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Project Finance Modeling


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Project Finance Modeling

  1. 1. Project Finance Modeling An Introduction
  2. 2. 2 What is a “project”?  A project is a temporary, one-time activity undertaken to create a unique product or service, which is intended to bring about beneficial change or added value.
  3. 3. 3 What is a “project”?  A project’s characteristic of being a temporary, one-time event contrasts with processes or operations, which are ongoing activities intended to create the same product or service over and over again.
  4. 4. 4 What is “project finance”?  Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure.  Both project debt and equity are used to finance the project.  Debt is repaid using the cash flow generated by operation of the project, rather than other resources of the project owners.
  5. 5. 5 What is “project finance”?  Financing is typically secured by all project assets, including any revenue-producing contracts intended to be fulfilled by future activities of the completed project.  Lenders are also given the right to assume control of a project if the project company has difficulties complying with loan terms.
  6. 6. 6 What is “project finance”?  Generally, a special purpose entity is created for each project.  This shields other assets owned by a project sponsor from failure of the project.  As a special purpose entity, the project company has no assets other than the project
  7. 7. 7 What is “project finance modeling”?  Project modeling is the development of analytical models to assess the risk-reward, cost-benefit or feasibility of a project.  Project finance modeling is the development of analytical models to assess the risk-reward of lending to or investing in a project.
  8. 8. 8 What is “project finance modeling”?  All financial evaluations of a project depend upon projections of expected future cash flows generated by activities of the completed project.  Forecasting project cash flows requires a thorough understanding of the methods, techniques and computer software commonly used in such projections.
  9. 9. 9 What is “project finance modeling”?  The analytical challenge is to design financial projection models that are: – Thorough in scope – Accurate and reliable – Flexible in accommodating revisions – Quick to develop and maintain
  10. 10. 10 Course Outline  Project lending: Credit considerations  Project investing: Measures of return  Lending or investing: Free cash flow  Modeling issues  Dealing with data
  11. 11. 11 Project Lending  Expected from owner before approval: – Economic justification for project  Feasibility study  Cost – benefit analysis – Demographics – Assumptions – Projections – IRR, NPV, etc. – Identified risks
  12. 12. 12 Project Lending  Expected from owner before approval: – Detailed cash flows – Detailed project time schedule  Together, cash flows and time schedule dictate borrowing and repayment schedule
  13. 13. 13 Project Lending  Expected from bank before approval: – Evaluation of project benefits and risks  Is economic justification believable? – Are assumptions logical and believable? – Are financial projections, especially cash flow, realistic? – Have all risks been adequately identified?  Does company management have sufficient expertise?  Can any risks be mitigated by insurance or “bonding”?  If recourse, can owner survive failed project and repay bank?
  14. 14. 14 Project Lending  Expected from bank before approval: – Is project time schedule realistic? – Is cost overrun contingency adequate? – Proposal for loan structure  Collateral  Covenants  Recourse – Preparation of borrowing schedule – Can bank manage failed project to recover loan?
  15. 15. 15 Project Lending  Expected from owner after approval: – Project status reports  Percentage completion  Actual expenditures versus budgeted expenditures  Cash flow re-forecasts  Changes to project  Increases or decreases in risk – Borrowing requests … based on scheduled expenditures
  16. 16. 16 Project Lending  Expected from bank after approval: – Ongoing review of status reports provided by owner – Regular on-site inspections of project progress by experts – Careful “yes or no” decision to fund each borrowing request based on project progress and known risks – If recourse, ongoing review of owner’s other “normal” business operations through ordinary credit analysis
  17. 17. 17 Project Lending  Loan structure – Recourse (guarantees, etc.)  Bank wants recourse to owner and owner’s assets – Moral value even if limited economic value [partner/ sophisticated investor theory] – Exercising rights of recourse expensive, time consuming  Owner wants “non-recourse” financing
  18. 18. 18 Project Lending  Loan structure – To completion versus through completion:  To completion – Acquisition/ development/ construction only – Completion guarantee  From owner to bank  From general contractor to owner, assigned to bank  Liquidated damages – Standby or “take out” financing
  19. 19. 19 Project Lending  Loan structure – To completion versus through completion:  Through completion – Financing ongoing operations – Clear conditions for if/ when working capital line/ loan begins – Clear conditions for if/ when acquisition/ construction loan converts into permanent term loan for property/ equipment – Revised set of operating covenants
  20. 20. 20 Project Lending  Loan structure – Covenants  Acquisition/ construction – Restrictive covenants to prevent loss of collateral value – Prescriptive covenants to promote successful completion – Tangible Net Worth – Net Working Capital  Permanent/ operational financing – Debt/ Worth – Current Ratio – EBITDA
  21. 21. 21 Credit Analysis  What factors influence the ability of a borrower to repay a loan? – External factors – Internal factors
  22. 22. 22 Credit Analysis  External versus internal factors: – Good external factors can not offset poor internal factors. – Good internal factors can often mitigate weak external factors.
  23. 23. 23 Credit Analysis  External factor analysis — a caution: – There are vast amounts of macro economic data available. The amount of industry-specific data is overwhelming. Analyzing these external factors is time consuming and often expensive. Decisions about how much analysis of external factors to include in a credit report should be based on the degree to which the analyst thinks these factors will affect a borrower’s ability to repay its loans.
  24. 24. 24 PEST Analysis  Political Factors – Political factors include governmental laws and regulations which define the rules of commerce.  Political stability  Labor laws  Tax laws  Trade restrictions  Environmental regulations
  25. 25. 25 PEST Analysis  Economic Factors – Economic factors include basic characteristics that affect consumer purchasing power and corporate capital costs.  Economic growth  Wage rates  Inflation rate  Interest rates  Exchange rates  Energy costs
  26. 26. 26 PEST Analysis  Social Factors – Social factors include demographic and cultural attitudes of a population that can influence issues as diverse as work force flexibility and market potential.  Population demographics  Educational quality  Labor unions  Healthcare  Work attitudes
  27. 27. 27 PEST Analysis  Technological Factors – Technological factors include research and development activities that can lower barriers to entry, reduce minimum efficient production levels, and influence outsourcing decisions.  Basic academic research  Applied research and development  Automation potential  Information systems  Technology incentives
  28. 28. 28 Sector Analysis  Industry sector analysis: – If a borrower has a significant share of industry sales, say 10% or more, it is then very important to fully review available information regarding the outlook for the industry. (Many government agencies and investment banks publish a variety of sector reviews.)
  29. 29. 29 SWOT Analysis  Strengths – A company’s strengths are its resources and capabilities that can be used as a basis for developing a competitive advantage.  Good reputation  Strong brand names  Patents  Proprietary cost advantages  Access to high-grade natural resources  Favorable access to distribution networks
  30. 30. 30 SWOT Analysis  Weaknesses – The absence of certain strengths usually results in weaknesses.  Poor reputation  Weak brand names  Lack of patent protection  High cost structure  Lack of access to natural resources  Lack of access to key distribution channels
  31. 31. 31 SWOT Analysis  Opportunities – The external environment may offer certain new opportunities for profit and growth.  Unfulfilled customer need  Development of new technologies  Loosening of regulations  Removal of trade barriers
  32. 32. 32 SWOT Analysis  Threats – Changes in the external environment may also present threats to a company.  Shifts in consumer tastes away from company’s products  Emergence of substitute products  New regulations  Increased trade barriers
  33. 33. 33 Strengths and Weaknesses S – W > U
  34. 34. 34 Strengths and Weaknesses Strengths – Weaknesses > Uncertainty
  35. 35. 35 Credit Analysis  Internal factor analysis: – Financial information  Ratios  Trends  Cash flow – Management information  Background and experience  Behavior as reflected in financial performance
  36. 36. 36 Liquidity Ratios  Current Ratio sLiabilitieCurrentTotal AssetsCurrentTotal  This ratio is a rough indication of a company’s ability to service its current liabilities when due. A high value is better than a low value. A ratio larger than one means there are more assets that are already cash or that can be converted into cash within a year than there are liabilities that will have to be paid with cash. However, the composition and quality of current assets is a critical factor in the analysis of an individual company’s liquidity.
  37. 37. 37 Leverage Ratios  Debt/ Worth  This ratio measures the relationship between capital contributed by creditors and that contributed by owners (minus any intangibles). It expresses the degree to which owners’ equity provides protection for creditors. A value that is lower than the industry norm is better than a value that is higher than the industry norm. A lower ratio generally indicates greater long-term financial safety and greater flexibility to borrow in the future. WorthNetTangible sLiabilitieTotal
  38. 38. 38 Project Investing  Common measures of return – Cost-benefit analysis (CBA) – Payback period – Net present value (NPV) – Internal rate of return (IRR)
  39. 39. 39 Project Investing  Cost-benefit analysis – Compare total costs to total benefits – If competing projects, choose:  Most profitable  “Best” – Not always financial
  40. 40. 40 Project Investing  Payback period – Period of time it takes to recover the initial investment – Does not properly account for:  Time value of money  Inflation  Risk  Financing costs – Managers like it because it is easy
  41. 41. 41 Project Investing  Internal Rate of Return – Potential problems:  Understates reinvestment value of future positive cash flows  Cannot deal with negative cash flows near end of a project (e.g., environmental cleanup costs)  Cannot deal with changing degrees of risk over life of a project – Managers like it because it can be used to compare projects of different size
  42. 42. 42 Project Investing  Mutual exclusivity – Assume a limit on availability of capital at an acceptable cost – Corresponding limit on the number of investments that can be made  If projects are mutually exclusive, academics argue that NPV is a better analytical measure than IRR  Ex: High initial cost versus high future cash flows
  43. 43. 43 Project Investing  Complex measures of return – Modified internal rate of return (MIRR)  Positive cash flows discounted at weighted average cost of capital (WACC) instead of discount rate making positive cash flows more valuable  Future negative cash flows discounted separately and added to initial cost of project
  44. 44. 44 Project Investing  Complex measures of return – Real options analysis  Each separate cash flow assumed to have unique uncertainty or risk  Uncertainty of each separate cash flow accounted for using “risk-adjusting probabilities”  Risk-adjusted cash flows then discounted at risk-free rate