The nature of interactions in the project financial model and its central role in project financing are displayed in Figure 14.3, which helps to visualize the tasks and activities performed in order to arrive at an optimized project financing structure. The annual amounts of cost and revenue projections are used to calculate the project company's annual cash flows and debt service requirements. Among the first order calculation from the project financial model outputs are the drawdown amounts of debt and equity in order to satisfy funding requirements.
Figure 14.3 The Central Role of the Project Financial Model
After all calculations are performed, the project model outputs define the project debt service profile, which is used in repayment schedule negotiations. From these
calculations various project parameters and ratios are calculated, such as:
1. Project sources and uses of funds, distributable cash, and directions for the project company's waterfall accounts
2. The project's NPV, which is the sum of the project's annual cash flows discounted at the sponsor company's weighted cost of capital. Sometimes, the profit to investment ratio is used instead of NPV, which is defined as NPV/initial investment. At other times, the project's risk adjusted NPV is estimated to account for cash flow
uncertainty each year
3. The sponsors' or equity IRR, which is the rate that makes the project NPV equal to zero and the minimum sponsor IRR, is used as a cut off point when assessing if the investment in a project is viable. The equity IRR for moderate risk projects in low risk countries ranges from 12% to 15% a year up to 20% for projects in developing
countries (Yescombe, 2014)
4. The annual debt service cover ratio (ADSCR), which is calculated from projections after the project company has been operating for at least one year. This ratio is defined as: ADSCR =annual net operating cash flow/annual project debt service, where annual project debt service is annual principal repayment plus interest. ADSCR is a basic
summary of the project company's ability to raise the funds required to meet interest expenses and principal payments during a specific time period. But, it is one
determinant of the level of debt the SPC is able to raise. The minimum ADSCR varies by project risk from 1.2 for accommodation based contracts to 2.0 for merchant power plants without offtake contracts or price hedging (Yescombe, 2014)
Accommodation type projects are social infrastructure projects such as schools, hospitals, prisons, elder care facilities, stadiums, etc.
5. Loan life cover ratio (LLCR) = NPV of net operating cash flow / (debt balance – service reserve amounts), where debt balance is usually senior debt at the time of calculation. This ratio gives lenders an indication of how many times the project' net cash flow over the project lifetime can repay the outstanding debt. The minimum initial requirement for average risk projects can be as 10% higher than the minimum ADSCR requirement
6. The average of annual ADSCR and LLCR ratios over the project's number of years of operations are better long term indicators of coverage and, therefore, are given more weight in lending decisions
7. Project life cover ratio (PLCR) = Net operating cash flow before debt service for the project's entire life discounted at the rate of NPV/debt outstanding at time of
calculation. This ratio is used in cases of cash flow volatility that cause on time
repayment difficulties. Lenders usually want to see PLCRs anywhere from 15% to 20%
higher than the minimum ADRCR
8. In projects that extract natural resources, two ratios are used in the evaluation of their financeability and reserve cover ratios. The first ratio is the production to reserves ratio (PRR) to determine if reserves are depleted by production. The second ratio is the reserve life index (RLI) defined as: RLI = reserves/production, which shows the number of years of reserves assuming the project company has the ability to develop the source of the reserves
9. Debt to equity ratio (D/E). The debt to equity ratio determines the SPC's financial leverage and shows the share of assets being financed through debt. It is considered a long term project company solvency indicator of the soundness its long term financial policies. The debt to equity ratio varies by type of project and can range from 90:10 for accommodation based contracts to 50:50 for natural resource extraction projects
10. Project company financial statements are derived from the financial model
calculations and—in addition to being used for tax calculation, financial analysis, and reporting purposes—they are used to check the validity of project model inputs and outputs
11. A valuable output of the project financial model is the model's sensitivity to results of different decision parameters due to changes in a single model driver or input.
Through sensitivity analysis one can identify which single individual model input to change in order to help improve project economics and ensure its long term viability
12. Sound development, simulation, and evaluation of different scenarios are only possible through the project financial model. Plausible scenario simulations for random changes in model assumptions and inputs are valuable because they define the outcome ranges of financial parameters and ratios under different probabilities of occurrence. Especially useful are black swan event scenario simulations for rare but extreme shocks to the project company's operations
Since account agreements, waterfall account structures, and various precedents and
conditions can be specified in the project financial model, the cascade of payments out of proceeds account is a model output requirement of lenders and sponsors and for that reason it must be tested and validated. Furthermore, the evaluation of the other project financial model outputs serves other useful functions and yields benefits which include the following:
1. Understanding the effects and impacts of changes in the amounts of project company debt capacity
2. Assessing the value of pursuing different short term project funding facilities based on cost considerations
3. Incorporating the effects of different refinancing channels and facilities in long term financing decisions
4. Determining the appropriate project life span to ensure adequate loan repayment capacity and equity investor expected returns
5. Establishing the adequacy of credit enhancements to confirm profitable project company viability
6. Validating the reasonableness and ensuring consistency of both financial model inputs and outputs