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FinancialStructure  Wali Memon
Project Finance Terms in Private Analysis The table below illustrates the type of terms that are in renewable project fina...
Other Loan Examples – Spanish Wind    Farm      The acquisition of 6 wind farms in Spain            Total Financing EUR 19...
Dokie Wind Energy Project –    Canadian Example      WestLB project financing for a wind farm in British Columbia,      Ca...
Example of Loan Life       BNP Paribas was in the market last week with a 144A for the       Panoche Energy Center in Cali...
Other Loan Examples – Spanish Wind    Farm      The acquisition of 6 wind farms in Spain            Total Financing EUR 19...
Dokie Wind Energy Project –    Canadian Example      WestLB project financing for a wind farm in British Columbia,      Ca...
Example of Loan Life       BNP Paribas was in the market last week with a 144A for the       Panoche Energy Center in Cali...
FPL Example (2003)    DSCR        Average 1.86        Minimum 1.74    Bond Rating        Moody’s Baa3        S&P BBB-    R...
Reserve Accounts – FPL Example       The debt service reserve covers 12 months of debt service             funded at closi...
FPL Example       Loan Amount $370 Million       Operating Reserve to Cover Expenses $14 Million       Debt Leverage – 52%...
Disbursement Controls and Basic     Covenants       Disbursement controls in the form of conditions precedent to each     ...
Covenants that Restrict Dividends and     Additional Debt        Borrower covenants restricting the payment of dividends o...
Cash Flow Waterfall – FPL Example       The flow of funds is not standard but acceptable. American Wind will repay       d...
Equity Returns and Re-Financing                      Equity IRR with and without Re-financing       50.0%                 ...
Project Finance Modelling of RenewableResources
Teaching Objectives of Model     Construction      The best and perhaps the only real way to learn modeling is under the  ...
A Financial Model is a Statistical Tool      In developing a financial model, the basic thing you are doing is      summar...
Danger of Believing too Much in Models       Alan Greenspan, Financial Times.             “The essential problem is that o...
General Objectives of Model Analysis              How to screen projects and value projects              How to structure ...
Financial Modelling Outline      Developing the structure and layout of alternative types of models      Notes on model st...
Introduction        General Comments about financial models              “It all has to make sense in a financial model”  ...
A Central Question in Economics and Finance is How to Evaluate Risk        As the growth of trade transformed the principl...
Financial Perspective on Renewable     Investments       Lessons from Financial Crisis on Risk Assessment             Comp...
Financial Models – Standard and Poor’s      A good financial model should:             Be relatively simple             Fo...
Fundamental Financial Issues and     Modelling       Financial issues that must generally be addressed in valuation,      ...
Resolution of Fundamental Financial     Issues        There are various ways to resolve the basic financial issues        ...
Equity Returns for Tollroads        The following slide illustrates equity IRR’s on selected toll-roads.        This infor...
Debt Service Coverage Criteria        Standard & Poors considers that minimum DSCR threshold tests for        most contrac...
Study of Problems with Project Finance     Models        Assumptions not Documented in Databook        No Integrated Cashf...
Example of Cash Flow Waterfall                      200,000                                                               ...
Structure of Project Finance Models
Basic Model Structure       A project finance model should correspond to the fundamentals of       project finance:       ...
Sheet Layout – Project Model      Contents      Input Sheets (Assumption Book)                  Different colors, Arrangin...
Structure of a Project Finance Model                                                                             Profit an...
Model Sheets in Project Finance Model                                      Debt Schedule –         Inputs –               ...
Table of Contents – Example of Different     Periodic Statements                  Note that financial                     ...
Sources and Uses Example – Summarizes                           The source and use statement together with     the whole p...
Summary of Modelling Practises
Good Modelling Practise       Divide the model into separate modules, beginning with an input       section.       Compute...
Simple FormulasThe modeling practices are discussed in another sheet namedspreadsheet conventions.The most important is ke...
Balance Sheet Accounts and Cork Screws       It is good practice to have accounts for all balance sheet items       Some e...
Example of Terms for Wind Project       Typically, the length of a loan is between 10 and 15 years, but loan terms       h...
Development Analysis and Time PeriodDefinitions in Models
Switches in Alternative Models        Switches for time periods in alternative models              General Corporate Model...
Steps in Project Financing        Step 1: Development, Feasibility and RFP                   RFP issues – bid evaluation s...
Steps in Development Phase47   Wali Memon
Valuation of Development Expenditures     and Probability of Proceeding       Simple approach             If 10% chance of...
Uncertainty of Costs and Time to     Development49    Wali Memon
Project Finance Timing and Finance        Finance is critical path.              After the Commercial Operation Date, the ...
Project Finance from Development               through Commercial Operation)           Time to Complete Task (months)     ...
Timeline Before Commercial Operation                                                                                      ...
Separation of Construction and Operation     Time Period                                        Income Statement and Cash ...
Sources and Uses Statement During     Construction       Interest During Construction             IDC is capitalized to co...
Equity IRR Issues        While the equity IRR is the fundamental measure of return for a        project, a number of ambig...
Free Cash Flow       Free Cash Flow (un-geared after tax cash flow)             Finance theory suggests analyzing free cas...
Discount Rates and Valuation for Real     Estate Projects        Merrill Lynch performed a discounted cash flow (“DCF”) an...
Free Cash Flow       Free cash flow can be computed from the income statement or from the cash flow statement.       The a...
Free Cash Flow Example59    Wali Memon
IRR, NPV and other Issues        NPV calculations are misleading if used to compared two projects of        different size...
Project IRR versus Equity IRR      A central issue in finance is equity valuation (P/E) versus enterprise      valuation (...
Project Finance versus Traditional InvestmentEvaluation                   Traditional                     Project Finance ...
Project and Equity IRR Issue – Equity     Bridge Loans and Recourse Debt        In some projects, equity holders provide l...
IRR’s in PFI        IRR’s are negotiated in PFI transactions as part of the concession        agreement where the IRR driv...
Other Valuation Metrics – Payback and     Discounted Payback       The payback period measures the number of years that it...
Hypothetical Investment Decision and Equity IRR CriteriaBegin with the notion that management has a rate of return criteri...
DSCRs in Project Finance
DSCR - General Discussion     Basic Definition – Cash into the project divided by debt paid to the bank     Should find in...
Debt Sizing        Borrowed amount is based on a conservative commercial case              Lenders will analyze conservati...
Debt Capacity from Cash Flows with     Different Volatility                                                               ...
Determining the Credit Classification of     Project Finance Debt        Determining the credit classification is importan...
Banks or Rating Agencies Value Debt with     Risk Classification Systems         Map of Internal Ratings to Public Rating ...
Risk Classification and Target of BBB in     Project Finance from S&P website73    Wali Memon
Updated S&P Stats74    Wali Memon
Traditional Credit Analysis – Backward     Looking Credit Ratios to Gauge Bond     Ratings and Bank Ratings     Credit rat...
General Use of Financial Ratios in                     Establishing Credit Quality                                    Busi...
Strong Ratings        Characteristics of Strong Ratings            Capacity to generate sufficient cash flow to maintain D...
Ratings Assignment – Basel II Document       Template of objective benchmarks that measure risk factors, such       as DSC...
DSCR Drives the Debt CapacityThe debt service coverage ratio is afinancial output in a project financetransaction which ca...
General DSCR Criteria to Establish Debt     Levels        Electric Power:        1.3-1.4        Resources:        1.5-2.0 ...
More on DSCR Targets for AlternativeIndustries Ranges in DSCR estimates
Example: DSCR for Wind Power       Typically, we want revenues after all operating costs and taxes to be       about 50% h...
DSCR Criteria (Reference)        At a minimum, investment-grade merchant projects probably will        have to exceed a 2....
Example of Project Finance as Risk     Measurement Survey of Electric Plants84    Wali Memon
DSCR Criteria in PFI Transactions        The DSCR in PFI transactions can be very low – in the range of 1.05        – 1.2....
Detailed Issues in Computing the DSCR       There are many intricacies in computing the DSCR despite it being a simple    ...
Alternative DSCR Calculations        Minimum DSCR             The most important ratio that measures the minimum DSCR the ...
Difference Between Free Cash Flow and     Cash Flow for the DSCR       Free cash flow             Excludes interest income...
Issue 1: DSRA Balances in the DSCR        A project has better quality if it has a debt service reserve account        Why...
Issue 2: Senior and Subordinated DSCR       Senior DSCR:             For the senior DSCR, divide the net cash flow by the ...
Issue 3: Operating Reserves and Debt     Service Reserve Account Movements        Operating Reserves              If cash ...
Other DSCR Issues       In reviewing various transactions, various DSCR issues arise. Some       of these include:        ...
Timing of DSCR Calculations        The DSCR is not generally computed before the date of project completion.        Theref...
Fundamental Events of Default       The primary function of the DSCR is to measure the probability of       defalut – a ra...
Other Events of Default - Reference        Other Events of Default Include:              operational covenants,           ...
LLCR and PLCR in Credit Analysis
LLCR and PLCR       Loan Life Coverage Ratio (LLCR):             The LLCR computes the present value of cash flows over th...
General Mathematics of LLCR       To see how the LLCR works, consider the following points             If all cash flow we...
Loan Life Coverage Ratio (LLCR)      Loan Life Coverage Ratio – the present value of cash flow before debt      service – ...
LLCR and Credit Quality         The LLCR Concept can be used to gauge the economics of the         project relative to the...
Project Life Coverage Ratio (PLCR)       The PLCR or project life coverage ratio covers the residual cash flow       of th...
LLCR and PLCR        The PLCR or project life coverage ratio covers the residual cash flow of the        project as well a...
Debt Tenor and Average Life         Lenders want to know how their risk reduces over the life of a         project.       ...
Credit Ratings, Loan Pricing and Loan Value
Default Rates and Credit Spreads -- Note      that Credit Spreads Increase When      Default Rates Increase105    Wali Memon
Credit Spreads                         Increase of 5%   Credit Crisis106   Wali Memon
Bond Ratings and Yield SpreadCredit classification is very important in establishing the access tofunding and the cost of ...
Table of Bond Spreads      Rating        1 yr          2 yr          3 yr          5 yr          7 yr        10 yr        ...
Theory of Credit Spreads: Credit Spread    on Debt Facilities                                         S The Credit Triangl...
Expected Loss Can Be Broken Down Into        Three Components                           Borrower Risk                     ...
Comparison of PD x LGD with Precise      Formula      Case 1: No LGD and One Year        .111   Wali Memon
Comparison of PD x LGD with Precise      Formula      Case 2: LGD and Multiple Years      Assumptions         Years       ...
Probability of DefaultThis chart shows rating migrations and the probability of default foralternative loans. Note the inc...
Updated Transition Matrix114   Wali Memon
Project Finance and Default History         Market participants consistently report lower default rates, and         espec...
Study of Probability of Default for Project      Finance116   Wali Memon
Default Rates by Industry117   Wali Memon
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
Financial Structure
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Financial Structure

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The specific mixture of long–term debt and equity that a company uses to finance its operations. This financial structure is a mixture that directly affects the risk and value of the business. The main concern for the financial manager of the company is deciding how much money should be borrowed and the best mixture of debt and equity to obtain. The financial manager also has to find the least expensive sources of funds for the company to use.

Financial structure is divided into the amount of the company's cash flow that goes to creditors and the amount that goes to shareholders. Each business will have a different mixture depending on its needs and expenses. Therefore, each company will have its own particular debt-equity ratio. For example, a company could issue bonds and use the proceeds to buy stock or it could issue stock and use the proceeds to pay its debt.



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  1. 1. FinancialStructure Wali Memon
  2. 2. Project Finance Terms in Private Analysis The table below illustrates the type of terms that are in renewable project finance transactions.
  3. 3. Other Loan Examples – Spanish Wind Farm The acquisition of 6 wind farms in Spain Total Financing EUR 195 M Total value of the transaction EUR235 M Equity -- about EUR 40 M Total 158 MW of Capacity Generating about 350 GWh per year Total cost 5 cents/kWh. Compute Sources and Uses of Funds and Leverage Cost per kW of Capacity Capacity Factor Turbine Capacity3 Wali Memon
  4. 4. Dokie Wind Energy Project – Canadian Example WestLB project financing for a wind farm in British Columbia, Canada. Capacity: 150 MW Sponsor: renewable energy developer EarthFirst Canada Inc. Loans: $214 million including a two-year construction period and will have a 20-year final maturity Average Life: 10- to 13-year range. Purchase Price Agreement: A 20-year power purchase agreement with British Columbia-based electric utility BC Hydro, which has a rating of AA by Standard & Poors.4 Wali Memon
  5. 5. Example of Loan Life BNP Paribas was in the market last week with a 144A for the Panoche Energy Center in California. The deal is $330 million in size, with a 21.5-year final, 14-year average life maturity. Standard & Poors has a rating of BBB- on the deal, which is expected to price this week.5 Wali Memon
  6. 6. Other Loan Examples – Spanish Wind Farm The acquisition of 6 wind farms in Spain Total Financing EUR 195 M Total value of the transaction EUR235 M Equity -- about EUR 40 M Total 158 MW of Capacity Generating about 350 GWh per year Total cost 5 cents/kWh. Compute Sources and Uses of Funds and Leverage Cost per kW of Capacity Capacity Factor Turbine Capacity6 Wali Memon
  7. 7. Dokie Wind Energy Project – Canadian Example WestLB project financing for a wind farm in British Columbia, Canada. Capacity: 150 MW Sponsor: renewable energy developer EarthFirst Canada Inc. Loans: $214 million including a two-year construction period and will have a 20-year final maturity Average Life: 10- to 13-year range. Purchase Price Agreement: A 20-year power purchase agreement with British Columbia-based electric utility BC Hydro, which has a rating of AA by Standard & Poors.7 Wali Memon
  8. 8. Example of Loan Life BNP Paribas was in the market last week with a 144A for the Panoche Energy Center in California. The deal is $330 million in size, with a 21.5-year final, 14-year average life maturity. Standard & Poors has a rating of BBB- on the deal, which is expected to price this week.8 Wali Memon
  9. 9. FPL Example (2003) DSCR Average 1.86 Minimum 1.74 Bond Rating Moody’s Baa3 S&P BBB- Reserve Accounts 12 Months Debt Service Reserve Account $15 Million Operating Reserve Major Maintenance Reserve Regulatory Support Guaranteed by Sponsor Covenants Distributions allowed only if DSCR is above 1.3 times9 Wali Memon
  10. 10. Reserve Accounts – FPL Example The debt service reserve covers 12 months of debt service funded at closing, either in cash or an Letter of Credit. The major maintenance account is funded at closing in the amount of $1 million initially to $3.5 million by 2020. The special $15 million O&M reserve is funded at closing, with either: cash, a letter of credit , or a guarantee from a corporate entity with a senior unsecured rating of at least BBB.10 Wali Memon
  11. 11. FPL Example Loan Amount $370 Million Operating Reserve to Cover Expenses $14 Million Debt Leverage – 52% Capacity – 700 MW Average PPA Tariff: $35/MWH (Excludes production tax credit) Most Projects already completed and FPL guarantees completion (limited construction risk) 2005 Loan Higher Leverage – 65% Additional Subordinated Debt – Total of 83% Financing11 Wali Memon
  12. 12. Disbursement Controls and Basic Covenants Disbursement controls in the form of conditions precedent to each drawdown under the construction loan, such as requiring the borrower to present invoices, builders certificates or other evidence as to the need and purpose for which funds will be used. Borrower covenants not to amend or waive any of its rights under the principal project agreements without the consent of the lender. Borrower completion covenants requiring the borrower to complete the project in accordance with project plans and specifications and prohibiting material alterations without the consent of the lender.12 Wali Memon
  13. 13. Covenants that Restrict Dividends and Additional Debt Borrower covenants restricting the payment of dividends or other distributions by the borrower during construction and, thereafter, only after satisfaction of required debt service and other reserves, debt service coverage ratios and certification of no existing defaults. Borrower covenants prohibiting incurring of additional liens and debt or issuing guarantees. Requirements that project participants affiliated with the project sponsors enter into subordination agreements under which certain payments to such participants from the borrower under project agreements are restricted (either absolutely or partially) and made subordinate to the payment of debt service. The project loan typically will be secured by all project assets, including a mortgage on the project facilities and real property; assignment of operating revenues; liens on all personal property; and assignment of all project agreements and project permits, including any letters of credit or performance bonds to which the borrower is the beneficiary.13 Wali Memon
  14. 14. Cash Flow Waterfall – FPL Example The flow of funds is not standard but acceptable. American Wind will repay debt once annually, due in part to the annual variation of wind and thus power production. However, the issuer desires to make bi-annual distributions, and has structured the flow of funds accordingly. The trustee allocates funds monthly in the following priority; O&M expenses, the debt service fund (1/12 of the debt service requirement), debt service reserve, major maintenance reserve, special O&M reserve, an optional additional payment into the debt service funds, payment on permitted debt (other than senior secured obligations).14 Wali Memon
  15. 15. Equity Returns and Re-Financing Equity IRR with and without Re-financing 50.0% 44.6% 45.0% Re-Finance No Re-Finance 40.0% 37.3% E q 35.0% u 29.2% i 30.0% t 25.0% y 21.7% 20.0% 18.9% I 16.0% R 15.0% R 10.0% 7.8% 7.7% 5.0% 0.0%15 Wali Memon Low Base High Very High Traffic Scenario
  16. 16. Project Finance Modelling of RenewableResources
  17. 17. Teaching Objectives of Model Construction The best and perhaps the only real way to learn modeling is under the tense pressure of a real transaction – when a model must be created and audited under a tight deadline. Notwithstanding this, the exercises and lecturers are intended to provide: A head start for those who have not created models and will have to learn the hard way. Helpful ideas to experienced model builders in designing and structuring more efficient, stable, transparent and accurate models. The discussion covers how to build a well structured financial model that clearly delineates inputs, effectively presents key value drivers, uses separate modules to organize various components, accurately computes cash flow that is available to different debt and equity investors, and presents results of the analysis that accurately display risks of the investment.17 Wali Memon
  18. 18. A Financial Model is a Statistical Tool In developing a financial model, the basic thing you are doing is summarizing a complex set of technical and economic factors into a number (such as value per share, IRR or debt service coverage). Forecasting has become an essential tool for any business and it is central to statistics -- in assessing value, credit analysis, corporate strategy and other business functions, you must use some sort of forecast. Some believe economic forecasting has limited effectiveness and worse, is fundamentally dishonest because uncertain unanticipated events such as the internet growth, high oil prices, sub-prime crisis, falling dollar continually occur. The whole idea of modeling, like statistics, is quantification. If a concept cannot be quantified, it is a philosophy. The fundamental notion of statistics is presenting and summarizing information, this is the same as a financial.18 Wali Memon
  19. 19. Danger of Believing too Much in Models Alan Greenspan, Financial Times. “The essential problem is that our models – both risk models and econometric models – as complex as they have become – are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world.” Nicholas Taleb: In the not too distant past, say the pre-computer days, projections remained vague and qualitative, one had to make a mental effort to keep track of them, and it was a strain to push scenarios into the future. It took pencils, erasers, reams of paper, and huge wastebaskets to engage in the activity. The activity of projecting, in short, was effortful, undesirable, and marred with self doubt. But things changed with the intrusion of the spreadsheet. When you put an Excel spreadsheet into computer literate hands, you get projections effortlessly extending ad infinitum. We have become excessively bureaucratic planners thanks to these potent computer programs given to those who are incapable of handling their knowledge.19 Wali Memon
  20. 20. General Objectives of Model Analysis How to screen projects and value projects How to structure the financing of projects How to analyze risk using models How to develop detailed financing provisions A database of information on the project20 Wali Memon
  21. 21. Financial Modelling Outline Developing the structure and layout of alternative types of models Notes on model structure, programming practices and model periods Organizing time periods in a model Value drivers and model inputs Debt modules -- sweeps, traps, defaults and debt IRR Fixed asset modules and depreciation and amortization Income statement and tax schedule Cash flow and waterfall Balance sheet and other auditing tools Presenting key valuation outputs of a model Performing sensitivity and scenario analysis on model outputs21 Wali Memon
  22. 22. Introduction General Comments about financial models “It all has to make sense in a financial model” One of the benefits of project finance is the transparency of the cash flows as shown in the model Major financial failures have occurred because the investors had no idea what was driving the value. Once problems occur when financial presentation is not transparent, panic often occurs. In understanding a transaction and writing language for project finance contracts (construction contract, loan agreement, concession agreement, purchase power agreement) cash flow is the ultimate issue. One must understand how much cash flow is generated, who gets the cash flow and the priorities each party has to the cash flow.22 Wali Memon
  23. 23. A Central Question in Economics and Finance is How to Evaluate Risk As the growth of trade transformed the principles of gambling into the creation of wealth, the inevitable result was capitalism, the epitome of risk-taking. But capitalism could not have flourished without two new activities that had been unnecessary so long as the future was a matter of chance. The first was bookkeeping, a humble activity but one that encouraged the dissemination of the new techniques of numbering and counting. The other was forecasting, a much less humble and far more challenging activity that links risk taking with direct payoffs. “The Remarkable Story of Risk”23 Wali Memon
  24. 24. Financial Perspective on Renewable Investments Lessons from Financial Crisis on Risk Assessment Complex Structuring Risk Analysis Financing and return requirements Evaluation of risks of capital investments Capital Intensity of Renewable Which Risks are Most Important Rate of return required by private investors in wind farm investments Criteria for bankers in wind farm investments in order to accept risk24 Wali Memon
  25. 25. Financial Models – Standard and Poor’s A good financial model should: Be relatively simple Focus on key cash flow drivers Clearly convey assumptions and conclusions Alternative Models Back of the Envelope Quickly run the impact of an acquisition on debt service coverage Sensitivity of earnings to commodity price swings Deterministic Set a number of assumptions and translate into financial ratios and cash flow Stochastic Develop a range of possible inputs using Monte Carlo simulation. Used where there is a good and predictable history for value drivers.25 Wali Memon
  26. 26. Fundamental Financial Issues and Modelling Financial issues that must generally be addressed in valuation, financial structuring and credit analysis include: What is the minimum level of the project IRR that is acceptable (relative to the weighted average cost of capital) What is the level of the minimum required equity IRR with different amounts of debt on the balance sheet What is the debt capacity of a project for senior debt and subordinated debt as measured by the minimum DSCR or the LLCR What should be the credit spread on senior and subordinated debt What is the tradeoff between risk and return in evaluating covenants26 Wali Memon
  27. 27. Resolution of Fundamental Financial Issues There are various ways to resolve the basic financial issues presented on the last slide: Financial theory Financial theory dictates that the CAPM should be used to compute the WACC, that the un-levered beta should be used to estimate equity returns, that options pricing models should be used for credit spreads, debt capacity and covenants. Mathematical Models Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk. Practical Market Information Practical market information can be used to gauge required equity returns, required credit spreads, required financial ratios to achieve investment grade rating and other issues. Direct Evaluation with Financial Models Use of financial models to directly assess risks through sensitivity, scenario and simulation analysis.27 Wali Memon
  28. 28. Equity Returns for Tollroads The following slide illustrates equity IRR’s on selected toll-roads. This information more relevant than theoretical weighted average cost of capital calculations28 Wali Memon
  29. 29. Debt Service Coverage Criteria Standard & Poors considers that minimum DSCR threshold tests for most contract-driven projects to be around 1.30 times (x), provided that this figure holds under stress analysis. Such levels are too low for merchant projects. Instead, minimum DSCR levels for equity distributions may need to exceed 1.70x for investment- grade transactions, depending on the industry. For example, one financial institution suggests that under base case assumptions the DSC should show not less than 1.2:1 for every year of operation during the loan life, and no less than 1.4 on average. Under a Downside Case, with up to 5 years added to the repayment period, the DSC should be no less than 1.0:1 for every year or less than 1.15:1 on average during the life of the loan. Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. On the other hand, contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.29 Wali Memon
  30. 30. Study of Problems with Project Finance Models Assumptions not Documented in Databook No Integrated Cashflow, P&L, Balance Sheet Significant Tax Errors Incorrect Accounting Deferred taxes Fees Operating Reserves No Flexibility for Breakeven Analysis and Other Risk Analysis Effect of cash flow sweeps, covenants and reserves Poor Presentation of the Model to Senior Management - Scope of Model - Model Conclusions30 Wali Memon
  31. 31. Example of Cash Flow Waterfall 200,000 Income Tax ASN Amortization 180,000 Revenues and Cash Flow Distributions in DEPFA Base Case Scenario ASN Interest Payment 160,000 Funding of Distribution and Sinking Funds CAB Amortization 140,000 TIFIA Amortization 120,000 CIB Amortization CIB Interest Payment 100,000 Bank Loan Amortization 80,000 Bank Loan Interest Payment TIFIA Interest Payment and Fee 60,000 Deposit to EMRR 40,000 Major Maintenance (net of use of MMRA) O&M Expenses 20,000 Total Revenue and Liquidity Total Revenue - 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2054 2058 2062 2066 2070 2074 2078 2082 2086 2090 Income Tax Break Even Analysis 200,000 Traffic Growth Post 2026 0.0% Post 2016 Toll Increase 0.0% ASN Amortization Wilton Farm Percent 70.0% Background Traffic Growth 0.0% O&M Increase 0.0% EMRR Increase 0.0% Interest Rate Increase 0.0% ASN Interest Payment 180,000 TIFIA Final Payment 31-Dec-2043 Funding of Distribution Account 160,000 Funding of Sinking Fund CAB Amortization 140,000 TIFIA Amortization 120,000 CIB Amortization CIB Interest Payment 100,000 Bank Loan Amortization 80,000 Bank Loan Interest Payment 60,000 TIFIA Interest Payment and Fee Deposit to EMRR31 Wali Memon 40,000 Major Maintenance (net of use of MMRA) 20,000 O&M Expenses Total Revenue and Liquidity - 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2054 2058 2062 2066 2070 2074 2078 2082 Total Revenue
  32. 32. Structure of Project Finance Models
  33. 33. Basic Model Structure A project finance model should correspond to the fundamentals of project finance: Different equations for different phases of the project Uses and sources of funds to define how project is financed Repayment of debt corresponding to cash flow Compute debt capacity and equity IRR Account for the effect of covenants, cash flow sweeps and other debt features Incorporate debt service reserves and operating reserves33 Wali Memon
  34. 34. Sheet Layout – Project Model Contents Input Sheets (Assumption Book) Different colors, Arranging of inputs Working Sheets Arrangements by revenues, expenses and capital expenditures Arrangements by capacity, demand, and cost structure Sources and Uses of Funds (Monthly Construction Expenditures) Conversion from Annual Computation of Interest During Construction Debt Schedule (Sources of Funds) Depreciation Schedule Financial Statements Income Statement Balance Sheet Cash Flow -- Waterfall Output Sheets Valuation – IRR, Debt Service Coverage Ratios34 Wali Memon
  35. 35. Structure of a Project Finance Model Profit and Loss Revenue, Expense and Capital Expenditure Analysis Taxes Paid, Taxes Inputs: Paid and Taxes Deferred Working Capital Analysis Debt and Operating DSCRADrivers from Schedule Contracts Cash Flow Statement and Other, With Waterfall, Debt Defaults,EPC Contract, Sources and Fixed Sweeps etc. S-Curve, Uses of Funds AssetsInterest Rate During Interest Construction Capitalized DSCRA Balance, Debt Balance Including Fees and Equity Balance Tax Interest Other Roll-up Balance Sheet Equity IRR 35 Wali Memon DSCR, LLCR
  36. 36. Model Sheets in Project Finance Model Debt Schedule – Inputs – Debt Balance From Prices, Costs, Capacity, Drawdown Debt Balance, Technical Parameters Interest Expense Outputs – Working Sheet to Depreciation – Free Cash Flow, Depreciation Expense Derive Revenues Expenses Equity Cash Flow Plant Balance and Working Capital Value (IRR), DSCR Source and Annual Financials – Income Statement, Cash Flow Use of Funds – (CASH WATERFALL)Draw down, IDC, Equity Issues and Balance Sheet and Capital Expenditures 36 Wali Memon
  37. 37. Table of Contents – Example of Different Periodic Statements Note that financial assumptions separated from operational assumptions Different time period for different statements37 Wali Memon
  38. 38. Sources and Uses Example – Summarizes The source and use statement together with the whole project the DSCRs and the IRR summarize the project and is the beginning of the analysis38 Wali Memon
  39. 39. Summary of Modelling Practises
  40. 40. Good Modelling Practise Divide the model into separate modules, beginning with an input section. Compute how the value drivers determine operating revenues, operating expenses and capital expenditures in a separate “working” module rather than in financial statements. Understand the starting point of the model as it relates to the valuation issue (balance sheet, sources and uses statement or both). Carefully define the time period of the model using codes that define alternative phases of the analysis. Work through every single balance sheet item showing the opening balance, changes and the closing balance for each the accounts. This analysis should be made for everything ranging from cash accounts to common equity. Include separate modules for debt issues, fixed plant assets, working capital and cash balances.40 Wali Memon
  41. 41. Simple FormulasThe modeling practices are discussed in another sheet namedspreadsheet conventions.The most important is keeping the formulas simple and making thesheets transparent and easy to read.The following should be in many other lines.
  42. 42. Balance Sheet Accounts and Cork Screws It is good practice to have accounts for all balance sheet items Some examples include: The plant balance The debt balance for each issue Debt service reserve balances Maintenance reserve balances The NOL balance The Un-amortised debt fee balance The basis for changes in working capital Common equity balance42 Wali Memon
  43. 43. Example of Terms for Wind Project Typically, the length of a loan is between 10 and 15 years, but loan terms have become longer as banks have become more experienced in the wind industry. The interest rate is often 1-1.5 per cent above the base rate at which the bank borrows their own funds (referred to as the interbank offer rate). In addition, banks usually charge a loan set-up fee of around 1 per cent of the loan cost, and they can make extra money by offering administrative and account services associated with the loan. Products to fix interest rates or foreign exchange rates are often sold to the project owner. It is also typical for investors to have a series of requirements over the loan period; these are referred to as ‘financial covenants’. These requirements are often the result of the due diligence and are listed within the ‘financing agreement’. Typical covenants include the regular provision of information about operational and financial reporting, insurance coverage and management of project bank accounts.43 Wali Memon
  44. 44. Development Analysis and Time PeriodDefinitions in Models
  45. 45. Switches in Alternative Models Switches for time periods in alternative models General Corporate Models Switch for History versus Forecast Switch for Terminal Period Project Finance Models Switch for Development Period Switch for Construction Period Switch for Operation Period Switch for Debt Repayment Period Leveraged Buyout Models Switch for Transaction Period Switch for Holding Period Switch for Terminal Period45 Wali Memon
  46. 46. Steps in Project Financing Step 1: Development, Feasibility and RFP RFP issues – bid evaluation system, communication, scoring, requirements, cost, stages Step 2: (Financial Close) Construction Financing Funding provided progressively with drawdown procedures that carefully test that money has been spent. Capital market financings can involve up- front money. Capitalize interest, finance up-front fees. Can have take-out at completion. Step 3: (Completion Test) Completion of the Project “Performance completion test.” Before test is satisfied, there is careful allocation of debt and equity and there often is recourse to a credit worthy company for cost over-runs. Step 4: (Commercial Operation Date) Project Financing Cash flows used to cover debt service. If do not meet completion test, do not become project financing.46 Wali Memon
  47. 47. Steps in Development Phase47 Wali Memon
  48. 48. Valuation of Development Expenditures and Probability of Proceeding Simple approach If 10% chance of proceeding, development expenditure is worth 10 times as much as other construction expenditure. Example: 2% of development cost really has a cost of 20% of the project48 Wali Memon
  49. 49. Uncertainty of Costs and Time to Development49 Wali Memon
  50. 50. Project Finance Timing and Finance Finance is critical path. After the Commercial Operation Date, the Permanent Loan is Repaid. The slower the loan is repaid, the better the financial results of the project. Bankers are reluctant to make loans with tenors that extend for the life of the project. After the Commercial Operation Date, the Project can Begin to Pay Dividends Dividends or Distributions Define the Equity Cash Flow of the Project. Dividend Payments can be Limited by Covenants and Cash Flow Sweeps. Financial Metrics in Project Finance Equity IRR – The amount of money you invest relative to the amount you get back. Debt Service Coverage – The cash flow of the project on a year to year basis relative to the amount of money (interest and principal) you have to repay.50 Wali Memon
  51. 51. Project Finance from Development through Commercial Operation) Time to Complete Task (months) 2 6 8 12 20 24 48 49 Completion TestSponsor Risk Construction Project Technical Fuel Supply Permits Letter Ground- Steady-State Identi- and and Power Obtained of breaking Operation fication Economic Purchase Financial Feasibility Intent Agreements Structure Commissioning Negotiated Financial Agreements Signed Time 51 Wali Memon
  52. 52. Timeline Before Commercial Operation 2-3 YRS. 1 YR Development Stage C Negotiations L Financing Negotiations Project Co. Project Contracts (JVA or JDA) Project O Form Partner S “Go-Ahead” O SIdentification Approval i Site & & Further Engineering t Gov’t Offtake M Fuel EPC Other E e Approval Contract Supply O&M Finalizing EPC and Commercial Contracts Design, Engineering & Procurement “Pre-Development” Costs Phase I Development Costs & Expenses Phase II Development Costs & Expenses 52 Wali Memon
  53. 53. Separation of Construction and Operation Time Period Income Statement and Cash Flow Statement Sources and Uses Statement During Construction Distribute cash flow to equity No cash distributions to equity Dividend distribution from the cash flow statement at the Sources and uses of cash to end of the cash flow waterfall determine equity and debt issuance Debt repayment included in the cash flow Debt drawdown and no debt maturities Interest expensed in the income statement Interest expense capitalized to construction Revenues, expenses and depreciation included No revenues, expenses or depreciation53 Wali Memon
  54. 54. Sources and Uses Statement During Construction Interest During Construction IDC is capitalized to construction cost -- this means that interest is not included on the income statements, but it is included as a part of construction cost. Depreciation includes IDC in the base. IDC can be computed from the debt balance. Interest Income on Debt Reserves has similar computations. Monthly versus Annual Sources and Uses The Only Reason for Monthly Analysis of Construction is for Accurate Representation of IDC, Otherwise Annual Would Be Fine: Monthly sources and uses of funds statement computed in exactly the same format, but compute monthly interest When computing interest expense, use the annual interest rate divided by twelve Tabulate the monthly interest balance and replace the lines in the annual model with the sum of the monthly interest. (You could do this with debt balances as well, but that is not necessary.)54 Wali Memon
  55. 55. Equity IRR Issues While the equity IRR is the fundamental measure of return for a project, a number of ambiguities arise from its measurement. Some of these include: Including shareholder subordinated loans in the calculation (these may depend on the tax law regarding the deductibility of interest for a particular country) Including development fees that are paid to the sponsor but do not cover out-of-pocket costs for consultants, lawyers etc. as a cash inflow in the equity IRR calculation Including assumptions with respect to debt re-financing which accelerates cash flows to equity holders. Basic rule: is money going into or out of the pockets of equity investors55 Wali Memon
  56. 56. Free Cash Flow Free Cash Flow (un-geared after tax cash flow) Finance theory suggests analyzing free cash flow and the claims on free cash flow PV of free cash flow discounted at the WACC defines the asset value or the Enterprise Value Free cash flow is the same no matter how high or low the debt level. Free cash flow determines the project IRR Project IRR can be compared with the after-tax interest rate to determine the benefits from leverage In contrast to free cash flow, equity cash flow should be discounted at a higher discount rate56 Wali Memon
  57. 57. Discount Rates and Valuation for Real Estate Projects Merrill Lynch performed a discounted cash flow (“DCF”) analysis on Equity Office, based on projections provided by our management. The illustrative present value indications of unlevered free cash flows for Equity Office for the years 2007 though 2010 using discount rates ranging from 7.25% to 7.75%, based on the estimated cost of capital of Equity Office, which included consideration of historical rates of return for publicly-traded common stocks, risks inherent in the industry and specific risks associated with the continuing operations of Equity Office on a standalone basis, The present value of the illustrative terminal value using estimated 2011 EBITDA based on terminal EBITDA multiples ranging from 17.5x to 18.5x, based upon total enterprise value to estimated 2007 EBITDA multiples for the selected comparable companies.57 Wali Memon
  58. 58. Free Cash Flow Free cash flow can be computed from the income statement or from the cash flow statement. The amount of free cash flow (free after all capital expenditures and operating expenses and taxes) is the sum of equity cash flow and debt service. From the cash flow statement, the formula is: Cash Before Financing Plus: Interest Expense Less: Tax Shield on Interest From the income statement, the formula is: EBITDA Less: Taxes on EBIT Less: Working Capital Investment Less: Capital Expenditures A complexity in measuring free cash flow is making adjustments for interest during construction. Interest during construction would not exist with no debt financing and the tax deductions on the depreciation portion that represents IDC would not exist. The first method is easier to compute, the second method is more intuitive.58 Wali Memon
  59. 59. Free Cash Flow Example59 Wali Memon
  60. 60. IRR, NPV and other Issues NPV calculations are misleading if used to compared two projects of different sizes IRR calculations exaggerate the value of early cash flows and understate the value of later cash flows Projects are exposed to non-traditional risks (discussed earlier). Have high and rapidly changing leverage. Typically have imbedded optionality. Projects have early, certain and large negative cash flows followed by uncertain positive cash flows.60 Wali Memon
  61. 61. Project IRR versus Equity IRR A central issue in finance is equity valuation (P/E) versus enterprise valuation (EBITDA). In project finance, the issue is whether investments should be assessed with project IRR on free cash flow or equity IRR on equity cash flow: In theory valuation of a project is from free cash flow, and the capital structure is irrelevant. A counter point is that financing provides essential valuation information on the risk and value of a project, this is how of banks and insurance companies are valued where financing drives value. In project finance, the level of debt tells a lot about the risk of a project – if a project has more debt capacity, the free cash flows have less risk. Begin with free cash flow and the project IRR to establish the “real” economics of the project. Then evaluate financial criteria such as covenants with equity IRR.61 Wali Memon
  62. 62. Project Finance versus Traditional InvestmentEvaluation Traditional Project Finance Valuation driven by assessment of Valuation driven by the equity IRR project IRR Equity IRR affected by debt leverage Project IRR compared to all-equity Constraint on issuing debt is risk cost of capital assessment of financial institutions Equity IRR and leverage do not impact The constrained optimization can be investment decision used to measure risk62 Wali Memon
  63. 63. Project and Equity IRR Issue – Equity Bridge Loans and Recourse Debt In some projects, equity holders provide loans to the project from their balance sheet instead of equity. The issue arises as to whether these should be considered equity or debt. Example Instead of providing equity, a sponsor secures a loan to the project. The loan will be re-paid in a bullet at the end of seven years. When the loan is re-paid, the sponsor provides equity to finance the loan. Issue Should the equity bridge loan be considered debt or equity for purposes of computing IRR. The loan uses resources of the parent and must be guaranteed by the parent63 Wali Memon
  64. 64. IRR’s in PFI IRR’s are negotiated in PFI transactions as part of the concession agreement where the IRR drives pricing in the contract. Concession agreements in PFI project financings limit increases in the IRR that come about from interest savings from re-financing. (e.g. share excess profit 50/50). In concession agreements, the IRR is used to monitor the performance of the project as well as for the investment decision.64 Wali Memon
  65. 65. Other Valuation Metrics – Payback and Discounted Payback The payback period measures the number of years that it takes before the cumulative forecast of cash flow equals the initial investment. It is criticized because it gives equal weight to cash flows before the payback and zero weight thereafter. However, if you are explaining the benefits of a project and you can tell an investor that the money he invests will be all paid back in three years, and everything else is gravy, the payback can be an effective analysis tool. The payback can be modified where cash flows are accumulated and the payback is measured using discounted cash flows. This is the discounted payback.65 Wali Memon
  66. 66. Hypothetical Investment Decision and Equity IRR CriteriaBegin with the notion that management has a rate of return criteria where only projects thathave an IRR of above 14% are approved for investment and projects that have an IRR below 14%are not. Further, assume that this rate of return is measured using equity cash flow rather thanfree cash flow, due to corporate objectives related to earnings per share (“EPS”) growth. In thishypothetical situation as long as free cash flow from the project is expected to yield a higher rateof return (project IRR) than the after tax cost of debt, the equity return can be increased if moredebt is used to finance the asset. (Magnifying asset returns to increase equity return is the wherethe term leverage comes from). If, because of the reluctance of bankers to take credit risk, debtcannot be raised for the project, the equity return criteria will probably not be met. On the otherhand, if a significant amount of project debt can be raised, the equity IRR will exceed 14% andthe investment will be made. Therefore, in this hypothetical example the amount of debt directlyaffects the investment decision. Indeed, the investment is driven by the amount of debt that canbe raised rather than by the beta of the project or the risk adjusted all-equity cost of capitalrelative to the project IRR.The notion that the leverage of a project affects cost of capital is demonstrated in the followingquote from a rating agency: Nonetheless, a projects leverage level is often an indication of its creditworthiness. For instance, a merchant projects ability to produce a stable and predictable revenue stream will never match that of a traditional contract revenue-driven project. Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. Contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.66 Wali Memon
  67. 67. DSCRs in Project Finance
  68. 68. DSCR - General Discussion Basic Definition – Cash into the project divided by debt paid to the bank Should find in the cash flow statement The rule is that the higher the risk, the higher the DSCR, since a larger multiple of cash flow has to be held in relation to debt-service. The DSCR used in Credit Rating and in Covenants – Measures the possibility of default For example, if a wind project generates a net income of a1 million per annum and the bank requires a DSCR of 1.3, the project could take out a loan for which the debt service would be a770,000 per annum.68 Wali Memon
  69. 69. Debt Sizing Borrowed amount is based on a conservative commercial case Lenders will analyze conservative assumptions because their only recourse is to the project and its cash flow: Conservative reserves estimate (in case of oil & gas) Product price forecast – low Capital and Operating Costs – high Debt sized by conservative case Debt Service Coverage Ratio69 Wali Memon
  70. 70. Debt Capacity from Cash Flows with Different Volatility Low Volatility High Volatility of Cash Flow of Cash Flow High Risk Cash Flows Low Risk Cash Flows High Risk Project has higher margin, shorter-term and declining debt service. Low risk has flat debt service, and longer-term and higher IRR on Equity70 Wali Memon
  71. 71. Determining the Credit Classification of Project Finance Debt Determining the credit classification is important because: Credit classification is probability of default Credit classification and risk drives the credit spread Credit classification drives the ability to gain bank financing Achieving an investment grade bond rating or above drives access to investors in bonds Other than being used for covenants, the primary purpose of credit ratios such as the DSCR is to gauge the credit risk of a project loan. Credit risk in turn is determined by the probability of default of a loan. The reason a PFI project with a 1.2x DSCR and a merchant power plant with a 2.5x DSCR may have the same credit rating is that they both have similar probability of default.71 Wali Memon
  72. 72. Banks or Rating Agencies Value Debt with Risk Classification Systems Map of Internal Ratings to Public Rating Agencies Internal Credit Corresponding Ratings Code Meaning Moodys 1 A Exceptional Aaa 2 B Excellent Aa1 3 C Strong Aa2/Aa3 4 D Good A1/A2/A3 5 E Satisfactory Baa1/Baa2/Baa3 6 F Adequate Ba1 7 G Watch List Ba2/Ba3 8 H Weak B1 9 I Substandard B2/B3 10 L Doubtful Caa - O N In Elimination S In Consolidation72 Z Pending Classification Wali Memon
  73. 73. Risk Classification and Target of BBB in Project Finance from S&P website73 Wali Memon
  74. 74. Updated S&P Stats74 Wali Memon
  75. 75. Traditional Credit Analysis – Backward Looking Credit Ratios to Gauge Bond Ratings and Bank Ratings Credit ratios are used gauge the credit classification from financial statements such as the debt service coverage benchmarks in project finance.75 Wali Memon
  76. 76. General Use of Financial Ratios in Establishing Credit Quality Business Risk/Financial Risk —Financial risk profile—Business risk profile Minimal Modest Intermediate Aggressive Highly leveragedExcellent AAA AA A BBB BBStrong AA A A- BBB- BB-Satisfactory A BBB+ BBB BB+ B+Weak BBB BBB- BB+ BB- BVulnerable BB B+ B+ B B-Financial risk indicative ratios* Minimal Modest Intermediate Aggressive Highly leveragedCash flow (Funds from operations/Debt) (%) Over 60 45–60 30–45 15–30 Below 15Debt leverage (Total debt/Capital) (%) Below 25 25–35 35–45 45–55 Over 55Debt/EBITDA (x) <1.4 1.4–2.0 2.0–3.0 3.0–4.5 >4.5 Key Industry Characteristics And Drivers Of Credit Risk Credit risk impact: High (H); Medium (M); Low (L) Regulatory/Gov Energy Risk factor Cyclicality Competition Capital intensity Technology risk ernment sensitivity Industry H H H L M/H H Airlines (U.S.) H H H M M H Autos* H H H M M M Auto suppliers* H H M H L L/M High technology* H H H M M/H H Mining* H H H L M L Chemicals (bulk)* H H H L M H Hotels* H H H L L M Shipping* H H H L L M Competitive power* H H M L H H Telecoms (Europe) M H H H H L 76 Wali Memon
  77. 77. Strong Ratings Characteristics of Strong Ratings Capacity to generate sufficient cash flow to maintain DSCR’s within industry norms for investment grade ratings. Fully amortizing debt Lender has control over cash flows and collateral Strong management with track record of meeting budgets in the country Comprehensive risk mitigation Characteristics of Weak Ratings DSCR below 1.0 under moderate stress test scenarios Bullet maturities Reserve funds from operating cash flow Lender has limited control over cash flow Management has limited experience in the country77 Wali Memon
  78. 78. Ratings Assignment – Basel II Document Template of objective benchmarks that measure risk factors, such as DSCR’s, LLCR’s and break-even oil prices. Simulation model that alters critical inputs changed that measures the likelihood of default (Monte Carlo Simulation with oil price varied to measure the potential for the DSCR to fall below 1.0) Stress test to evaluate whether the transaction can withstand in a critical revenue or expense. Determine financial flexibility in the face of adversity. Judgmental criteria and weighting systems that use descriptions to distinguish credit quality.78 Wali Memon
  79. 79. DSCR Drives the Debt CapacityThe debt service coverage ratio is afinancial output in a project financetransaction which cannot be determinedby sponsors of a project in advance. The Debt Ratio and Debt Service Coveragedebt service coverage ratio statistic canbe driven my many factors including the 3.5debt to capital ratio. Unlike the DSCR, 3 Averagethe debt to capital ratio is driven by a 2.5 2.74 2.43 Minimumdecision by sponsors and lenders. 2.22 2.19 DSCR 2 1.97 1.98 1.82 1.76 1.68There is a direct relationship between 1.5 1.59 1.45 1.34 1.55 1.45 1.24debt service coverage ratios and the debt 1 1.15to capital ratio once free cash flows have 0.5been established. The table above shows 0the average and minimum debt service 40% 45% 50% 55% 60% 65% 70% 75% 80%coverage ratio for the combined cycle Debt to Capital Ratioplant assuming that price levels for theplant result in a project IRR of 11.09%.The graph illustrates that a debt servicecoverage ratio of 50% is consistent witha minimum debt service coverage ratioof 1.76x and Memon 79 Wali an average debt servicecoverage ratio of 2.19x.
  80. 80. General DSCR Criteria to Establish Debt Levels Electric Power: 1.3-1.4 Resources: 1.5-2.0 Telecoms: 1.5-2.0 Infrastructure: 1.2-1.6 Minimum ratio could dip to 1.5 At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poors will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poors may rely on more conservative scenarios when determining its rating levels. For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.80 Wali Memon
  81. 81. More on DSCR Targets for AlternativeIndustries Ranges in DSCR estimates
  82. 82. Example: DSCR for Wind Power Typically, we want revenues after all operating costs and taxes to be about 50% higher than what we actually need to repay the debt. This means that on any given period, revenues can be a third lower for any reason (whether lower wind, poor operating performance, or lower electricity prices) and we will still have enough money to repay debt. This implies 1.5x DSCR Wind is highly predictable in the long run but highly volatile and uncertain in the short term, thus leading to strong comfort that the long term average will be close to predictions, but with an also strong likelihood that some seasons or even some years could see significantly lower production levels. The DSCR has increased from 1.40x to 1.45x according to a study by LBL.82 Wali Memon
  83. 83. DSCR Criteria (Reference) At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poors will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poors may rely on more conservative scenarios when determining its rating levels. For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.83 Wali Memon
  84. 84. Example of Project Finance as Risk Measurement Survey of Electric Plants84 Wali Memon
  85. 85. DSCR Criteria in PFI Transactions The DSCR in PFI transactions can be very low – in the range of 1.05 – 1.2. The low DSCR results from the tight coverage of revenue and expense fluctuations with contracts. With the low DSCR, small risks in other transactions can become large risks for project loans. For example, interest rate fluctuations may have a small effect on transactions where the DSCR is 1.8, but the fluctuations in interest rates can cause default in the very tight PFI transactions. This is why there are 100% interest rate swaps in PFI.85 Wali Memon
  86. 86. Detailed Issues in Computing the DSCR There are many intricacies in computing the DSCR despite it being a simple ratio. First, some general discussion DSCRs are the primary quantitative measure of project financial credit strength. The DSCR is the ratio of net cash flow to principal and interest obligations. Cash from operations is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal needed to maintain ongoing operations. Should also subtract changes in working capital and sustaining capital expenditures To the extent that a project has tax obligations, such as host country income tax, withholding taxes on dividends and interest paid overseas, etc., these taxes are treated as ongoing expenses needed to keep a project operating.86 Wali Memon
  87. 87. Alternative DSCR Calculations Minimum DSCR The most important ratio that measures the minimum DSCR the project will see through debt maturity. The minimum DSCR will likely point to the projects greatest period of financial stress. Short-term DSCR looks forward three years, as a near-term measure of financial strength. The Average DSCR averages all of the minimum DSCRs remaining through maturity (as opposed to calculating the average CFO and dividing by the average annual debt service). The average DSCR provides a general measure of a projects cash flow coverage of debt obligations. The average DSCR, when viewed alongside the long-term and short-term minimum DSCR, does provide another measure of project comparability. Generally, stronger projects will show annual DSCRs that steadily increase with time to partially offset the risk that future cash flows tend to be less certain than near term cash flows.87 Wali Memon
  88. 88. Difference Between Free Cash Flow and Cash Flow for the DSCR Free cash flow Excludes interest income Adjusts taxes to remove benefits of interest income Includes proceeds from asset sales and insurance proceeds Determines the amount the project would earn if there was no debt financing Should make adjustments for interest during construction Cash flow for debt service Includes interest income Uses actual taxes Excludes amounts that will not be available on an on-going basis to pay debt service88 Wali Memon
  89. 89. Issue 1: DSRA Balances in the DSCR A project has better quality if it has a debt service reserve account Why not include all cash available to pay bank, including cash in accounts According to S&P The ratio calculation also excludes any cash balances that a project could draw on to service debt, such as the debt service reserve fund or maintenance reserve funds.89 Wali Memon
  90. 90. Issue 2: Senior and Subordinated DSCR Senior DSCR: For the senior DSCR, divide the net cash flow by the senior debt service obligations, exactly as it would if only one class of debt existed. Subordinated DSCR – Two Methods. The first method calculates the ratio of the total net cash flow to the projects total debt service obligations (senior plus subordinated). This consolidated calculation provides the only true measure of project cash flow available to service subordinated debt. The second method takes the net cash flow and then subtracts the senior debt service obligation to determine the residual cash flow available to cover subordinated debt service. This method, does not, however, provide a reliable measure of credit risk that subordinated debt faces. A combination of small subordinated debt service relative to the residual CFO could result in a much higher subordinated DSCR relative to the consolidated DSCR calculation. Moreover, the ratio of residual CFO to subordinated debt is much more sensitive to small changes to a projects total CFO than the consolidated measure.90 Wali Memon
  91. 91. Issue 3: Operating Reserves and Debt Service Reserve Account Movements Operating Reserves If cash must be put aside into a reserve account for major maintenance or other lumpy expenditures, the cash that goes into the accounts should be treated as a cash outflow, like an operating expense. When the operating expense occurs and funds are withdrawn, then the cash withdrawn is included as an inflow in the DSCR. Therefore, the DSCR is smoothed out Debt Service Reserve Account Sometimes, money is put aside in a DSRA account from operating cash flows. If there are cash short-falls, then cash is taken out of the DSRA. Is the issue the same91 Wali Memon
  92. 92. Other DSCR Issues In reviewing various transactions, various DSCR issues arise. Some of these include: If there is a cash flow sweep, should an interest only ratio be computed, or should alternative ratios be used. In computing break-even analysis should debt service reserves be included in the ratio. If there are breakage costs for interest rate swaps, how should breakage costs be treated. Should different ratios be used for backward looking analysis and forward looking analysis. In using DSCR’s as triggers to limit dividends or to sweep cash flow, which ratios should be used.92 Wali Memon
  93. 93. Timing of DSCR Calculations The DSCR is not generally computed before the date of project completion. Therefore, language related to the definition of the completion of the project must be included in the loan agreement: "Completion Date" means the first date on which the Agent receives notification from the Lenders Technical Adviser that the following conditions have been fulfilled to the satisfaction of the Lenders Technical Adviser: [the completion tests under the Concession Agreement have been completed, the Authority has issued to the Borrower the [Completion Certificate] pursuant to Clause {cross-reference} of the Concession Agreement and the [Operating Commencement Date] under the Concession Agreement has occurred]; [and] [the completion tests under the Construction Contract have been completed and the Borrower has issued to the Contractor the [Final Acceptance Certificate] pursuant to Clause {cross-reference} of the Construction Contract]; [and {describe other Completion Date conditions}][;93 Wali Memon
  94. 94. Fundamental Events of Default The primary function of the DSCR is to measure the probability of defalut – a ratio of 1.0 implies a default. Fundamental events of default include the failure of the borrower to pay debt service; failure to comply with insurance requirements; entry of a final court judgment in excess of a significant dollar amount which is not paid or stayed after a certain period; abandonment of the project; bankruptcy of the borrower; failure of the sponsor to maintain ownership of the project (if the sponsors ownership is a critical component of the evaluation of the projects credit risk).94 Wali Memon
  95. 95. Other Events of Default - Reference Other Events of Default Include: operational covenants, a merger or sale of assets failure to deliver notices failure to obtain or comply with governmental permits. Depends on Materiality Negotiated ad hoc. Agreements should provide for a clear and adequately described mechanism for allowing the parties to deal with the defaulted project. The hardest part of any negotiation is the definitions of the triggers (called "events of default") which allow banks, in theory, to have the right to take the project from the investors. It is not a simple task, as banks want to be able to step in as soon as something fishy appears, but on the other hand, they do not want to get too closely involved in the running of a project and the inevitable hiccups that happen; it also makes sense to step in only if there is a real problem which the investors seems unable or unwilling to solve. Investors emphatically do not want the banks to have the right to stp in the project, but they know that it is the price to pay to get the leverage they want (in the wind sector, banks usually provide 70-80% of the investment amount upfront)95 Wali Memon
  96. 96. LLCR and PLCR in Credit Analysis
  97. 97. LLCR and PLCR Loan Life Coverage Ratio (LLCR): The LLCR computes the present value of cash flows over the debt tenor at the interest rate on debt as the numerator of the ratio. The denominator of the ratio is the present value of debt service at the debt rate. The denominator should equate to the amount of the debt. The denominator should be reduced for debt service and other reserves Project Life Coverage Ratio (PLCR): The PLCR is similar to the LLCR except that the present value of cash flows is computed over the economic life rather than over the debt tenor. As with the LLCR, the denominator of the PLCR is the present value of debt service at the debt rate. The PLCR measures how much “tail” the project has from cash flows after the loan is re-paid.97 Wali Memon
  98. 98. General Mathematics of LLCR To see how the LLCR works, consider the following points If all cash flow were invested at the interest rate in a bank account, and there was a bullet payment, then one could measure if that cash account was high enough to cover debt payments. If the cash account in the above example were reduced by maturity payments, the end result would be no different. If there is money in a DSRA, this could be used to make the requirement less, it is just like the concept of net debt in corporate finance. The present value of debt service at the interest rate is the same as total debt98 Wali Memon
  99. 99. Loan Life Coverage Ratio (LLCR) Loan Life Coverage Ratio – the present value of cash flow before debt service – using the interest rate; divided by the remaining debt balance: LLCR = PV (debt rate, cash before debt service)/Debt Balance - DSRA Essentially the LLCR is DSCR on a present value basis so that the credit quality of the whole project is measured. LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR99 Wali Memon
  100. 100. LLCR and Credit Quality The LLCR Concept can be used to gauge the economics of the project relative to the amount of debt outstanding: If no dividends can be paid until all of the debt is paid, the present value of cash flow can be compared to the present value of the debt. If the present value of the debt exceeds the present value of the free cash flow at the debt rate, there is no way the project can payoff the debt – the project has too much gearing. If the debt holders get all of the cash flow before any equity, the present value of the debt relative to the present value of cash is an effective statistic that can measure how much a variable changes before a debt default occurs. For example, if the cost increases by a certain amount, a LLCR of 1.0 measures the break-even point before which the debt cannot be repaid.100 Wali Memon
  101. 101. Project Life Coverage Ratio (PLCR) The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period. In the PLCR, the numerator uses the present value of cash flow over the life of the project rather than over the life of the debt. The PLCR is related to the loan to value ratio if one assumes that the present value of the cash flow is the value of the project: PLCR = Value/Loans Debt to Value = Loan/Value Debt to Value = 1/PLCR As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount.101 Wali Memon
  102. 102. LLCR and PLCR The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period. As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount. Loan Life Coverage Ratio Essentially the DSCR on a present value basis LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR Prospective DSCR and Borrowing Base102 Wali Memon
  103. 103. Debt Tenor and Average Life Lenders want to know how their risk reduces over the life of a project. If the loan was only for one year, the risks are less than a 20 year loan, if the cash flows are the same and the cash flow can support the debt repayment. In project finance, the risk associated with longer terms is measured by the average loan life. Average loan life is used in a similar manner to the payback period to check that the loan is not over-extended. The Average loan life accounts for the manner in which a loan is paid back – if the loan has a bullet payment, the loan life is the same as the tenor. The formula is simply the average outstanding amount of the loan divided by the initial balance of the loan.103 Wali Memon
  104. 104. Credit Ratings, Loan Pricing and Loan Value
  105. 105. Default Rates and Credit Spreads -- Note that Credit Spreads Increase When Default Rates Increase105 Wali Memon
  106. 106. Credit Spreads Increase of 5% Credit Crisis106 Wali Memon
  107. 107. Bond Ratings and Yield SpreadCredit classification is very important in establishing the access tofunding and the cost of funding as illustrated on the graphs below: 107 Wali Memon
  108. 108. Table of Bond Spreads Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr Aaa/AAA 5 10 15 22 27 30 55 Aa1/AA+ 10 15 20 32 37 40 60 The following is an example of bond spreads at a point in time Aa2/AA 15 25 30 37 Note the Jump50 44 at 65 Aa3/AA- 20 30 35 45 BB+ to BB 53 55 70 (bondsonline.com). These spreads change over time. A1/A+ 30 40 45 58 62 65 79 A2/A 40 50 57 65 71 75 90 A3/A- 50 65 79 85 82 88 108 Baa1/BBB+ 60 75 90 97 100 107 127 Baa2/BBB 65 80 88 95 126 149 175 Baa3/BBB- 75 90 105 112 116 121 146 Ba1/BB+ 85 100 115 124 130 133 168 Ba2/BB 290 290 265 240 265 210 235 Ba3/BB- 320 395 420 370 320 290 300 B1/B+ 500 525 600 425 425 375 450 B2/B 525 550 600 500 450 450 725 B3/B- 725 800 775 800 750 775 850 Caa/CCC 1500 1600 1550 1400 1300 1375 1500108 Wali Memon
  109. 109. Theory of Credit Spreads: Credit Spread on Debt Facilities S The Credit Triangle The spread on a loan is directly related to the probability of default and the loss, given default. S = P (1-R) P R The credit spread (s) can be characterized as the default probability (P)109times the loss in the event of a default (R). Wali Memon
  110. 110. Expected Loss Can Be Broken Down Into Three Components Borrower Risk Facility Risk Related EXPECTED Probability of Loss Severity Loan Equivalent LOSS Default x Given Default x Exposure = (PD) (Severity) (Exposure) $$ % % $$ What is the probability If default occurs, how If default occurs, how of the counterparty much of this do we much exposure do we defaulting? expect to lose? expect to have?The focus of grading tools is on modeling PD 110 Wali Memon
  111. 111. Comparison of PD x LGD with Precise Formula Case 1: No LGD and One Year .111 Wali Memon
  112. 112. Comparison of PD x LGD with Precise Formula Case 2: LGD and Multiple Years Assumptions Years 5 BB 5 Risk Free Rate 1 5% 7 Prob Default 1 20.8% PD 20.80% Loss Given Default 1 80% Alternative Computations of Credit Spread Credit Spread 1 3.88% PD x LGD 1 16.64% Proof . Opening Closing Value Risk Free 100 127.63 127.63 Prob Closing Value Risky - No Default 100 0.95 153.01 145.36 Risky - Default 100 0.05 30.60 1.53 Total Value 146.89 FALSE Credit Spread Formula With LGD cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1112 Wali Memon
  113. 113. Probability of DefaultThis chart shows rating migrations and the probability of default foralternative loans. Note the increase in default probability with longerloans. 113 Wali Memon
  114. 114. Updated Transition Matrix114 Wali Memon
  115. 115. Project Finance and Default History Market participants consistently report lower default rates, and especially lower loss rates on project finance than on other equivalent corporate exposure, largely because of the effect of transaction structuring and transparency and control of collateral. Project finance transactions are by their nature, complex and require a strong understanding of the underlying markets and their risk drivers. Only a limited number of banks have dedicated project finance credit teams.115 Wali Memon
  116. 116. Study of Probability of Default for Project Finance116 Wali Memon
  117. 117. Default Rates by Industry117 Wali Memon

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