how much equity investment is advisable for a business proposal ?

Question

i have been approached to place a 30% equity injection (for a 30% stake in a power plant business); the value approx USD4.6 million. The project cost is USD 14.8 million
The financial model indicates for the 30% injection that Equity NPV Post Tax (at 9% discounted rate for 21 yrs) is USD5.4 million. The Equity IRR Post Tax is 23.9%.
I'm interested only to remain for 7 yrs and exit (not the whole 21 yrs), for that the NPV is USD 3.6 million, IRR 16%.
Based on the figures above, should I go ahead with the full equity injection requested or what should be my optimal equity injection value recommended ?

Answer 1

This sounds unfavorable, simply because it is too good to be true.


First. Your math is a bit suspect. IRR is the discount rate so that the NPV equals the future cash flows. 16% return over 7 years equalling 3.6m and 5.4m at 9%, but you're getting it for 4.6m which indicats an IRR somewhere in the teens.

Secondly, the IRR seems to high for a power plant. Typically, Independent Power Producers tend to have take-or-pay cost-plus contracts with low yields (roughly 3-5%). Since cost-plus takes out most of the operating risk, it is low return (but can be enhanced through leverage). Your IRR is basically "too good to be true", which makes me think that the contract is not cost-plus (e.g. pre-schedule pricing with a mismatch in revenues/costs where you bear price risk on fuel) or is in a situation where there are other mitigating factors (e.g. unstable government, lack of reliable legal system).

If it is not cost-plus, you will need to hedge away price risk on your fuel. Since futures contracts don't go out 7 years, let alone 21, you would need to secure in deliverable forwards - or preferrably in actually buying a fuel (e.g. coal commitment, natural gas line) due to default risk.

Also, how do you plan on exiting this investment unless you structure a put in the equity injection?