The years after the power purchase agreement carry little weight in the project's value and a great deal in the equity's, because the lenders have already been repaid out of the contracted years.
Value the merchant tail as the present value of the cash flow available for debt service after the power purchase agreement ends, discounted at a merchant rate rather than the contracted one. On an illustrative 200 MW solar project with a 15-year PPA and ten merchant years at 40.00 a MWh, the tail is 23.8 per cent of the undiscounted cash flow but only 9.7 of 136.8 of project value, 7.1 per cent. Because the debt is repaid from the contracted years, the same 9.7 is 26.5 per cent of the equity value.
Worked in full in The Project Finance Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A contracted solar project is two assets in one model: fifteen years of a fixed price paid by an offtaker, and the years after that, when the output is sold into the market at whatever price the plant captures. Lenders size on the first and mostly ignore the second. Equity buys both. A single discount rate across the whole life either overvalues the tail or undervalues the contract, so the tail has to be valued on its own and then compared with what it represents to each party.
| Input | Value |
|---|---|
| Capacity; year-one P50 output | 200 MW; 480,000 MWh |
| Capacity factor | 27.4% |
| Annual degradation | 0.5% |
| PPA price, flat, years 1 to 15 | 48.00 |
| Merchant captured price, flat, years 16 to 25 (illustrative) | 40.00 |
| Operating cost, year one, rising 2% a year | 7.5 |
| Discount rate: contracted; merchant (illustrative) | 7%; 10% |
| Senior debt: sculpted DSCR, rate, tenor | 1.30x; 6%; 14 years |
The merchant price is a captured price, after the discount solar suffers for producing when everyone else does. Cash flows are pre-tax throughout, and the tail is valued before debt so that it is isolated; the debt only enters at the equity line.
1. CFADS each year = output × price − operating cost. Year 1: 480,000 × 48.00 = 23.04 of revenue, less 7.50, gives 15.54.
2. Year 15, last PPA year: 447,470 MWh, revenue 21.48, cost 9.90, CFADS 11.58.
3. Year 16, first merchant year: 445,233 MWh × 40.00 = 17.81, cost 10.09, CFADS 7.72. By year 25 CFADS is 4.96.
4. Present value of years 1 to 15 at 7% = 127.1. Present value of years 16 to 25 at 10% = 9.7. Project value = 136.8.
5. Debt sculpted at 1.30x on years 1 to 14 (debt service = CFADS / 1.30, discounted at 6%) = 100.2.
6. Equity value = 136.8 − 100.2 = 36.6, of which the tail is 9.7 / 36.6 = 26.5%.
Excel: =NPV(MerchantRate, CFADS16:CFADS25)/(1+MerchantRate)^15 for the tail, which gives the same 9.7.
Valued at year 15, when the PPA ends, the tail is worth 40.5. Discounting that back fifteen years at 10 per cent divides it by 4.177, which is why a tail that is nearly a quarter of the cash is under a tenth of the value.
| Measure | Contracted years | Merchant tail | Tail share |
|---|---|---|---|
| Undiscounted CFADS | 204.1 | 63.6 | 23.8% |
| Project value | 127.1 | 9.7 | 7.1% |
| Equity value, after 100.2 of debt | 26.9 | 9.7 | 26.5% |
The lenders take most of the contracted value and none of the tail, so the tail's share grows almost fourfold between the project line and the equity line. An equity investor who reads the 7.1 per cent and concludes that the merchant assumption does not matter has read the wrong line.
| Merchant price | Tail at 8% | Equity share | Tail at 10% | Equity share | Tail at 12% | Equity share |
|---|---|---|---|---|---|---|
| 30.00 | 4.6 | 14.7% | 3.3 | 10.9% | 2.3 | 8.0% |
| 35.00 | 9.2 | 25.6% | 6.5 | 19.4% | 4.6 | 14.6% |
| 40.00 | 13.9 | 34.0% | 9.7 | 26.5% | 6.9 | 20.3% |
| 45.00 | 18.5 | 40.7% | 12.9 | 32.4% | 9.1 | 25.3% |
| 50.00 | 23.1 | 46.2% | 16.1 | 37.5% | 11.4 | 29.7% |
Each 1.00 a MWh on the merchant price moves equity value by 0.64, about 1.8 per cent of it. The operating cost does the rest of the damage: it keeps rising while output degrades, so the price at which a merchant year earns nothing climbs from 22.67 in year 16 to 28.34 in year 25. At 30.00 the last years are close to worthless, and at that price a longer life adds little because the late years are already marginal.
The book's own solar and storage project, contracted for fifteen years and merchant for ten, is in the free workbooks for this case; the contract price that clears a target return is worked in how to calculate the break-even PPA price.
A higher rate than for contracted revenue, because the price is unhedged and the volume is exposed to curtailment and capture discounts. The spread is a judgement, not a market fact. In the illustrative case moving the merchant rate from 8 to 12 per cent takes the tail from 13.9 to 6.9, and its share of equity value from 34.0 to 20.3 per cent.
Usually little or none: debt is typically sized and amortised on the contracted years, often with a tail before the PPA ends. In the illustrative case 100.2 of debt is sculpted at 1.30x over 14 years and the merchant years go entirely to equity, which is why they are 26.5 per cent of equity value but only 7.1 per cent of project value.
More than the project valuation suggests. In the illustrative case each 1.00 a MWh on the merchant price moves equity value by 0.64, about 1.8 per cent of the 36.6 equity value. Between 30.00 and 50.00 a MWh the tail's share of equity value runs from 10.9 to 37.5 per cent at a 10 per cent rate.
This article is one calculation from The Project Finance Handbook. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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