I'm reviewing the DCF for a project that requires a letter of credit to be posted throughout the life of the project. It is unlikely to be drawn as it is merely for credit support for the project. My thought is that the letter of credit posting should be treated the same as if it were a cash posting to support the project since the company's LC posting capacity is finite. Thus, it looks like a loan with a cash outflow for the posting on Day 0 and a cash inflow for the posting at termination and annual cash payments equivalent to the fronting fee (0.125%) for issuing the LCs. All of these cash flows would be discounted by the company's WACC to determine the impact of the credit support to the project valuation.
My line of thinking is that, while cheaper and finite resources - such as a letter of credit facility - exist to support projects, any particular project should not be directly benefitted by those cheaper resources since its use of this finite resource will ultimately cause other projects to be funded with capital at the company's marginal cost of capital (WACC). The one issue that I have with my approach is that it makes the NPV of the LC posting worse than if we chose a cash posting of equal amount (since the cash posting would not carry the 0.125% fronting fee). However, as a practical matter, we would generally always chose to post LCs vs. cash if the nominal amount of the posting was the same.
How do others thing about project valuations requiring such credit support? Do you agree with my line of thinking and valuation approach?
Also, how do you think about valuations that require other less tangible forms of credit support (e.g., unsecured guaranties, secured guaranties, liens, etc.)? As a corporate finance professional; my natural pecking order would be to first give no credit support, followed by unsecured guarantees, then secured guarantees, next LCs, and finally cash. However, I haven't seen a valuation decision-making framework to address this issue.
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