage, terrorism and theft risk: Risk that all or parts of the solar park will be subject to sabotage, terrorism or theft and thus generate less electricity than planned.
Now the question arises how to mitigate these risk’s which is indeed a concern is solar projects,well the immediate impact of the presence of any of these risk factors is uncertainty around the revenue and profitability projections for the project and thus the financial viability of the project.
Many of the risks mentioned above can be managed through financial instruments and insurance products. For example, weather risks can be mitigated through weather futures and technology risks can be offset through warranties. However, for a relatively young industry such as solar, a lack of engineering studies for actuarial purposes often means that financial risk management products are badly re-purposed from other fields.
Above mentioned details and calculations is just a crux of the valuation approach taken for solar projects. Hence valuation is considered to be most important function,when a company plans to take up solar projects.It helps the investors/developers to know what benefits they can reap in in the long run,at the same time shows the expected return one can get in coming future.