Consistent Valuation Of Project Finance And LBO's Using The Flows-To-Equity Method

A common method of valuing the equity in leveraged transactions is the flows-to-equity method whereby the free cash flow available to equity holders is discounted at the cost of equity. This method uses a standard definition of equity free cash flow, but the cost of equity varies over time as leverage varies. Various formulas can be used to calculate the time-varying cost of equity, most of which are inconsistent with the assumptions underlying the free cash flow calculation.