1. Financial Statement Analysis and Financial Ratios for Project Finance

2. Valuation and Financial Ratio Analysis Topics
Introduction
Financial Statement Review
Objectives of Financial Ratios in Financial Analysis
IRR and Valuation Analysis
DSCRs in Credit Analysis
LLCR and PLCR in Covenants
DSCR in Financial Covenants
Case Study

3. Objective of Discussion
How projects are valued by equity sponsors and how the creditworthiness of projects is assessed by lenders.
Understand the main forms of financial ratios used in project finance and be able to review typical financial covenants.
Understand how to measure compliance with financial ratios and their shortcomings when used to protect lenders (i.e. common methods borrowers use to subvert them).
The main issues boil down to:
What is the Equity IRR required by investors
What is the DSCR for different types of projects
How to compute the risk rating of projects

4. Financial Statement Review

5. Objectives of Financial Statement Analysis
How do financial analysts use information in financial statements to make assessments of various issues related to risk assessment and valuation:
How can do financial analysts quickly review the income statement, balance sheet and cash flow statement to determine the value of a project?
How do financial analysts look the financial statements and assess risks associated with a project and/or whether the company has sufficient cash flow to pay off debt?
How do financial analysts financial statements be used to assess the performance of a project relative to what was initially projected?
How should financial covenants be computed from financial statements?

6. Financial Statement Analysis in Project Finance
A little review of financial statement analysis is necessary because the financial ratios and the covenants are derived from financial statement data.
You should be comfortable in reading various different financial statements for valuation and financial analysis purposes.
Financial statements will be used to relate financial statement information to economic value drivers and evaluation of company performance.
Example: When determining whether price adjustments are appropriate in a PFI transaction, an IRR calculation is made from cash flows.

7. Financial Statement Review
Sources and Uses
Income Statement
EBITDA – revenues less operating expenses
Net Income
Cash Flow Statement
Free Cash Flow
Equity Cash Flow
Cash Flow for DSCR
Balance Sheet

8. Sources and Uses Statement
The primary statement for analysis during the construction of a project is the source and use statement.
This statement demonstrates, for alternative periods, how much money has been spent on the project and where the money for the project is coming from.
The sources and uses statement shows interest during construction, the capital structure of the company, and total cost of the project.
The sources and uses statement shows joint venture contributions, the funding by subordinated debt and any grants from government agencies.
There is no debt service during the construction period and the debt service coverage ratio is not computed.
Cash flow is negative during the construction period.

9. Example of Sources and Uses of Funds

10. Income Statement Focus on EBITDA, EBIT and Net Income
Determine why these items move over time
Revenues from price and volume – do revenues change because of price or volume
Revenue Items that are not due to operations
Interest Income
Asset Sales
Proceeds from swap agreements
Lease payments, amortization of loan fees, deferred taxes

11. Actual Financial Statements During Construction Period
Actual Statements show virtually nothing on the income statement and the build up of assets and liabilities on the balance sheet

12. Sutton Bridge Actual Income Statement

13. Accounting for Interest During Construction
IDC is capitalized to construction cost -- this means that interest is not included on the income statements, but it is included as a part of capital expenditures on the cash flow statement.
The IDC is ultimately recorded as an operating expense because capital expenditures and therefore depreciation is higher.
If there is a cash reserve that earns interest during the construction period, this interest income is credited against IDC, and treated in a similar manner to the IDC.
IDC is accumulated and added to the depreciation base, which means the amount of debt financing affects the cost of the project.

14. Cash Flow Statement
Fundamental separation between operations, capital expenditures (to maintain and grow operations) and financing.
Add back items from the income statement that do not use cash (depreciation, dry hole costs etc)
Used as a basis to compute free cash flow although free cash flow not presented on the statement
Example
Scrap proceeds – in capital expenditures; remove gain on sale from operations
Minority Interest – in financing flows; remove from operations
Operating reserves – in financing

15. Cash Flow Statement
Derive the amount of dividends or distributions to partners.
Basic cash flow -- separate the statement into operating cash flows and financing cash flows.
Equity cash flow
Distributions
Contributions
Free cash flow
After Adjusted Tax
Before Financing
Cash flow for debt service
After Actual Tax
Before Interest Expense

16. Cash Flow Statement in Project Finance
Operations
Includes interest expense
Includes all taxes
Capital Expenditures (after plant operation)
Add back interest
Senior debt
Interest
Principal
Debt service reserve funding
Maintenance reserve funding
Pre-payment of debt (covenants)
Payment for defaulted debt
Junior Debt
Equity Distributions
Joint Venture Distributions

17. Sutton Bridge Actual Cash Flow
5.250

18. Balance Sheet
Maintains value of assets – from original cost rather than market value and may be conservative
Used for base for many financial ratios – debt to capital, depreciation rates, return on average equity, return on invested capital
Use to establish the historical analysis and where money was earned and where it is spent
Important as an audit tool in financial modeling
Less significant in project finance than in corporate finance

19. Project Finance and Off-Balance Sheet
At one time Off-balance-sheet finance was a common objective of Project Financings where or interest expenses were not recorded on the balance sheet as senior debt. International accounting standards have now moved just about every obligation and indebtedness onto the balance sheet, if not formally requiring a statement in the notes to the company’s accounts.
The preponderance of joint ventures and consortia undertaking project developments makes it relatively easy to hold a party’s interest to 50% or less in the SPV, thereby enabling the project debt to be deconsolidated. Only the investment in the SPV is booked on that party’s balance sheet.
Case Example: In the Colowyo Project Financing in Wyoming, the project company was owned 50:50 by W R Grace and Hanna. In addition to the Project Finance debt not appearing on these company’s balance sheets, the bank also did not include the debt in its legal-lending limit established for both companies.

20. Sutton Bridge Balance Sheet

21. Project Financing and the Balance Sheet
Three possibilities for project financing and the sponsor balance sheet
On balance sheet
Mentioned in Notes
Off-balance sheet
Hold an equity position of between 20% and 50%

22. Objectives of Financial Ratio Analysis

23. Classes of Financial Ratios
Management Performance
Ratios that measure the historic economic performance of management and evaluate whether the economic performance is in accordance with expectations (e.g. Cash to Invested Capital)
Valuation
Ratios that are used to give an indication of the value of the project for purposes of making investments or for terminating the concession agreement (e.g. equity IRR)
Credit Analysis
Ratios that gauge the credit quality and liquidity of the project (e.g. DSCR, LLCR)

24. Class 1: Financial Indicators of Management Performance
Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if the company is appropriately valued)
Return on Invested Capital
Return on Assets
Return on Equity
Market/Book Ratio
Market Value/Replacement Cost
Key Issue
Evaluate relative to risk
ROE versus Cost of Equity
ROIC versus weighted average cost of capital (weighted average of debt and equity)

25. Problem with Traditional Performance Measures in Project Finance
Investment declines to zero at the end of the project
Cash flow is reasonably similar over the life of the project
Therefore, the cash flow to invested capital increases as the project ages.
One cannot interpret the cash flow to invested capital
Income is influenced by depreciation charges
Weighted average cost of capital is not constant
Income can be negative in early years because of high depreciation charges and because of high interest charges before debt is repaid.
Income to invested capital and income to equity ratios are very distorted for projects.

26. Performance Measures in Project Finance
Projects are generally not listed
Cannot compare market value with book value or replacement cost
Equity IRR involves projections of cash flow
One cannot evaluate a single year and determine if the target IRR has been achieved.
Alternatives
IRR using historic and projected data (PFI)
Cash flow to initial invested capital. (Return on Initial Investment or return on initial equity)

27. Simple Illustration of Returns
Alternative return measures
Return on book equity
Return on equity invested
IRR on Equity
Modified IRR on Equity

28. IRR and Valuation Analysis

29. Illustration of Return on Invested Capital and Cash Flow to Invested Capital in Project Finance

30. Project Finance and Finance Theory
Project Finance is a unique financial instrument in its ability to measure risk. Projects are built as a function of the amount of debt financing that can be raised. Project Finance is driven by the incentive to maximize debt capacity and can be used to assess risk.
One issue in project finance is establishing the discount rate and risk measurement using capital asset pricing models.
Financial principles of efficient markets, market expectations and event studies lie behind a number of project finance modeling concepts.
Option pricing model concepts can be used to measure value in project finance models
Capital structure theory and analysis is basic to project finance
Arbitrage concepts in portions of the analysis

31. Valuation Metrics in Project Finance and Corporate Finance
Project Finance Investment
Equity IRR
Project IRR
Equity NPV
Project NPV
Project Finance Debt
DSCR
LLCR
PLCR
Liquidity
Debt Service Reserve
Corporate Finance Valuation
P/E Ratio
EV/EBITDA
Projected Dividend and Earnings
Free Cash Flow
Corporate Finance Debt
Times Interest Earned
Debt to EBITDA
Debt to Capital
Corporate Finance Liquidity
Current Ratio; Quick Ratio

32. Classic Valuation PV of Cash Flows at the WACC gives Enterprise Value
Enterprise Value less Net Debt is Equity Value
IRR vs WACC is Value
Project Finance Problems
WACC is not constant
Project Discount Rate not known

33. Valuation Analysis in Project Finance
Basic Valuation
IRR’s to value a project in base and sensitivity case
DSCR’s to evaluate the value of debt in alternative cases
Compute value of contract and contract prices
Debt sizing to achieve DSCR’s
More Subtle Valuation Issues
Value (costs and benefits) of covenants for alternative transactions
Evaluate the pricing on senior versus subordinated debt facilities
Compute the cost and benefits of alternative contract provisions
Covenant levels
Debt service reserve amounts
Liquidated damage levels
Value of Equity Tranches
Evaluate the value of options in contracts

34. IRR Issues Basic Notion of IRR Rate of return
Number such that NPV is zero
IRR Timing
Use XIRR for timing issues
Need small negative number to start
MIRR
Re-investment
Value of Project

35. IRR Mathematics IRR is simply rate of return
Example: Invest 100 and receive 120 in 1 year
IRR = 120/100 = 120% - 100% = 20%
If the cash flow is over two years
IRR = -100 , 60 , 60  13.07%
Modified IRR with 5% Re-investment
60 receives 5% in year two  60 x (1.05) = 63
Plus final 60 = 123
MIRR = (123/100)^(1/2) - 1 = 10.9%

36. Equity Cash Flow
Equity cash flow consists of money that is spent by owners in the project relative to the distributions made to the owners. Equity cash flow can be computed from the cash flow statement.
Equity Investment During Development (negative)
Dividends During Investment (positive)
Since a project does not re-invest income into other activities, the residual cash flow – the end of the cash flow waterfall -- comes in the form of dividends.
Equity cash flow is the negative of the equity investment during the construction period and the positive dividends later on.
The equity IRR is computed from the equity cash flows – it is the rate of return earned on the investment.

37. Equity Internal Rate of Return
Since a project does not re-invest income into other activities, the residual cash flow comes in the form of dividends.
Equity cash flow is the negative of the equity investment during the construction period and the positive dividends later on.
The equity IRR is computed from the equity cash flows – it is the rate of return earned on the investment.
Compute IRR on equity using the excel IRR formula on the equity cash flow (you may have to use a guess at the end of the formula)
It does not matter whether there are leading or trailing zeros in the IRR formula
The IRR formula assumes that cash flows occur at the end of each period. If the flows do not occur at the end of the period, you can use the xirr function and put in the dates the cash flows are assumed to occur.

38. Current Market Middle East IRR 10-12% DSCR 1.2-1.3 Debt Tenor 17 ++yrs
Africa
IRR 19%
DSCR
Debt Tenor yrs
Vietnam
IRR 13%
DSCR 1.3
Debt Tenor 15 years

39. Equity Returns for Tollroads
The following slide shows equity returns over time and how they have come down

40. Equity Returns and Re-Financing

41. IRR on Wind Projects per FPL
Combination of all these elements, generally yield projects with prospective cash-on-cash internal rates of return of 10% or better, with 10% to 12% being typical.
The increasing availability of capital seeking PTC and accelerated depreciation tax benefits has lowered the post-tax equity returns for non-utility investors to about 8.5%.

42. Equity IRR Issues
While the equity IRR is the fundamental measure of return for a project, a number of ambiguities arise from its measurement. Some of these include:
Including shareholder subordinated loans in the calculation (these may depend on the tax law regarding the deductibility of interest for a particular country)
Including development fees that are paid to the sponsor but do not cover out-of-pocket costs for consultants, lawyers etc. as a cash inflow in the equity IRR calculation
Including assumptions with respect to debt re-financing which accelerates cash flows to equity holders.
Basic rule: is money going into or out of the pockets of equity investors

43. Free Cash Flow Free Cash Flow (un-geared after tax cash flow)
Finance theory suggests analyzing free cash flow and the claims on free cash flow
PV of free cash flow discounted at the WACC defines the asset value or the Enterprise Value
Free cash flow is the same no matter how high or low the debt level.
Free cash flow determines the project IRR
Project IRR can be compared with the after-tax interest rate to determine the benefits from leverage
In contrast to free cash flow, equity cash flow should be discounted at a higher discount rate

44. Discount Rates and Valuation for Real Estate Projects
Merrill Lynch performed a discounted cash flow (“DCF”) analysis on Equity Office, based on projections provided by our management.
The illustrative present value indications of unlevered free cash flows for Equity Office for the years 2007 though 2010 using discount rates ranging from 7.25% to 7.75%, based on the estimated cost of capital of Equity Office, which included consideration of historical rates of return for publicly-traded common stocks, risks inherent in the industry and specific risks associated with the continuing operations of Equity Office on a standalone basis,
The present value of the illustrative terminal value using estimated 2011 EBITDA based on terminal EBITDA multiples ranging from 17.5x to 18.5x, based upon total enterprise value to estimated 2007 EBITDA multiples for the selected comparable companies.

45. Free Cash Flow
Free cash flow can be computed from the income statement or from the cash flow statement. The amount of free cash flow (free after all capital expenditures and operating expenses and taxes) is the sum of equity cash flow and debt service.
From the cash flow statement, the formula is:
Cash Before Financing
Plus: Interest Expense
Less: Tax Shield on Interest
From the income statement, the formula is:
EBITDA
Less: Taxes on EBIT
Less: Working Capital Investment
Less: Capital Expenditures
A complexity in measuring free cash flow is making adjustments for interest during construction. Interest during construction would not exist with no debt financing and the tax deductions on the depreciation portion that represents IDC would not exist.
The first method is easier to compute, the second method is more intuitive.

46. Free Cash Flow Example

47. IRR, NPV and other Issues
NPV calculations are misleading if used to compared two projects of different sizes
IRR calculations exaggerate the value of early cash flows and understate the value of later cash flows
Projects are exposed to non-traditional risks (discussed earlier).
Have high and rapidly changing leverage.
Typically have imbedded optionality.
Projects have early, certain and large negative cash flows followed by uncertain positive cash flows.

48. Project IRR versus Equity IRR
A central issue in finance is equity valuation (P/E) versus enterprise valuation (EBITDA). In project finance, the issue is whether investments should be assessed with project IRR on free cash flow or equity IRR on equity cash flow:
In theory valuation of a project is from free cash flow, and the capital structure is irrelevant.
A counter point is that financing provides essential valuation information on the risk and value of a project, this is how of banks and insurance companies are valued where financing drives value.
In project finance, the level of debt tells a lot about the risk of a project – if a project has more debt capacity, the free cash flows have less risk.
Begin with free cash flow and the project IRR to establish the “real” economics of the project. Then evaluate financial criteria such as covenants with equity IRR.

49. Project Finance versus Traditional Investment Evaluation
Valuation driven by assessment of project IRR
Project IRR compared to all-equity cost of capital
Equity IRR and leverage do not impact investment decision
Project Finance
Valuation driven by the equity IRR
Equity IRR affected by debt leverage
Constraint on issuing debt is risk assessment of financial institutions
The constrained optimization can be used to measure risk

50. Project and Equity IRR Issue – Equity Bridge Loans and Recourse Debt
In some projects, equity holders provide loans to the project from their balance sheet instead of equity. The issue arises as to whether these should be considered equity or debt.
Example
Instead of providing equity, a sponsor secures a loan to the project.
The loan will be re-paid in a bullet at the end of seven years.
When the loan is re-paid, the sponsor provides equity to finance the loan.
Issue
Should the equity bridge loan be considered debt or equity for purposes of computing IRR.
The loan uses resources of the parent and must be guaranteed by the parent

51. IRR’s in PFI
IRR’s are negotiated in PFI transactions as part of the concession agreement where the IRR drives pricing in the contract.
Concession agreements in PFI project financings limit increases in the IRR that come about from interest savings from re-financing. (e.g. share excess profit 50/50).
In concession agreements, the IRR is used to monitor the performance of the project as well as for the investment decision.

52. Other Valuation Metrics – Payback and Discounted Payback
The payback period measures the number of years that it takes before the cumulative forecast of cash flow equals the initial investment. It is criticized because it gives equal weight to cash flows before the payback and zero weight thereafter.
However, if you are explaining the benefits of a project and you can tell an investor that the money he invests will be all paid back in three years, and everything else is gravy, the payback can be an effective analysis tool.
The payback can be modified where cash flows are accumulated and the payback is measured using discounted cash flows. This is the discounted payback.

53. Hypothetical Investment Decision and Equity IRR Criteria
Begin with the notion that management has a rate of return criteria where only projects that have an IRR of above 14% are approved for investment and projects that have an IRR below 14% are not. Further, assume that this rate of return is measured using equity cash flow rather than free cash flow, due to corporate objectives related to earnings per share (“EPS”) growth. In this hypothetical situation as long as free cash flow from the project is expected to yield a higher rate of return (project IRR) than the after tax cost of debt, the equity return can be increased if more debt is used to finance the asset. (Magnifying asset returns to increase equity return is the where the term leverage comes from). If, because of the reluctance of bankers to take credit risk, debt cannot be raised for the project, the equity return criteria will probably not be met. On the other hand, if a significant amount of project debt can be raised, the equity IRR will exceed 14% and the investment will be made. Therefore, in this hypothetical example the amount of debt directly affects the investment decision. Indeed, the investment is driven by the amount of debt that can be raised rather than by the beta of the project or the risk adjusted all-equity cost of capital relative to the project IRR.
The notion that the leverage of a project affects cost of capital is demonstrated in the following quote from a rating agency:
Nonetheless, a project's leverage level is often an indication of its creditworthiness. For instance, a merchant project's ability to produce a stable and predictable revenue stream will never match that of a traditional contract revenue-driven project. Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. Contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.

54. Middle East Example Qurayyah IPP/Hajr Electricity Company
4,000 MW (Only Power No Water)
PPA 20 years/ Energy Conversion Agreement
Financing
19.5 Years
DSCR 1.20
Debt to Equity at Commercial Operation: 80:20
Balloon and cash trap
Levelized tariff low because of financing
Average Loan Life 13.32
Credit Spread
Pre-completion: 125 BPS
Post completion: BPS
IRR 12% to 16%

55. Loan Terms - Continued Loan tenor is explained by
the repayment period is still within the PPA terms (i.e. 20 years from PCOD), giving a one year tail, and
the project is a Build, Own and Operate (BOO) and a BOOT.
Debt Service Reserve Account (DSRA) covering debt service for 6 months or a letter of credit of the same amount;

56. Example of Pricing and Changing Credit Spreads

57. Example of Covenants Minimum Senior DSCR of 1.20x in Base Case,
Minimum Senior DSCR for the previous 12 months to be greater than 1.10x for distribution,
Minimum Senior DSCR of 1.05x for Event of default,
Senior Debt not to exceed 80% of the total project costs

58. Off-Taker Saudi Electricity Company is a strong credit:
74% ownership by the Government of Saudi Arabia (which has a rating of AA- S&P and Fitch and Aa3 from Moody’s – all rating for Long Term Foreign Currency Debt of KSA) and
7% by Saudi Aramco and Is rated AA- (stable outlook) by S&P and Fitch and A1 (positive outlook) by Moody’s;
Project is 50% owned by the off-taker
PPA of 20 years
Build own and operate

59. DSCRs in Project Finance

60. DSCR - General Discussion
Basic Definition – Cash into the project divided by debt paid to the bank
Should find in the cash flow statement
The rule is that the higher the risk, the higher the DSCR, since a larger multiple of cash flow has to be held in relation to debt-service.
The DSCR used in Credit Rating and in Covenants – Measures the possibility of default
For example, if a wind project generates a net income of a1 million per annum and the bank requires a DSCR of 1.3, the project could take out a loan for which the debt service would be a770,000 per annum.

61. Use of DSCR, LLCR and PLCR Formula
Basic Formula: DSCR
Percent Reduction in one year:
Percent Reduction = (DSCR-1)/DSCR
Same formula for LLCR and PLCR
Percent Reduction over Loan Life
Percent Reduction = (LLCR-1)/LLCR
Percent Reduction over Project Life
Percent Reduction = (PLCR-1)/PLCR
Be Careful with Fixed Costs

62. Debt Sizing Borrowed amount is based on a conservative commercial case
Lenders will analyze conservative assumptions because their only recourse is to the project and its cash flow:
Conservative reserves estimate (in case of oil & gas)
Product price forecast – low
Capital and Operating Costs – high
Debt sized by conservative case Debt Service Coverage Ratio

63. Determining the Credit Classification of Project Finance Debt
Determining the credit classification is important because:
Credit classification is probability of default
Credit classification and risk drives the credit spread
Credit classification drives the ability to gain bank financing
Achieving an investment grade bond rating or above drives access to investors in bonds
Other than being used for covenants, the primary purpose of credit ratios such as the DSCR is to gauge the credit risk of a project loan.
Credit risk in turn is determined by the probability of default of a loan.
The reason a PFI project with a 1.2x DSCR and a merchant power plant with a 2.5x DSCR may have the same credit rating is that they both have similar probability of default.

64. Banks or Rating Agencies Value Debt with Risk Classification Systems
Map of Internal Ratings to Public Rating Agencies

65. Risk Classification and Target of BBB in Project Finance from S&P website

66. Updated S&P Stats

67. Traditional Credit Analysis – Backward Looking Credit Ratios to Gauge Bond Ratings and Bank Ratings
Credit ratios are used gauge the credit classification from financial statements such as the debt service coverage benchmarks in project finance.

68. General Use of Financial Ratios in Establishing Credit Quality

69. Strong Ratings Characteristics of Strong Ratings
Capacity to generate sufficient cash flow to maintain DSCR’s within industry norms for investment grade ratings.
Fully amortizing debt
Lender has control over cash flows and collateral
Strong management with track record of meeting budgets in the country
Comprehensive risk mitigation
Characteristics of Weak Ratings
DSCR below 1.0 under moderate stress test scenarios
Bullet maturities
Reserve funds from operating cash flow
Lender has limited control over cash flow
Management has limited experience in the country

70. Ratings Assignment – Basel II Document
Template of objective benchmarks that measure risk factors, such as DSCR’s, LLCR’s and break-even oil prices.
Simulation model that alters critical inputs changed that measures the likelihood of default (Monte Carlo Simulation with oil price varied to measure the potential for the DSCR to fall below 1.0)
Stress test to evaluate whether the transaction can withstand in a critical revenue or expense. Determine financial flexibility in the face of adversity.
Judgmental criteria and weighting systems that use descriptions to distinguish credit quality.

71. DSCR Drives the Debt Capacity
The debt service coverage ratio is a financial output in a project finance transaction which cannot be determined by sponsors of a project in advance. The debt service coverage ratio statistic can be driven my many factors including the debt to capital ratio. Unlike the DSCR, the debt to capital ratio is driven by a decision by sponsors and lenders.
There is a direct relationship between debt service coverage ratios and the debt to capital ratio once free cash flows have been established. The table above shows the average and minimum debt service coverage ratio for the combined cycle plant assuming that price levels for the plant result in a project IRR of 11.09%. The graph illustrates that a debt service coverage ratio of 50% is consistent with a minimum debt service coverage ratio of 1.76x and an average debt service coverage ratio of 2.19x.

72. General DSCR Criteria to Establish Debt Levels
Electric Power:
Resources:
Telecoms:
Infrastructure:
Minimum ratio could dip to 1.5
At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poor's may rely on more conservative scenarios when determining its rating levels.
For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.

73. More on DSCR Targets for Alternative Industries
Ranges in DSCR estimates

74. Example: DSCR for Wind Power
Typically, we want revenues after all operating costs and taxes to be about 50% higher than what we actually need to repay the debt. This means that on any given period, revenues can be a third lower for any reason (whether lower wind, poor operating performance, or lower electricity prices) and we will still have enough money to repay debt.
This implies 1.5x DSCR
Wind is highly predictable in the long run but highly volatile and uncertain in the short term, thus leading to strong comfort that the long term average will be close to predictions, but with an also strong likelihood that some seasons or even some years could see significantly lower production levels.
The DSCR has increased from 1.40x to 1.45x according to a study by LBL.

75. DSCR Criteria (Reference)
At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poor's may rely on more conservative scenarios when determining its rating levels.
For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.

76. Example of Project Finance as Risk Measurement Survey of Electric Plants

77. DSCR Criteria in PFI Transactions
The DSCR in PFI transactions can be very low – in the range of 1.05 – The low DSCR results from the tight coverage of revenue and expense fluctuations with contracts.
With the low DSCR, small risks in other transactions can become large risks for project loans.
For example, interest rate fluctuations may have a small effect on transactions where the DSCR is 1.8, but the fluctuations in interest rates can cause default in the very tight PFI transactions. This is why there are 100% interest rate swaps in PFI.

78. Detailed Issues in Computing the DSCR
There are many intricacies in computing the DSCR despite it being a simple ratio.
First, some general discussion
DSCRs are the primary quantitative measure of project financial credit strength. The DSCR is the ratio of net cash flow to principal and interest obligations. Cash from operations is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal needed to maintain ongoing operations.
Should also subtract changes in working capital and sustaining capital expenditures
To the extent that a project has tax obligations, such as host country income tax, withholding taxes on dividends and interest paid overseas, etc., these taxes are treated as ongoing expenses needed to keep a project operating.

79. Alternative DSCR Calculations
Minimum DSCR
The most important ratio that measures the minimum DSCR the project will see through debt maturity. The minimum DSCR will likely point to the project's greatest period of financial stress.
Short-term DSCR
looks forward three years, as a near-term measure of financial strength.
The Average DSCR
averages all of the minimum DSCRs remaining through maturity (as opposed to calculating the average CFO and dividing by the average annual debt service). The average DSCR provides a general measure of a project's cash flow coverage of debt obligations.
The average DSCR, when viewed alongside the long-term and short-term minimum DSCR, does provide another measure of project comparability.
Generally, stronger projects will show annual DSCRs that steadily increase with time to partially offset the risk that future cash flows tend to be less certain than near term cash flows.

80. Difference Between Free Cash Flow and Cash Flow for the DSCR
Excludes interest income
Adjusts taxes to remove benefits of interest income
Includes proceeds from asset sales and insurance proceeds
Determines the amount the project would earn if there was no debt financing
Should make adjustments for interest during construction
Cash flow for debt service
Includes interest income
Uses actual taxes
Excludes amounts that will not be available on an on-going basis to pay debt service

81. Issue 1: DSRA Balances in the DSCR
A project has better quality if it has a debt service reserve account
Why not include all cash available to pay bank, including cash in accounts
According to S&P
The ratio calculation also excludes any cash balances that a project could draw on to service debt, such as the debt service reserve fund or maintenance reserve funds.

82. Issue 2: Senior and Subordinated DSCR
Senior DSCR:
For the senior DSCR, divide the net cash flow by the senior debt service obligations, exactly as it would if only one class of debt existed.
Subordinated DSCR – Two Methods.
The first method calculates the ratio of the total net cash flow to the project's total debt service obligations (senior plus subordinated). This consolidated calculation provides the only true measure of project cash flow available to service subordinated debt.
The second method takes the net cash flow and then subtracts the senior debt service obligation to determine the residual cash flow available to cover subordinated debt service. This method, does not, however, provide a reliable measure of credit risk that subordinated debt faces. A combination of small subordinated debt service relative to the residual CFO could result in a much higher subordinated DSCR relative to the consolidated DSCR calculation. Moreover, the ratio of residual CFO to subordinated debt is much more sensitive to small changes to a project's total CFO than the consolidated measure.

83. Issue 3: Operating Reserves and Debt Service Reserve Account Movements
If cash must be put aside into a reserve account for major maintenance or other lumpy expenditures, the cash that goes into the accounts should be treated as a cash outflow, like an operating expense.
When the operating expense occurs and funds are withdrawn, then the cash withdrawn is included as an inflow in the DSCR.
Therefore, the DSCR is smoothed out
Debt Service Reserve Account
Sometimes, money is put aside in a DSRA account from operating cash flows.
If there are cash short-falls, then cash is taken out of the DSRA.
Is the issue the same

84. Other DSCR Issues
In reviewing various transactions, various DSCR issues arise. Some of these include:
If there is a cash flow sweep, should an interest only ratio be computed, or should alternative ratios be used.
In computing break-even analysis should debt service reserves be included in the ratio.
If there are breakage costs for interest rate swaps, how should breakage costs be treated.
Should different ratios be used for backward looking analysis and forward looking analysis.
In using DSCR’s as triggers to limit dividends or to sweep cash flow, which ratios should be used.

85. Timing of DSCR Calculations
The DSCR is not generally computed before the date of project completion. Therefore, language related to the definition of the completion of the project must be included in the loan agreement:
"Completion Date" means the first date on which the Agent receives notification from the Lenders' Technical Adviser that the following conditions have been fulfilled to the satisfaction of the Lenders' Technical Adviser:
[the completion tests under the Concession Agreement have been completed, the Authority has issued to the Borrower the [Completion Certificate] pursuant to Clause {cross-reference} of the Concession Agreement and the [Operating Commencement Date] under the Concession Agreement has occurred]; [and]
[the completion tests under the Construction Contract have been completed and the Borrower has issued to the Contractor the [Final Acceptance Certificate] pursuant to Clause {cross-reference} of the Construction Contract]; [and
{describe other Completion Date conditions}][;

86. Fundamental Events of Default
The primary function of the DSCR is to measure the probability of defalut – a ratio of 1.0 implies a default. Fundamental events of default include
the failure of the borrower to pay debt service;
failure to comply with insurance requirements;
entry of a final court judgment in excess of a significant dollar amount which is not paid or stayed after a certain period;
abandonment of the project;
bankruptcy of the borrower;
failure of the sponsor to maintain ownership of the project (if the sponsor's ownership is a critical component of the evaluation of the project's credit risk).

87. Other Events of Default - Reference
Other Events of Default Include:
operational covenants,
a merger or sale of assets
failure to deliver notices
failure to obtain or comply with governmental permits.
Depends on Materiality
Negotiated ad hoc.
Agreements should provide for a clear and adequately described mechanism for allowing the parties to deal with the defaulted project.
The hardest part of any negotiation is the definitions of the triggers (called "events of default") which allow banks, in theory, to have the right to take the project from the investors. It is not a simple task, as banks want to be able to step in as soon as something fishy appears, but on the other hand, they do not want to get too closely involved in the running of a project and the inevitable hiccups that happen; it also makes sense to step in only if there is a real problem which the investors seems unable or unwilling to solve. Investors emphatically do not want the banks to have the right to stp in the project, but they know that it is the price to pay to get the leverage they want (in the wind sector, banks usually provide 70-80% of the investment amount upfront)

88. LLCR and PLCR in Credit Analysis

89. DSCR versus LLCR versus PLCR

90. LLCR and PLCR Loan Life Coverage Ratio (LLCR):
The LLCR computes the present value of cash flows over the debt tenor at the interest rate on debt as the numerator of the ratio. The denominator of the ratio is the present value of debt service at the debt rate. The denominator should equate to the amount of the debt.
The denominator should be reduced for debt service and other reserves
Project Life Coverage Ratio (PLCR):
The PLCR is similar to the LLCR except that the present value of cash flows is computed over the economic life rather than over the debt tenor. As with the LLCR, the denominator of the PLCR is the present value of debt service at the debt rate.
The PLCR measures how much “tail” the project has from cash flows after the loan is re-paid.

91. General Mathematics of LLCR
To see how the LLCR works, consider the following points
If all cash flow were invested at the interest rate in a bank account, and there was a bullet payment, then one could measure if that cash account was high enough to cover debt payments.
If the cash account in the above example were reduced by maturity payments, the end result would be no different.
If there is money in a DSRA, this could be used to make the requirement less, it is just like the concept of net debt in corporate finance.
The present value of debt service at the interest rate is the same as total debt

92. Loan Life Coverage Ratio (LLCR)
Loan Life Coverage Ratio – the present value of cash flow before debt service – using the interest rate; divided by the remaining debt balance:
LLCR = PV (debt rate, cash before debt service)/Debt Balance - DSRA
Essentially the LLCR is DSCR on a present value basis so that the credit quality of the whole project is measured.
LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate
LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project
The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR

93. LLCR and Credit Quality
The LLCR Concept can be used to gauge the economics of the project relative to the amount of debt outstanding:
If no dividends can be paid until all of the debt is paid, the present value of cash flow can be compared to the present value of the debt.
If the present value of the debt exceeds the present value of the free cash flow at the debt rate, there is no way the project can payoff the debt – the project has too much gearing.
If the debt holders get all of the cash flow before any equity, the present value of the debt relative to the present value of cash is an effective statistic that can measure how much a variable changes before a debt default occurs.
For example, if the cost increases by a certain amount, a LLCR of 1.0 measures the break-even point before which the debt cannot be repaid.

94. Project Life Coverage Ratio (PLCR)
The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period.
In the PLCR, the numerator uses the present value of cash flow over the life of the project rather than over the life of the debt.
The PLCR is related to the loan to value ratio if one assumes that the present value of the cash flow is the value of the project:
PLCR = Value/Loans
Debt to Value = Loan/Value
Debt to Value = 1/PLCR
As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount.

95. LLCR and PLCR
The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period.
As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount.
Loan Life Coverage Ratio
Essentially the DSCR on a present value basis
LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate
LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project
The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR
Prospective DSCR and Borrowing Base

96. Debt Tenor and Average Life
Lenders want to know how their risk reduces over the life of a project.
If the loan was only for one year, the risks are less than a 20 year loan, if the cash flows are the same and the cash flow can support the debt repayment.
In project finance, the risk associated with longer terms is measured by the average loan life.
Average loan life is used in a similar manner to the payback period to check that the loan is not over-extended.
The Average loan life accounts for the manner in which a loan is paid back – if the loan has a bullet payment, the loan life is the same as the tenor.
The formula is simply the average outstanding amount of the loan divided by the initial balance of the loan.

97. Credit Ratings, Loan Pricing and Loan Value

98. Default Rates and Credit Spreads -- Note that Credit Spreads Increase When Default Rates Increase

99. Credit Spreads
Increase of 5%
Credit Crisis

100. Bond Ratings and Yield Spread
Credit classification is very important in establishing the access to funding and the cost of funding as illustrated on the graphs below:

101. Table of Bond Spreads
The following is an example of bond spreads at a point in time (bondsonline.com). These spreads change over time.
Note the Jump at BB+ to BB

102. Theory of Credit Spreads: Credit Spread on Debt Facilities
The spread on a loan is directly related to the probability of default and the loss, given default. S
The Credit Triangle
S = P (1-R) P R
The credit spread (s) can be characterized as the default probability (P) times the loss in the event of a default (R).

103. Expected Loss Can Be Broken Down Into Three Components
Borrower Risk
Facility Risk Related
EXPECTED LOSS $$
Probability of Default
(PD) %
Loss Severity
Given Default
(Severity) %
Loan Equivalent
Exposure
(Exposure) $$ x x =
What is the probability of the counterparty defaulting?
If default occurs, how much of this do we expect to lose?
If default occurs, how much exposure do we expect to have?
The focus of grading tools is on modeling PD

104. Comparison of PD x LGD with Precise Formula Case 1: No LGD and One Year.

105. Comparison of PD x LGD with Precise Formula Case 2: LGD and Multiple Years.

106. Probability of Default
This chart shows rating migrations and the probability of default for alternative loans. Note the increase in default probability with longer loans.

107. Updated Transition Matrix

108. Project Finance and Default History
Market participants consistently report lower default rates, and especially lower loss rates on project finance than on other equivalent corporate exposure, largely because of the effect of transaction structuring and transparency and control of collateral.
Project finance transactions are by their nature, complex and require a strong understanding of the underlying markets and their risk drivers. Only a limited number of banks have dedicated project finance credit teams.

109. Study of Probability of Default for Project Finance

110. Default Rates by Industry

111. Moody’s Forecast of Default Rates
Defaults versus Long-term Average
Moody's Speculative Grade Trailing 12-Month Default Rates
Actual Jan to Aug / Forecasted Sept to Feb. 2003
12.0%
11.0%
10.5%
10.7%
10.5%
10.3%
10.3%
10.5%
10.3%
10.1%
9.8%
10.0%
10.0%
10.0%
10.0%
9.8%
10.0%
9.6%
9.3%
8.8%
9.0%
8.8%
9.0%
8.5%
8.0%
7.7%
7.7%
7.9%
7.1%
7.0%
6.7%
6.2% %
6.0%
5.0%
4.0%
3.77%*
3.0%
2.0%
1.0%
0.0%
Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Jul-01
Aug-01
Sep-01
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
Jul-02
Aug-02
Sep-02
Oct-02
Nov-02
Dec-02
Jan-03
Feb-03
Months
Note: *Long run annual default rate is 3.77%

112. Project Finance and Basel II
The table below shows the default rates in a study conducted for Basel II

113. Recovery rates Estimating recovery rates
There is no market or highly illiquid market
Immediately upon announcement of default, after some reasonable period for information to become available, or after a full settlement has been reached
Recovery rates of bond
Subordinated classes are appreciably different from one another in recovery realization
Difference between secured vs. unsecured senior is not statistically significant
Recovery rates of bank facilities
Bank facilities( loans, commitments, letter of credit) are senior to all public senior bonds
Bankruptcy law and practices differs from jurisdiction to jurisdiction
Distribution of recovery rates
Consistently wide uncertainty
Beta distribution

114. Recovery Rates

115. Project Finance Ratios
Net cash from operations before debt service (CFO)
Revenues minus cash expenses, including taxes, but excluding debt service
Minimum debt service coverage ratio (MDSCR)
Lowest CFO to annual principal and interest payment ratio
Short-term minimum DSCR (STDSCR)
Lowest DSCR over the next three years
Average debt service coverage ratio (ADSCR)
Average of annual DSCRs through debt maturity
Loan life coverage ratio (LLCR)
Total remaining present value CFOs divided by outstanding principal balance

116. Debt Capacity and Pricing

117. Returns on Project Finance Loans
The probability of default and the loss given default
Probability of default through 2002 – 13.3%
Large defaults in 2002 from telcom and merchant power

118. Project Finance and Basel II – Pre 2003
Three approaches
Basic
PD and LGD defined from four supervisory ratings categories
Foundation
Bank estimates PD or other risk parameters and uses basic approach for other parameters
Advanced
Bank estimates PD, LGD, EAD
Correlation of LGD and PD
LGD 2001: Initial evidence on realised losses suggests that losses during difficult periods exceeds those of senior, unsecured corporate exposures.

119. Mathematical Credit Analysis

120. General Payoff Graphs from Holding Investments with Future Uncertain Returns

121. Payoff Graphs from Call Option – Payoffs when Conditions Improve

122. Payoff Graphs from Buying Put Option – Returns are realized to buyer when the value declines

123. Payoff Graphs from Selling Put Option – Value Changes with Value Decreases

124. The Black-Scholes/Merton Approach
Consider a firm with equity and one debt issue.
The debt issue matures at date T and has principal F.
It is a zero coupon bond for simplicity.
Value of the firm is V(t).
Value of equity is E(t).
Current value of debt is D(t).

125. Nominal Debt Repayment
Payoff to
claimholders
At maturity date T, the debt-holders receive face value of bond F as long as the value of the firm V(T) exceeds F and V(T) otherwise.
They get F - Max[F - V(T), 0]: The payoff of riskless debt minus the payoff of a put on V(T) with exercise price F.
Equity holders get Max[V(T) - F, 0], the payoff of a call on the firm.
Value of the company and changes in value to equity and debt investors
Nominal Debt Repayment
Equity F
Debt
V(T)
Value of Firm in Time T

126. The payoffs to the bond holders are limited to the amount lent B
Payoff to
debt holders
Credit spread is the payoff from selling a put option A1 A2
Assets B
The payoffs to the bond holders are limited to the amount lent B
at best.

127. Merton’s Model
Merton’s model regards the equity as an option on the assets of the firm
In a simple situation the equity value is
max(VT -D, 0)
where VT is the value of the firm and D is the debt repayment required
Assumptions
Markets are frictionless, there is no difference between borrowing and lending rates
Market value of the assets of a company follow Brownian Motion Process with constant volatility
No cash flow payouts during the life of the debt contract – no debt re-payments and no dividend payments
APR is not violated

128. Merton‘s Structural Model (1974)
Assumes a simple capital structure with all debt represented by one zero coupon bond – problem in project finance because of amortization of bonds.
We will derive the loss rates endogenously, together with the default probability
Risky asset V, equity S, one zero bond B maturing at T and face value (incl. Accrued interest) F
Default risk on the loan to the firm is tantamount to the firm‘s assets VT falling below the obligations to the debt holders F
Credit risk exists as long as probability (V<F)>0
This naturally implies that at t=0, B0<Fe-rT; yT>rf, where πT=yT-rf is the default spread which compensates the bond holder for taking the default risk

129. Merton Model Propositions
Face value of zero coupon debt is strike price
Can use the Black-Scholes model with equity as a call or debt as a put option to directly measure the value of risky debt
Can use to compute the required yield on a risky bond:
PV of Debt = Face x (1+y)^t or
(1+y)^t = PV/Face
(1+y) = (PV/Face)^(1/t)
y = (PV/Face)^(1/t) – 1
With continual compounding = - Ln(PV/Face)/t
Computation of the yield allows computation of the required credit spread and computation of debt value
Borrower always holds a valuable default or repayment option. If things go well repayment takes place, borrower pays interest and principal keeps the remaining upside, If things go bad, limited liability allows the borrower to default and walk away losing his/her equity.

130. Default Occurs at Maturity of Debt if V(T)<F
Asset Value VT V0 F
Probability of default T
Time

131. Black-Scholes Assumptions with Respect to Firm Value
Firm value is lognormal; constant volatility; deterministic interest rate; no frictions.
E(t) = Call[V(t),F,T]
D(t) = Exp[-r(T-t)]*F – Put[V(t),F,T]
Put-call parity implies also:
D(t) = V(t) – Call[V(t),F,T]
Firm value is simply sum of equity and debt:
V(t) = E(t) + D(t).
Merton showed value of a risky loan
F(t) = Be-it[(1/d)N(h1) +N(h2)]
Written as a yield spread
k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
where k(t) = Required yield on risky debt
ln = Natural logarithm, i = Risk-free rate on debt of equivalent maturity

132. Merton Model and Recovery Rate
If Merton’s model applies, the probability of default can be computed.
It is the probability that firm value will exceeds debt face value at T.
Debt Value = Face at Risk Free Rate less Value of Put Option
Put Option Value = Probability of Default x Cost When Default
Black-Scholes formulation allows one to divide the value of the put option into probability of default and recovery rate

133. Reference Slides on Financial Ratios

134. Telecom DSCR Criteria (Reference)
Standard & Poor’s believes that a project’s credit is generally strengthened by covenants that limit, or even preclude, distributions to sponsors unless both robust historic and projected DSCRs are met, and reserve funds are fully funded.
Given the merchant-type risk associated with most telecom deals, Standard & Poor’s would generally require that distribution test DSCRs be computed on a 12-months-back and 24-months-forward basis, using forecasts made by independent consultants, and be at least 2 times (x) for low speculative- and investment-grade projects.

135. Debt Service Coverage Criteria
Standard & Poor's considers that minimum DSCR threshold tests for most contract-driven projects to be around 1.30 times (x), provided that this figure holds under stress analysis.
Such levels are too low for merchant projects. Instead, minimum DSCR levels for equity distributions may need to exceed 1.70x for investment-grade transactions, depending on the industry.
For example, one financial institution suggests that under base case assumptions the DSC should show not less than 1.2:1 for every year of operation during the loan life, and no less than 1.4 on average.
Under a Downside Case, with up to 5 years added to the repayment period, the DSC should be no less than 1.0:1 for every year or less than 1.15:1 on average during the life of the loan.
Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. On the other hand, contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.

136. Effect of Financing on the Required Cost of Electricity

137. Investment Grad Bond Ratings
Moodys
S&P
Aaa
AAA
The debt has the highest rating. Capacity to pay interest and principal is extremely strong. Regarded as having maximum safety and gilt-edged. Aa AA
The debt has a very strong capacity to pay interest and repay principal. Regarded as ‘high-quality.’ A
The debt has a strong capacity to repay interest and principal. However, it is somewhat susceptible to adverse changes in circumstances and economic conditions. Regarded as upper-medium grade in terms of creditworthiness.
Baa
BBB
The debt is regarded as having adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances may lead to a weakened capacity to pay interest and repay principal for debt. These bonds/loans are lower-medium grade in therms of creditworthiness.

138. Non-Investment Grade Bond Ratings
Moodys
S&P
Debt rated in the categories below are regarded as low grade and predominantly speculative. Ba BB
The ability of these entities to meet obligations may be moderate and not well safeguarded in the future. The lowest degree of speculative. B
These issues offer poor financial security. Assurance of payment of obligations over the long term is small.
Caa
CCC
Very poor financial security. They may be in default of their obligations or there may be dangers present with respect to timely debt repayment. Ca CC
These entities are often in default or have other marked shortcomings. The highest degree of speculation. C
This rating is preserved for debt that may have substantial risk; be in default; or extremely speculative. Potential recovery values are low. D
The debt is in default and payment of interest and/or repayment of principal is in arrears.
Investment-grade cutoff

139. Sutton Bridge Financial Ratios

140. Pre-2003 Basel II Proposal
The pre-2003 proposal was harmful to project finance

141. Correlation of PD and LGD in Basel II