Project finance model

Project finance is only possible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt. A financial model is needed to assess economic feasibility of the project.

Model's output is also used in structuring of a project finance deal. Most importantly, it is used to determine the maximum amount of debt the project company can have and debt repayment profile, so that in any year the debt service coverage ratio (DSCR) should not exceed a predetermined level. DSCR is also used as a measure of riskiness of the project and, therefore, as a determinant of interest rate on debt. Minimal DSCR set for a project depends on riskiness of the project, i.e. on predictability and stability of cash flow generated by it. As a rule of thumb, DSCR should not be less than 1.60. However, in some cases (such as power plant projects with strong off-take agreements) it could be set at as low as 1.15.

General structure

A general structure of any financial model is very simple: input – calculation algorithm – output. While the output for a project finance model is more or less uniform and the calculation algorithm is predetermined by accounting rules, the input is highly project-specific. Generally, it can be subdivided into the following categories:

Variables needed for forecasting revenues
Variables needed for forecasting expenses
Capital expenditures
Financing

Input for a thermal power plant model

For a thermal power plant project, a project finance model's input typically looks as follows:

Power plant's installed capacity, MW
Capacity utilization factor
Internal consumption rate, %
Power plant's gross efficiency, %
Lower heat value of fuel, MJ/unit
Price of fuel, $/unit
Offtake electricity price, $/MWh
Inflation rate, %
Fuel price escalation, % per year
Electricity price escalation, % per year
Cost of consumables, $/MWh
Equipment maintenance, $/MWh
Depreciation period, years
Personnel expenses, $ per year
General and administrative expenses, $ per year
Corporate tax rate, %
Total CAPEX, $
'Buffer' for cost overruns, % of total amount to be financed
Fuel and consumables reserve, days
Imported equipment, % of total CAPEX
Import duties, %
Initial insurance premium, % of total CAPEX
Construction period, years
Period of commercial operation, years
Equity portion in total financing, %
Required return on equity, %
Tenor of debt, years
Grace period on debt repayment, years
Interest rate during construction, %
Interest rate during commercial operation, %

Excel spreadsheets

Project finance models are usually built as Excel spreadsheets and typically consist of the following interlinked sheets:

Data input and assumptions
Capital costs (construction)
Insurance
Taxes
Depreciation
Financings
Income statement
Balance sheet
Cash flow
Retained earnings
Coverage ratios
Present values

A model is usually built for a most probable (or base) case. Then, a model sensitivity analysis is conducted to determine effects of changes in input variables on key outputs, such as internal rate of return (IRR), net present value (NPV) and payback period.

Key metrics

Cash flow available for debt service (CFADS)
Debt service coverage ratio (DSCR)
Project life cover ratio (PLCR): ratio of the net present value of the cashflow over the remaining full life of the project to the outstanding debt balance in the period. It is a measure of the number of times the cash flow over the life of the project can repay the outstanding debt balance.
Loan life cover ratio (LLCR): ratio of the net present value of the cashflow over the scheduled life of the loan to the outstanding debt balance in the period.
Drawdown cover ratio (DCR)
Historic debt service cover ratio (HDSCR)
Projected debt service cover ratio (PDSCR)
Repayment cover ratio (RCR)
Internal rate of return (IRR)
Return on assets (ROA)
Return on equity (ROE)

Debt sculpting

Debt sculpting is common in the financial modelling of a project. It means that the principal repayment obligations have been calculated to ensure that the principal and interest obligations are appropriately matched to the strength and pattern of the cashflows in each period.

The most common ways to do so are to manually adjust the principal repayment in each period, or to algebraically solve the principal repayment to achieve a desired DSCR.

References

Penelope Lynch, Financial Modelling for Project Finance, 1997, ISBN 978-1-85564-544-8.
Peter K Nevitt and Frank J Fabozzi, Project Financing, 2000, ISBN 978-1-85564-791-6
John Tjia, Building Financial Models, 2009, ISBN 978-0-07-160889-3