project finance modeling

Project Finance Modeling

An Introduction

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

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

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


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


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

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


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


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

Course Outline

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

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

Project Lending

Expected from owner before approval:– Detailed cash flows– Detailed project time schedule

Together, cash flows and time schedule dictateborrowing and repayment schedule

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

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

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

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

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

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

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

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

Credit Analysis

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

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

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

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

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

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

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

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

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

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

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

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

Strengths and Weaknesses

S – W > U

34

Strengths and Weaknesses

Strengths – Weaknesses > Uncertainty

35

Credit Analysis

Internal factor analysis:– Financial information

Ratios Trends Cash flow

– Management information Background and experience Behavior as reflected in financial performance

36

Liquidity Ratios

Current Ratio

sLiabilitieCurrentTotalAssetsCurrentTotal

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

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.

WorthNetTangiblesLiabilitieTotal

38

Project Investing

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

39

Project Investing

Cost-benefit analysis– Compare total costs to total benefits– If competing projects, choose:

Most profitable “Best”

– Not always financial

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

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

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

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

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