Project Finance: Valuation of Commercial UAV Projects

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Project Finance Valuation of Commercial UAV
Projects

• Vitaly S. Guzhva
• College of Business
• ERAU
• November 1, 2005

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Market for UAV

• Military applications
• Teal Groups forecast
• 43 billion for next 10 years
• Mostly airborne intelligence, surveillance, and
  reconnaissance
• Commercial applications
• ???
• Still not as large as military
• Will expand rapidly

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Commercial UAV Applications

• Wildfire mapping needs
• Agricultural monitoring
• Disaster management
• Thermal infrared power line surveys
• Highway speed control

• TV news coverage
• Telecommunication
• Weather monitoring
• Aerial imaging/mapping
• Environment monitoring
• Many more to come

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How to Structure, Value, Manage, and Finance a
Commercial UAV Project?

• Corporate finance approach
• Finance assets jointly
• May have underinvestment problem
• Due to debt overhang
• Due to distress costs managerial risk aversion
• Project finance approach
• Reduces costs of market imperfections
• Mitigate incentive conflicts
• May not be effective for certain kinds of assets
• Hybrid of project and corporate finance

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Project Finance

• Project companies are legally independent
  entities with very concentrated equity ownership
• One to three sponsoring firms
• High leverage
• Founded on a series of legal contracts in a
  vertical chain from input supplier to output
  purchaser
• Tightly integrated set of organizational,
  financial, and contractual features generates a
  low-cost financing vehicle for sponsoring firms
  and creates an effective governance structure
  Benjamin Esty, HBS

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Structuring Projects

• The combination of a firm plus a project might be
  worth more when financed separately
• Separate incorporation can reduce the net cost of
  financing
• Agency cost motivation inside project companies
  and among capital providers
• Debt overhang motivation reduce
  leverage-induced underinvestment in sponsoring
  companies
• Risk management motivation reduce
  underinvestment in positive NPV projects due to
  distress costs and/or managerial risk aversion

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Valuing Projects

• Often projects are
• exposed to nontraditional risks
• have embedded optionality
• involve both subsidized and guaranteed cash flow
  streams
• have high and changing leverage ratios
• Discounted cash flow analysis
• Real option analysis

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Valuation of a Commercial UAV Project

• NASA UAV Coffee Project
• PI Dr. Stanley R. Herwitz
• Images from a solar powered UAV (AeroVironment)
  assist Hawaiian coffee growers in optimizing
  harvest timing
• 3,600-acre Kauai Coffee Plantation (KCP) produces
  4-5 million pounds per year
• More ripe coffee cherries in the harvest lead to
  a substantial increase in revenues

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Valuation of a Commercial UAV Project

• Assumptions
• Revenue per pound of coffee is 1.00
• Current production is 5 mln pounds per year 5
  mln in revenues
• Utilizing one UAV will increase revenues by 10
  (net of UAV operating expenses and taxes)
• Weighted average cost of capital of KCP is 10
• Initial investment for one UAV with imaging,
  communication and analysis equipment is 2.5 mln
• KCP has a 5-year lead in using UAVs in coffee
  production industry

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Valuation of a Commercial UAV Project

• Discounted Cash Flow Analysis
• NPV PV(CFs) Investment
• CF extra 0.5 mln a year for 5 years
• NPV 1.9 mln - 2.5 mln - 0.6 mln
• Should we accept the project??

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Valuation of a Commercial UAV Project

• Project optionality
• Option to delay a project
• Option to expand a project to cover new
  products/markets
• Option to abandon the project if cash flows do
  not meet expectations
• Maybe CFs will be lower or higher than expected?
• Is the discount rate constant over the life of
  the project?

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Valuation of a Commercial UAV Project
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Valuation of a Commercial UAV Project

• Option to delay a project
• Similar to a call option
• Value of the underlying asset is a value of the
  project PV(CFs)
• Variance of the value of the asset
• Variance of the CFs of similar projects in the
  past
• Simulation method (using assigned probabilities
  to various market scenarios and calculating
  variance of CFs under each scenario)
• The variance in firm value of firms involved in
  the same business as the project being considered

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Valuation of a Commercial UAV Project

• Option to delay a project
• Exercise price Investment 2.5 mln
• Expiration 5 years
• Riskless rate 5 year Treasury rate 4.45
• Standard deviation of CFs SD of the value of
  parent company 6.67

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Valuation of a Commercial UAV Project

• Black-Sholes Option Pricing Model

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Valuation of a Commercial UAV Project
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Valuation of a Commercial UAV Project

• If we do not consider the optionality of the
  project
• NPV - 600,000
• Decision reject the project
• If we consider the optionality of the project
• Value of the project 72,259
• Decision??

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Valuation of a Commercial UAV Project

• Option to expand the project
• If KCP proceeds with its negative NPV project, it
  can expand its business provide UAV monitoring
  and harvest timing optimization to other coffee
  producers
• This opportunity also can be valued in real
  option framework and added to the NPV of the
  original project

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Valuation of a Commercial UAV Project

• Option to abandon the project
• KCP has an option to abandon the project if the
  effect on revenues is not as expected
• KCP could sell an UAV and its equipment for 1.5
  mln to the Forest Service for wildfire mapping
  needs
• KCP has a valuable put option
• Its value should be added to the NPV of the
  original project

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Conclusion

• Always consider the best structure for the
  project
• Corporate finance, Project finance or a
  combination of them
• Verify if the project
• Has embedded optionality
• Comes with changing leverage
• Exposed to nontraditional risks
• Use an appropriate valuation technique
• Cash flow analysis
• Real option analysis

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Thank you very much!