5.2 Defining the Optimal Capital Structure for the Deal
5.2.5 Identifying Sustainable Debt/Equity Mixes for Sponsors and Lenders
Up to this point we have studied what operating cash flow is and where it can be channeled, but we haven’t yet mentioned how to define the debt and equity mix to use to finance the structure. Clearly, without this information we can’t evaluate whether the inequality in Figure 5-5 (Capacity> Requirements) is verified or determine the values on which the waterfall structure in Figure 5-6 is based.
What’s more, from the perspective of financial models, the problem generates a circular calculation: The operating cash flow has to be used to pay the debt service and dividends, but we don’t know how much this is until we work out the quantity of debt and capital conferred for the project. On the other hand, the amount of the loan actually drawn down, in turn, determines the total cash flow to cover in light of the capitalization of interest and fees on the same loan during the construction period.
This problem is solved through a process of trial and error. Basically, the arranger makes note of the variables that determine operating cash flow, along with project risks and relative coverage. A definite capital structure is then included in the model (usually the one the sponsors have in mind or suggest) and slotted into the framework of the spreadsheet. The proposed financial structure together with the hypothetical debt repayment plan give rise to the requirements for debt service for the principal and interest. By comparing the debt capacity (represented by operating cash flow) and debt requirements, we can see if the debt/equity mix is sustainable. If the former is larger than the latter, the hypothesis is technically feasible from a financial standpoint. If the opposite is true, the proposal is rejected. At this point the arranger will come up with another alternative with a lower debt component or with different contract terms with respect to the prior proposal.
By means of the simulations run through the financial model, the advisor/
arranger can come up with a series of debt/equity mixes that in every year of the operating phase satisfy the condition:
Operating cash flow > Debt service
The final solution chosen lies in the logical scheme illustrated in Figure 5-9. The dotted lines in the work flowchart show a revision in the variables that determine operating cash flow; solid lines correspond to a change in the debt/equity mix or a modification in the terms of the loan agreement. The advisor’s main concern is to set up the deal with a capital structure that can satisfy the demands of SPV shareholders as far as IRR. However, a necessary compromise between the needs of the sponsors and the interest of lenders must be found. If this doesn’t happen, it will be impossible to raise the capital needed for the project.
5.2.5.1 Optimal Capital Structure for Project Sponsors
To ascertain which solution is actually chosen among the possible options, let’s begin by saying that an advisor’s first concern is to set up a deal that’s consistent with the sponsors’ mandate. Essentially, sponsors expect a return on the capital they’ve invested that is consistent with the degree of risk they’ve taken on in the project.
In finance literature on capital budgeting for investment projects, one of the most commonly used indicators for measuring the return on an investment is the internal rate of return (IRR). This is the interest rate that makes the net present value of a 124 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
project’s positive operating cash flows equal to the net present value of its negative operating cash flows. With project finance, the former are generated during the operating phase; the latter are concentrated during the construction phase.
In other words, we have XM
t¼0
OCFt
(1þIRRproject)t¼Xn
t¼M
OCFt
(1þIRRproject)t
The term on the left is the sum of the present value of negative cash flows from time 0 (project start-up) to M(end of the construction phase or COD, commercial operating date). The term on the right, in contrast, indicates the present value of positive flows produced by the project fromM(again, the COD) ton(the last year of the project’s life).
Consider the fact that the following is true of the operating cash flows.
. They are financed in part with debt and in part with equity during the con- struction phase.
. A portion is earmarked to repay the debt service, and another portion goes to paying dividends during the operating phase.
Operating Cash Flow
Capital Structure Proposal
Is the D/E consistent with the lenders’
IRR?
Is the D/E able to satisfy the cover ratios?
Optimal Capital Structure NO
NO NO
YES YES YES
NO NO NO
Is the D/E consistent with the sponsors’
IRR?
F I G U R E 5-9 Arranger’s Work Flow in Choosing a Financial Structure
Defining the Optimal Capital Structure for the Deal 125
Keeping this in mind, it is also possible to calculate an IRR from the viewpoint of the sponsors and of the lenders. The IRR, in this case, represents the return on the operation for those who confer equity and the financing bank.
As for sponsors, future positive flows are represented by the dividends disbursed by the SPV or interest and principal repayments on the subordinate debt (see Chapter 6).
Negative flows consist of equity injections for the initiative.10 In other words, we have
XM
t¼0
Ct
(1þIRRequity)t¼Xn
t¼M
Dt (1þIRRequity)t where:
Ct¼Capital contribution in year t
M¼Last year of equity contribution by sponsors Dt¼Dividends received by the sponsors in year t IRRequity ¼Internal rate of return for the sponsors
The term on the left side of the equation represents the discounting of all equity contributions, which offsets the right side, the current value of all dividends collected by sponsors starting from yearM. Naturally, ifM¼0, there would be only one equity payment at the start-up of construction and the left term would be simplified toC0.
When sponsors commission the advisor/arranger to set up the deal, they already have a clear idea of the lowest acceptable IRR: This is their weighted average cost of capital (WACC) or a higher predefined threshold rate. Below this floor the initiative is of little interest to sponsors, and realizing it with project finance techniques is no longer economically convenient.
The calculation of WACC for the SPV must take into consideration both the cost of equity (ke) and the cost of debt (kd), with weights represented by the optimal debt- to-equity ratio selected on the basis of the work flow illustrated in Figure 5-9.
The cost of equity for the SPV (this equity being the sponsors’ investment), in turn, reflects the WACC of each sponsor. Moreover, the cost of debt reflects the financial market’s perception of the project’s inherent risk as well as the intensity of competition on the financial markets. Therefore, this cost depends on project fea- tures, such as the economic/financial soundness of the initiative, the level of risk coverage provided by the contractual network surrounding the deal, and the standing of the counterparties to these contracts.
It follows that valuing the economic convenience of a project finance deal is more complicated than one involving an already-in-place company. This valuation must be done by comparing the project’s IRR, calculated by using operating cash flows (IRRProject) and the WACC of the SPV. This, in turn, is the weighted cost of the equity conferred by sponsors and the cost of the loans provided by creditors. The concepts are summarized in Figure 5-10.
10. Moreover, among other future benefits, there is interest on the cash in the SPV’s accounts that was set aside during the operating phase. These are dividends that were not distributed for lack of economic ‘‘capacity’’
of net revenues of the vehicle company due to the weight of amortization during the project’s first years of life.
This is the effect of the ‘‘dividend trap,’’ which is discussed in Section 6.8.
126 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
The term on the right side of the formula in Figure 5-10 is the WACC of the SPV, which, in turn, is given as the average of the cost funding on the debt (kd) net of the fiscal effect (l – t) and the cost of equity. This latter factor is the WACC of each sponsor who participates in the deal.
In addition to the use of NPV and IRR for the valuation of the economic convenience of a project finance, many sponsors often also use thepayback period, which is the moment in time when the project’s outflows and inflows are equal. There are two variants of the payback period, one based on nominal flows and one based on discounted flows:
Nondiscounted payback: Xx
t¼0
Ft¼0
Discounted payback: Xx
t¼0
Ft
(1þi)t¼0
whereFtare the cash inflows and outflows from the project,xis the payback period, andiis the selected discounting rate.
Although payback is not an accurate criterion for evaluating the economic convenience of investments projects, it is useful as a complementary indicator to the IRR. With equal rates of return, in fact, a project that can achieve payback more quickly is more attractive to a risk-averse investor.
5.2.5.2 Optimal Capital Structure for Lenders
An arranger or a participant in a project finance deal can frame an assessment of economic convenience in various ways.
A D
E Project IRR
SPV’s cost of debt (kd SPV)
Sponsor 1
Sponsor 2
Sponsor n
D E
D E
D E
WACC Sponsor 1
WACC Sponsor 2
WACC Sponsor n
Special-Purpose Vehicle
Accept if:
D + E E E
Equity−sponsork WACC sponsork
D + E IRR ≥ kd (1−t ) × D n
k =1
⎟×
⎠
⎜ ⎞
⎝
⎛ ×
+ ∑
F I G U R E 5-10 Calculation of WACC for an SPV
Defining the Optimal Capital Structure for the Deal 127
The first is to calculate the net present value (NPV) by using the data contained in the financial model compiled by the advisor. Cash flows are discounted until the moment of assessment (realistically speaking, when the arranger asks the bank for the first disbursement of funds for the project) utilizing one’s own cost of funding:
NPV¼MþnX
t¼M
DSt
(1þc funding)tXM
t¼0
DUt
(1þc funding)t
In the formula, M stands for the year when debt repayment begins, n is the terminal date for the last installment, DS is the debt service for each periodtduring the operating phase, and DU is the debt utilization during construction.
As we can see, the higher the NPV, the lower the cost of funding. Retail banks (i.e., banks that collect deposits from ordinary customers) can often earn lucrative margins because they can obtain a lower cost of funding than banks that would finance the deal by sourcing the interbank market. For these organizations, the initiative is only evaluated in terms of the margin over the benchmark rate.
The second way to value the economic convenience of a deal is to compute the IRR of the flows of lenders’ fees, interest, and capital contributions/repayments, once again gleaned from the financial model drawn up by the advisor. Potential lenders evaluate whether the project’s IRR is consistent with the degree of risk inherent to the initiative. The IRR for a lender who provides ‘‘pure’’ debt capital (that is, excluding the option of recourse to forms of mezzanine or subordinate debt) is influenced by the expected flows for debt service and the dynamic for the disbursement of funds during construction.
As a mathematical formula, we have XM
t¼0
Dt
(1þIRRdebt)t¼XM
t¼M
KtþIt (1þIRRdebt)t where:
Dt¼Drawdowns on funds in yeart M¼Last drawdown period on loans M0¼Last payback period on funds
Kt¼Principal repayment in yeart It¼Interest repayment in yeart IRRdebt¼IRR for lenders
The sensitivity and expertise of the advisor/arranger lies in the ability to pinpoint an IRR that would elicit the interest of lenders’ credit committees. Proposing an IRR that’s too low would work to the sponsors’ advantage but would involve the risk of taking on a sizeable portion of the financing. Advancing an IRR that’s too high is no doubt appealing to the banking community, but it would jeopardize sponsors’
128 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
satisfaction. A satisfactory level of IRR provides an additional filter to the advisor for the different debt/equity options for the initiative in question. In fact:
. If the proposed financial structure satisfies the sponsors but not the lenders, it has to be rejected.
. If there is no debt/equity mix that satisfies shareholders and lenders at the same time, estimates on operating cash flow should be revised. Then further attempts should be made to strike a balance between sponsors’ and financers’ interests.
. If the debt/equity mix satisfies both parties, the condition of economic conveni- ence is guaranteed. The analysis should then be completed by calculating the cover ratios. If lenders find these acceptable too, then the project’s financial structure has been found.
If the difference between the IRR and the cost of funding for an individual bank is positive, this signals that undertaking the initiative would be convenient because the NPV is positive. This difference, like the NPV, is not the same for all the banks because it depends on the cost of the funding sourced to participate in the initiative and on the fee level paid to each category of bank.
The limitation of the two methods just described lies in the basic assumption that the bank finances participation in the deal solely with capital collected from retail deposits (or from other banks if the funding is raised wholesale on the interbank market). In actual fact, lending also absorbs shareholders’ equity. In fact, the riskier the loan, the greater this absorption should be. (In banking jargon, we say that the risk capital, or CaR—capital at risk, should be greater.) The shareholders’ equity has a much higher opportunity cost than the cost of funding, and the two previous criteria could distort assessments on economic convenience.
There are a number of possible solutions to this crucial problem. The first is to calculate NPV by discounting the flows to a rate that represents a combination of risk capital and loan capital (intended as the marginal cost of funding based on an appropriate interbank rate) rather than only the cost of funding. The rate used for discounting can then be calculated as
WMCF¼IR(1RW8%)(1t)þkeRW8%
where:
WMCF¼Weighted marginal cost of funding IR¼Interbank rate
RW¼Risk weight t¼Corporate tax rate ke¼Cost of bank equity
8%¼Minimum capital requirement coefficient
The weighting factors (RW) can be the percentages required by supervisory bodies in terms of capitalization (standardized approach), or they can be calculated internally by the bank using its internal rating systems (see Section 8.4). For example, suppose that the interbank rate is 4.5%, thatke for the bank is 10%, and that the corporate tax rate is 40%. If the bank uses the risk weight proposed by the Basel
Defining the Optimal Capital Structure for the Deal 129
Committee for deals qualified as ‘‘strong’’ (70%), the deal is supposed to be financed with 70%8%¼5.6% equity and (100% – 5.6%)¼94.4% interbank deposits. The weighted marginal cost of funding would then be
WMCF¼4:5%(10:708%)(10:40)þ10%0:78%¼4:81%
The second solution would be to compare this same weighted marginal rate to the IRR of the initiative. If the difference between the IRR and the weighted marginal rate is positive, the deal is accepted; it’s rejected if the opposite is true.
The third solution hinges on accounting parameters, although they are less accurate methodologically speaking. On the other hand, accounting data are imme- diately understandable by credit committees or the boards of directors of lending banks. Some banks take a criterion based on calculating the annual return on their equity absorbed by the project. They then compare it with a benchmark established by top management that represents the cost of funding for the bank (ke). In some countries, banks refer to this with the acronym ROS (return on solvency).
A simplified calculation of the equity absorbed can be done by multiplying the outstanding debt at the end of every year (O) by the coefficient of the minimum capital requirement established by supervisory bodies. (For the portion of the loan that has actually been disbursed, this is 8%; for the portion that has been committed but not yet utilized, 6% is applied, i.e., 75% of an 8% coefficient.) The numerator of the quotient is represented by the margin with respect to the cost of funding (S, or spread) plus fees (F).
It would be convenient for the bank in question to participate in the initiative if:
SþF
O8%þC6%ke>0
where C (committed) stands for the amount of financing that has not yet been utilized.
Table 5-13 provides an example showing this calculation with reference to a generic valuation date (December 31, 2005). Note that calculations are done on an actual/360 basis, and the return on equity absorbed is annualized under simple capitalization conditions. In this case, with a benchmark rate of 13%, the project generates an 11.91% return on solvency. Therefore, it should be rejected.
The last available option is based on the assumption that the bank can estimate value at risk (VaR), i.e., the unexpected loss on project finance initiative. This is done to quantify the maximum amount the bank could lose on a given time horizon and with a certain statistical level of confidence (usually 99%). As we’ll see in Sections 8.4.1.1 and 8.4.1.2, some empirical tests show that the recovery rate on project finance deals is statistically higher than similar corporate exposures. So applying standard weighting factors (8% and 6%) could result in an overestimation of the equity absorbed.
Given historical data on the probability of default (PD) and the loss given default (LGD), if a bank can estimate the expected loss (EL) and its frequency distribution, a percentage value of unexpected loss can be computed within the chosen statistical level of confidence interval. While expected loss should be covered by the cost of funding (the margin), unexpected loss is a risk taken on by shareholders. They sustain this risk by utilizing their own equity, which has a cost of ke. It follows that the 130 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
interest rate the bank should charge on this deal in order to satisfy the expectations of shareholders must take the following into account:
. The internal transfer interest rate (IRT) used to finance the operation, usually close to an interbank rate
. The expected loss on project finance deals that are comparable to the case in question (EL)
. The value at risk of the deal (VaR)
. The difference between theke and the IRT (though the deal could be financed entirely with interbank loans, ideally, the project should absorb shareholders’
equity as well) So we have
Rr¼IRTþELþVaR(keIRT)
Rearranging this equation to express (keIRT), we can get a measure of return corrected for risk, or risk-adjusted return on capital (RAROC).
TABLE 5-13 Calculation of ROS for Banks for December 31, 2005 Amount
(euro/mil.)
Margin (b.p.)
Days in the Period
Margin (euro/mil.)
VAT loan—conferred at start of period 8,400 100 184 42,93
Base loan—conferred at start of period 40,791 150 184 312,73
Standby loan—conferred at start of period — 160 184 —
Total margin 355,66
Amount (euro/mil.)
Commitment Fee
Days in the Period
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
Amount (euro/mil.)
Weighting Factor
Equity Absorbed (euro/mil.)
VAT loan—committed, utilized at end of period 11,350 8.00% 908.00
Base loan—committed, utilized at end of period 59,238 8.00% 4,739.04
Standby loan—committed, utilized at end of period — 8.00% —
VAT loan—committed, not utilized at end of period 10,650 6.00% 639.00
Base loan—committed, not utilized at end of period 58,762 6.00% 3,525.72
Standby loan—committed, not utilized at end of period 7,000 6.00% 420.00
Total equity absorbed 10,231.76
Return on equity absorbed (annualized) 11.91%
Benchmark rate 13.00%
Defining the Optimal Capital Structure for the Deal 131