Chapter 5 The financial assessment process
5.2 The financial assessment structure
Figure 5.1 illustrates the major processes involved in the assessment of a project procured using project finance from inception to financial close. The financial assessment structure is developed in three stages with the initial assessment by the SPV, typically the shareholders to the SPV, followed by the lender’s assessment and finally a joint assessment by both SPV and lenders.
SPV assessment
The SPV is initially concerned with the commercial viability of a project. In most cases the SPV will be involved in a competitive bid, usually awarded on the basis of the lowest price offered to the prin- cipal for providing a product or service. It should be noted that the principal is accountable to the public and must ensure they achieve 51
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Lender assessmentSPV and lender final assessment
Financial close
Assessment of base case model incorporating risks Identification of risks and deterministic assumptions
(best and worst case)
Development of base case to determine CCF and economic parameters (IRR, NPV, CLU, PB) Estimate of activities, times, costs and revenues of
a project
Reassessment
No go Decision regarding further assessment
Development a financial package based on assessment provided by SPV
Determination of project economics and cover ratios (CAPEX, OPEX, revenue, cash flows and cover
ratios for worst case scenario)
Financial assessment typically using different ratios of financial instruments
Decision regarding further assessment of preferred financial package
Risk assessment: identification, analysis and response
No go
Reassess
Financial engineering
Due diligence
Determine preferred financial and technical structure
SPV assessment
Financial and risk assessment on project Assessment of financial package for worst case scenario
Building financial model
Figure 5.1 Financial assessment structure.
value for money from a project using project finance. The SPV initially identifies the project’s major activities, costs and revenues based on es- timated values either from past experience or from other sources such as consultant organisations. The SPV is therefore initially concerned with estimates of the project’s capital (CAPEX) and operational expen- ditures (OPEX) and revenue generation over its life cycle.
Using the timing of activities and costs and revenues, the SPV can quickly develop a cumulative cash flow (CCF) model to determine the project’s base case economic parameters. These are typically the amounts of cash required at different intervals referred to as cash lock- up, the rate at which cash can be required and spent (cash burn), the time required to break-even, interest cover and the project’s internal rate of return (IRR) and net present value (NPV). From these economic parameters, a decision can be made on whether the project is commer- cially viable based on the estimated values. In many cases the project’s IRR is the metric used to determine whether further assessment is required. This is often based on its relationship to the minimum ac- ceptable rate of return (MARR) set by the SPV. The MARR is often determined on the characteristics of the project, its location and the perceived risks. At this stage the cost of finance is not included in the assessment. An example of this assessment and its generated outputs are provided in Chapter 7.
Risks associated with the project are identified to determine whether the project should undergo further assessment. In most cases these risks will not be assessed individually, with the SPV relying only on a deterministic analysis to determine the worst and best case scenarios.
This is often performed by assuming a range of 5% gain in the best case and 10% loss for the worst case. The 10% worst case is sometimes referred to as the red line case (Merna and Faisal Fahad Al-Thani 2008). If the CCFs are found to be lower than the red line in the worst case scenario, the assessment may be abandoned or the cost estimates associated with construction and operation are revisited to identify possible savings. Similarly, if an identified risk cannot be managed then a decision to cancel further assessment may be taken.
The economic parameters for the worst case scenario are then com- puted. If the project is deemed commercially viable, typically based on the worst case scenario IRR, then further assessment by a lender to determine whether the project is bankable is performed. If the worst
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Table 5.1 Typical costs and revenues over project life cycle CAPEX
Capitalised interest Total revenue OPEX
Cost of supplied materials
case scenario does not meet the SPV’s required return, the project can be reassessed or no further assessment can be recommended.
Lenders’ assessment
The initial model developed by the SPV, based on estimates of time, CAPEX and OPEX and revenue generation, forms the basis of the lender’s assessment. From the estimated costs, revenues and their tim- ings, a CCF can be developed on the basis of the worst case scenario and a financial package developed by the lender to reflect the cash flows.
An assessment of this financial package will typically determine the project’s economics and specified coverage ratios and be presented in tabular form as shown in Chapter 8. These may include some or all the following depending on the type of project, financial instruments used and the ratio of financial instruments required in the decision-making process as illustrated in Tables 5.1–5.3.
A project economics and cover ratio table incorporating the above is shown in Chapter 8, with values assigned relating to the case study described in Chapter 6.
Table 5.2 Typical financial instruments, repayments and cash flows Project finance loan (debt)
Equity Bonds
Loan interest payment Capital repayment
Cash available for dividends and coupons Actual cash flow available for debt service Cumulative (actual) cash flow
Cumulative (predicted) cash flow
Table 5.3 Typical cover ratios used by lenders Actual debt service cover ratio
Interest cover ratio Loan life cover ratio Project life cover ratio
Further assessment can then be undertaken using different financial packages often incorporating different ratios of debt in combination with equity or equity and bonds to determine the associated economic parameters and cover ratios. It should be noted that as alternative fi- nancial instruments are selected variations in the terms and conditions of borrowing occur, usually in the debt service coverage ratio, loan life coverage ratio and project life cover ratio.
Having assessed a number of financial packages, the lender would determine the preferred package and build a financial model, often after discussions with equity and bond providers.
If the preferred finance package is acceptable to the SPV and other finance providers then a more detailed final assessment is carried out jointly between the SPV and the lender incorporating a detailed stochastic analysis, often assisted by technical advisers. If no suitable package can be developed then further reassessment may be required, which will often involve decisions regarding the scope of the project or whether other sources of finance such as aid or grants can be made available. In most cases, financial engineering techniques may also be considered where beneficial to the project’s cash flows. If no satisfac- tory financial package can be found then no further assessment would be recommended.
SPV and lender final assessment
The final assessment provides both the SPV and the lender with the opportunity to assess the project based on the lenders’ financial pack- age and to incorporate risks identified by both parties and, if neces- sary, explore suitable financial engineering techniques to improve the project’s economics.
In most cases the risks associated with the project’s activities and financings will be identified and a qualitative analysis will be
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performed. Many of these risks may be mitigated, leaving only a small number of risks to be addressed in a quantitative analysis, as described in Chapter 4.
The effects of quantified risks can be evaluated against the project’s cash flows and the economic parameters. A stochastic analysis will provide probability distributions against any of the economic pa- rameters used in the decision-making progress. In some cases, finan- cial engineering techniques involving interest rate collars, demand guarantees, refinancing, additional revenue generation and extending concession periods as described in Chapter 9 can be incorporated to improve the project’s economics.
A full financial assessment is described in Chapter 10 and pro- vides outputs expected from this type of assessment to be used in the decision-making process.
Once the final assessment is agreed, the preferred technical and fi- nancial structure can be developed and due diligence can be performed prior to financial close as described in Chapter 11.