Financing of BOT concessions follows the limited recourse project finance model, whereby a project’s cash flow and risk profile are used to determine the financial structure, sources of finance and terms of lending. The direct link between the cash flow generation potential and funding methods means that sponsors, investors and lenders must ensure that the project is financed in such a way that each will achieve their expected returns.
Three financial packages are first considered to determine the most appropriate finance package for the water treatment plant (as shown in Table A1.1):
Package 1: Debt/equity 65:35 Package 2: Debt/equity 75:25 Package 3: Debt/equity 70:30
AFCOs’ minimum acceptable rate of return (MARR) is assumed to be 11%, and the basic economic parameters of each combination
Table A1.1 Economic parameters of the financial models
Economic parameters Model 1: 65/35 Model 2: 75/25 Model 3: 70/30
WACC (%) 8.61 5.97 7.88
Debt/equity (US$) 39:21 45:15 42:18
IRR (%) 12.6 17 13.2
of debt and equity after adjustment for inflation are illustrated in Table A1.1.
The most important element in project finance is the raising of debt capital. Furthermore, water projects generate cash flows that are typically steady or grow slowly; thus, financing justifies higher debt ratios with long maturities. From Table A1.1, Model 2 (debt/equity ratio 75:25) is chosen as the best option of those initially considered to finance the project as it has a higher leverage of debt. Although the internal rate of return (IRR) for all three models exceeds the MARR of 11%, Model 2 generates the highest IRR and the lowest project WACC (weighted average cost of capital) but has the longest payback period.
Project debt will be raised domestically, thus protecting the project from potential losses from currency fluctuation. Local finance is par- ticularly suitable because the host country benefits from high vol- ume of institutional financing strengthened by recent amendments to regulations which now permit increased involvement of insurance companies in AA-rated project bonds. Additionally, the debt market for infrastructure projects in the host country offers long-term loans.
Finance for the water treatment project will be raised by commer- cial bank loans and institutional private placement. DIV Bank will provide the senior debt (45%). The financing terms of banks allow refinancing at lower interest rate every 3 years until the debt is fully serviced.
Municipal bonds will also be used to finance the project, sold via private placement to institutional investors, mainly insurance com- panies and pension funds. The bond financing will be considered as subordinated debt, as this type of financing generally provides lower borrowing costs if the credit rating for the project is sufficiently strong.
Many operators deem this method of financing as the forerunner of project finance. The cost of distributing bonds in the private market is
152 Project Finance in Construction
cheaper, and it is easier to renegotiate the terms and conditions of the bond in the event of default.
The bond issue for the project will be managed by CECom Un- derwriters. This represents 55% of the total debt finance, and an AA rating from the host country local rating agency has been secured.
The interest on municipal bonds is tax-free, which further boosts its attractiveness to the investors. The bond issue will comprise of two tranches, the first which will be disbursed during the institutional ten- der and the second after financial close. Overall, the project will utilise financial insurance products and services by commercial insurance underwriters to mitigate financial risks.
Equity share in the total finance for the project as a margin of safety for the lenders is 25%. Equity finance is a condition to the host gov- ernment granting the concession and to the availability of commercial debt funding. ABG, the consortium of the three original equity in- vestors who participate in the equity of the concessionaire, namely AFCO Water, TLC Construction and Ela Group, shares a total contri- bution of 30% of the equity raised for the project. This high stake was required by the lenders to secure a continuing interest of the sponsors throughout the project’s life cycle. The project company has obtained funding opportunities both from the financial market of the host coun- try where local commercial banks will contribute 40% of the equity, and has also attracted international commercial banks for a 20% share, and from multilateral agencies for the remaining 10%.
In order to maintain greater levels of debt-to-equity ratios, part of the equity is in the form of mezzanine contributions (preferred stock), and a rate of return on equity of 15% has been secured throughout the project’s life cycle. Tariff mechanisms have been structured by the host country government to provide this maximum limit of 15% rate of return to the shareholders.
Assessment of Model 2
Base case
The finance package for this project is 75% debt and 25% equity, which provides the lowest WACC and the best IRR.
The project is considered on the following metrics:
Capital expenditures US$60 million
Operational expenditures US$2 million per annum
Revenue US$195 million
MARR 11%
Lending rate 4.0%, years 3–5 inclusive Lending rate 3.0%, years 6–8 inclusive
Lending rate 2.5%, years 9–10 inclusive (through an IR swap)
Inflation rate 2.0%
Dividend rate 15%
Tax rate 26%
FigureA1.1 illustrates the cumulative cash flows of the project before the cost of finance is included at an annual inflation rate of 2%. This is the base case assessment performed by the sponsor.
From Figure A1.1 and Table A1.2, it can be seen that the project will achieve an IRR of 17% with a payback period of just over 7 years from granting of the concession. The net present value is US$134.03 million with a discount rate of 0.
Table A1.2 is now developed to show the project’s cash flow after the cost of finance is included and to determine the debt service cov- erage ratio (DSCR) for each year of operation. In years 3–9, the DSCR increases from 1.42 to 1.53, respectively.
–100 –50 0 50 100 150
17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
Time (years)
US$ million
Figure A1.1 The project’s cumulative cash flow adjusted for inflation.
TableA1.2CashflowandDSCRforinflation-adjustedbasecase TimeCost Operations and maintenanceRevenueCash flow Inflation- adjusted cashflowCumulative cashflowCostof finance
Cash flow available after interest payment
Cash dedi- catedto service princi- pal
Outstanding balanceof debt Cash flow after debt financeDSCRDividend payment
Profit after divi- dend pay- ment 1−30−30−30.00−30.00 2−30−30−30.00−60.00−45.00 32131111.22−48.78−1.809.426.12−38.883.301.420.492.80 42131111.44−37.34−1.569.896.43−32.453.461.430.522.94 52131111.67−25.66−1.3010.386.74−25.703.631.450.543.09 62131111.91−13.76−0.7711.147.24−18.473.901.490.583.31 72131112.14−1.61−0.5511.597.53−10.934.061.500.613.45 82131112.3910.78−0.3312.067.84−3.094.221.520.633.59 92131112.6423.41−0.0812.568.165.074.401.530.663.74 102131112.8936.3012.891.9310.96 112131113.1549.4513.151.9711.17 122131113.4162.8613.412.0111.40 132131113.6876.5313.682.0511.63 142131113.9590.4813.952.0911.86 152131114.23104.7114.232.1312.10 162131114.51119.2314.512.1812.34 172131114.80134.0314.802.2212.58 IRR15%17%134116.94
US$116.94 million is available after debt service and dividend pay- ments over the operational life of the project, rising from US$2.8 million at the end of the first year’s operation to US$12.58 million at the end of the final year’s operation. This assessment illustrates that there are sufficient margins in the project to make it attractive to lenders and equity takers. The authors have not assessed dividends after tax in this assessment as would be the norm.
Worst case
For the worst case scenario, the authors have identified three potential risks: revenues decrease by 10%, operations and maintenance costs increase by 25%, and inflation increases by 3%.
The effects of the risks described above are then represented in Table A1.3, and worst case cash flows and DSCRs are computed. The IRR has fallen to 15% but is still above the MARR of 11%. The DSCRs remain at, or above, 1.4, and the cash available before tax is US$107.68 million.
Conclusion
On the basis of the context of the assessment, the finance package con- sisting of a mixture of debt and equity (75:25) is the least risky option in terms of finance because debt is the cheapest form of borrowing and generates the highest return for shareholders. The project is consid- ered risky as the technology is proven and host country guarantees are in place and the project has contract-led revenues. Additional revenue streams can also be generated from this project under the concession.
In the worst case scenario, typical risks for this type of project are considered, those being rising energy costs, possible shortfalls in the quality of water and higher-than-expected inflation.
The initial assessment to determine the commercial viability for all those involved in financing the project is determined based on a single finance package, in this case 75:25 debt/equity, which was primarily selected on the basis of its WACC.
Finally, the cash available in the worst case assessment when dis- counted at 6% would be US$42.7 million.
TableA1.3CashflowsandDSCRforworstcase Time Capital expen- dituresOperational expendituresRevenueCash flow Inflation- adjusted cashflowCumulative cashflowCostof finance
Cash flow available after interest payment
Cash dedi- catedto service princi- pal
Outs- tanding balance ofdebt Cash flow after debt financeDSCRDividend payment
Profit after divi- dend pay- ment 1−30−30.0−30.00−30.00 2−30−30.0−30.00−60.00−45.00 32.511.79.29.48−50.52−1.807.684.99−40.012.691.400.402.28 42.511.79.29.76−40.76−1.608.165.30−34.712.861.410.432.43 52.511.79.210.05−30.71−1.398.665.63−29.073.031.430.452.58 62.511.79.210.35−20.36−0.879.486.16−22.913.321.470.502.82 72.511.79.210.67−9.69−0.699.986.49−16.433.491.490.522.97 82.511.79.210.991.29−0.4910.496.82−9.613.671.500.553.12 92.511.79.211.3112.61−0.2411.077.20−2.413.881.520.583.29 102.511.79.211.6524.2611.651.759.91 112.511.79.212.0036.2712.001.8010.20 122.511.79.212.3648.6312.361.8510.51 132.511.79.212.7361.3712.731.9110.82 142.511.79.213.1274.4813.121.9711.15 152.511.79.213.5187.9913.512.0311.48 162.511.79.213.92101.9113.922.0911.83 172.511.79.214.33116.2414.332.1512.18 IRR12%15%116.24107.58
Other combinations of debt and equity can be assessed in the same manner, although projects that generate revenues on a contract-led basis maximising debt are often the preferred route.
Acknowledgements
Thanks go to Apostolos Chatzilakos and Fisayo Otudeko for preparing this case study.
158
Glossary
accrued interest: Interest earned on a loan between two specified pay- ment dates.
amortisation: Periodic reduction of principal.
bankable: Sufficiently secure for financing.
base case: Cumulative cash flow developed using expected values.
base rate: The underlying interest rate used by lenders to determine the total lending rate.
capital expenditures (CAPEX): Expenditures for property and equip- ment.
capitalised interest: The interest paid to service current loan obliga- tions.
debt service: Principal repayments plus interest payments usually expressed over a period of 1 year.
debt service coverage ratio (DSCR): A metric used by lenders to determine whether a project’s net cash flow can service a given amount of debt under the terms of a loan.
debt service reserve account: A reserve account set up to ensure timely payment of interest and principal should cash inflows be below base case expectations.
discount rate: The annual percentage rate used to compute the present value of future cash flows.
financial close: The date on which all project contracts and financing documentation are signed.
gearing: A measure of leverage such as the debt-to-equity ratio or debt to total capitalisation.
grace period: A period within which default is resolved without in- curring charges.
inter-creditor agreement: Agreement between lenders describing the rights and obligations in the event of default.
159
160 Glossary
interest rate coverage ratio: Safety margin of a project to meet interest obligations.
internal rate of return (IRR): The discount rate that makes the net present value equal to zero.
loan life coverage ratio (LLCR): The net present value of cash avail- able for debt service from the initial date of calculation until the maturity date.
margin: The percentage amount per time period above the interest rate or cost of funds.
Monte Carlo simulation: Random number generation to quantify the effects of uncertainty in a financial model.
net present value (NPV): The total present value of a time series of cash flows using the time value of money to appraise long-term projects.
operational expenditures (OPEX): The ongoing expenses associated with operating a facility or business.
project finance: A sponsor investing in and owning a single-purpose asset, usually for a fixed period, through a legally independent entity finance on a non-recourse basis.
project life cover ratio (PLCR): The net present value of a project’s cash available for debt service over a defined life divided by the amount of principal outstanding at the time of computation.
refinancing: Prepayment of existing debt through new debt on more attractive terms in illiquid markets.
sponsor: A party developing and financing (with equity) a project.
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