The process illustrated in Figure 5-9 includes the verification of cover ratios in the decision-making process. In this section, we explain what these indices are and why they are used to value the bankability of project finance initiatives. An example will prove useful for introducing this topic.
TABLE 5-14 Example of a RAROC Calculation for December 31, 2005 Amount
(euro/mil.)
Margin
(b.p.) (days)
Margin (euro/mil.)
VAT loan—disbursed at the start of the period 8,400 100 184 42.93
Base loan—disbursed at the start of the period 40,791 150 184 312.73
Standby loan—disbursed at the start of the period — 160 184 –
Total margin 355.66
Amount (euro/mil.)
Commitment
fee Days
Commitment fee (euro/mil.)
VAT loan—committed, not utilized 13,600 0.50% 184 34.76
Base loan—committed, not utilized 77,209 0.50% 184 197.31
Standby loan—committed, not utilized 7,000 0.60% 184 21.47
Total commitment fees 253.53
Total revenues 609.20
Annualized return (including fees) 2.48%
Annualized return (including fees) (A) 2.48%
Expected loss (B) 1.50%
VaR (C) 5%
RAROC ((AB)/C) 19.54%
Benchmark rate 13.00%
132 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
We’ve seen that one of the discriminating criteria in various debt/equity mixes is the IRR level. One might ask then why the advisor doesn’t stop at this stage in defining the financial structure.
Let’s say that two project finance initiatives, A and B, have a total estimated cost of 1,000. Of this total, 800 is financed with bank loans organized by an arranger and 200 with shareholders’ equity. Moreover, for simplicity’s sake we’ll suppose that construction will be finished on the two projects in the first working period (year 0) and that both begin to generate positive flows starting from year 1. The dynamic of the financial flows is represented in Tables 5-15 and 5-16, and the flow of the last year also includes the liquidation of any remaining assets.
TABLE 5-15 Project A—Financial Flows and Return Indicators
Year
0 1 2 3 4 5
Operating cash flows 1,000 50 150 850 1,800 2,100
Debt service — — — — — 2,011
Dividends to sponsors — 50 150 850 1,800 89
Investments—sponsors 200
Investments—banks 800
Year
0 1 2 3 4 5
Financial flows—bank 800 0 0 0 0 2,011
Financial flows—sponsors 200 50 150 850 1,800 89
IRR—bank 20.2%
IRR—sponsors 124%
TABLE 5-16 Project B—Financial Flows and Return Indicators
Year
0 1 2 3 4 5
Operating cash flows 1,000 50 150 850 1,800 6,900
Debt service 0 35 110 600 730 0
Dividends to sponsors 0 15 40 250 1,070 6,900
Investments—sponsors 200
Investments—banks 800
Year
0 1 2 3 4 5
Financial flows—bank 800 35 110 600 730 —
Financial flows—sponsors 200 15 40 250 1,070 6,900
IRR—bank 20.2%
IRR—sponsors 124%
Cover Ratios 133
As we can see, the same result emerges for both projects in terms of IRR, both for SPV shareholders and for a hypothetical lender. In the first case, however, the loan is reimbursed with a bullet payment at the end of the fifth year; in the second, capital is gradually collected and by the end of the fourth year the loan is paid in full.
The example reveals a simple conclusion, but not a trivial one: The same IRR can be obtained through different combinations of cash flows earmarked for debt service.
Clearly, if the arranger is making forecasts and referring to expected flows, in the first case he or she will realize that payback to lenders depends exclusively on the fact that in year 5 the flow from Project A will be no less than the 2,011 debt service. If it were less, in fact, the project would have reached its last year of life and it wouldn’t be possible to renegotiate the terms of repayment. In the case of Project B, in contrast, debt repayment is adapted, or ‘‘matched,’’ to the dynamic of operating cash flows.
When calculating the ratio between operating cash flow and the debt service (which shortly we will refer to as thedebt service cover ratio), we note that this varies from a minimum of 1.36 in year 2 to 2.47 in year 4.
Basically, in Project B the arranger structured the financing so that in each year of the project’s life, lenders collect on a part of their initial investment. Moreover, Project B’s repayment plan finishes at the end of year 4, which also makes it possible to renegotiate the terms of repayment, taking advantage of the key terminal value of 6,900.
Summing up, then, with Project B there is a financial flow dynamic that is modulated according to the trend in operating cash flows. This match between the operational and financial aspects of the flows is exactly what cover ratios measure.
5.3.1 What Cover Ratios Can Tell Us and What They Can’t
To make it easier to understand the meaning of cover ratios, it’s helpful to look at what theydon’tdo. They aren’t indicators of the profitability for lenders in partici- pating in a project. In fact, we have already seen that the financial model serves to compute the IRR for lenders and sponsors.
We have to remember that along with economic convenience, an initiative should also be valued in terms of financial sustainability. In other words, a project can be extremely lucrative (i.e., offer lenders an interesting IRR), yet it might not be financed if the timing for operating cash flows doesn’t match the needs for debt service payment to lenders. Moreover, a project can generate a set IRR with various cash flow combinations, but these mixes are not always acceptable to lenders.
Cover ratios are indicators of financial sustainability. These parameters enable us to recognize the sustainability of the capital structure (and repayments on financing we’ve chosen) to realize a project finance deal. Put another way, cover ratios are indices that can show the extent to which a project’s operating flows match those linked to the dynamic of financial items. A number of cover ratios are currently in use; two are particularly interesting.
5.3.1.1 Debt Service Cover Ratio (DSCR)
For each year of project operations11 this ratio expresses the relationship between operating cash flow and the debt service on the principal and interest. So we have
11. Obviously, this ratio is meaningless during the construction phase, when by definition the numerator and denominator are both zero.
134 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
DSCR¼ OCFt
KtþIt
where:
OCF¼Operating cash flow for yeart K ¼Payment on the principal in yeart
I ¼Interest payment in yeart
The ratio tells us that in any given year of operations, the financial resources generated by the project (represented by the numerator) must be able to cover the debt service to lenders (the denominator of the quotient).
In theory, the lowest number the coefficient can be is 1. In this case, clearly the entire available cash flow can be used to the advantage of lenders to service the debt.
We’re speaking theoretically because it’s equally clear that a DSCR sequence of 1 wouldn’t be sustainable. This is true not so much for lenders, who would be com- pletely satisfied (assuming for the moment there is no uncertainty regarding the outcome of the project), but for sponsors. In this situation, in fact, the flow of dividends would fall to zero for all the years earmarked for debt service. The end result in terms of the project’s IRR for sponsors would be extremely unfavorable, to the point where the project would not be economically convenient.
The theoretical situation of a DSCR equal to 1 is not acceptable to lenders either, if we remove the unrealistic hypothesis of total certainty of the value of future cash flows generated by the project. The more lenders are risk-averse, the more they would insist that a safety margin be established to guard against unexpected circumstances that could shrink the project’s cash flows and the greater than 1 the level of DSCR required for the initiative.
In this regard, the values gleaned from the project finance market are summed up in Table 5-17. As one would imagine, the level of cover ratios depends on the risk inherent to the project as perceived by lenders. This, in turn, is closely linked to the TABLE 5-17 DSCRs in Various Sectors Where Project Finance Is Used
Project Sector Average DSCR
Power:
Merchant Plants (plants with no offtake agreement) 2x–2.25x
With a tolling agreement 1.5x–1.7x
In cases involving regulated business 1.3x–1.5x
Transportation/shipping 1.25x–1.5x
Telecom* 1.2x–1.5x
Water 1.20x–1.30x
Waste to energy 1.35x–1.40x
PFI** 1.35x–1.40x
* In the telecom sector, the average DSCR is determined by the security package. The data provided in Table 5-17 refer not only to project finance deals in the strict sense, but also to refinancing existing positions on a nonrecourse basis.
** As regards PFIs, one should consider the makeup of the base case used as a point of reference. The relevant data slotted into Table 5-17 do not take into account market risk due to revenue variables (parking lots, shopping centers, restaurants, etc.). Instead, they assess only counterparty risk and the transfer of project risk underwritten in the concession agreement to the concession awarder.
Cover Ratios 135
degree with which various cash flows are secured and therefore predictable. Projects in the transportation and telecommunications sectors, where long-term offtake con- tracts can’t be implemented, can generally be financed only with higher cover ratios.
As far as the actual use of the DSCR, many loans require a specific average minimum level in addition to minimum cover ratios at set intervals (i.e., year by year). The average DSCR is nothing more than the average of the single DSCRs recorded in each year of operations:
AVDSCR¼