The document provides an introduction to project finance modeling. It defines a project as a temporary, one-time activity intended to create a unique product or service. Project finance involves using both debt and equity to finance long-term infrastructure projects, with debt repaid through cash flows generated by the project's operations. Project finance modeling develops analytical models to assess the risk and return of lending to or investing in a project by forecasting its expected future cash flows.

1. Project Finance Modeling
An Introduction

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
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
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
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
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
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
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
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
Course Outline
 Project lending: Credit considerations
 Project investing: Measures of return
 Lending or investing: Free cash flow
 Modeling issues
 Dealing with data

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
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
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
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
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
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
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
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
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
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
Credit Analysis
 What factors influence the ability of a borrower
to repay a loan?
– External factors
– Internal factors

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
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
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
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
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
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
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
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
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
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
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
Strengths and Weaknesses
S – W > U

34. 34
Strengths and Weaknesses
Strengths – Weaknesses > Uncertainty

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
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
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
Project Investing
 Common measures of return
– Cost-benefit analysis (CBA)
– Payback period
– Net present value (NPV)
– Internal rate of return (IRR)

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
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
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
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
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
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