5.1 Analysis of Operating Cash Flows and Their Behavior in Different Project Life-Cycle Phases
5.1.1 Inputs for Calculating Cash Flows
From an operational standpoint, to come up with the estimate of expected future cash flows shown in Figure 5-1, first we have to define an extremely detailed set of input variables:
. The timing of the investment
. Initial investment costs
. The VAT dynamic
. Grants (when applicable), especially in PPP initiatives
. Analysis of sales revenues and purchasing costs
. Analysis of operating costs during the operating life of the project
. Fluctuations in working capital
. Taxes
. Macroeconomic variables 5.1.1.1 The Timing of the Investment
First, a thorough understanding of the time frame for the investment is needed. As an example, Table 5-1 shows the timing on the Italy Water Project, specifying the start and end dates, the duration of the concession, and the construction period (split into two work sections) and the operating period (again, divided into two work sections).
The length of the plant construction period impacts financial costs, especially interest and commitment fees, which accrue during construction. Legislation in many countries allows capitalization of these costs. In other words, they are not included in the profit and loss account and are added to plant costs and treated likewise during amortization. If the completion date set down in the contract is not respected, the contractor is subject to penalties, which must be factored into the financial model.
When the physical building of the plant is complete (i.e., mechanical completion), turnkey construction contracts usually call for successive testing and a commission- ing period. If the plant has not achieved the preset minimum performance levels, the contractor is forced to pay the project company penalties proportional to the length
Analysis of Operating Cash Flows and Their Behavior 105
of the delay in reaching these levels. The delay liquidated damages are also specified in the construction contract and must be included in the model. In fact, it is actually by analyzing the model that the sum of these damages is calculated; this figure is then incorporated into the construction contract. The model quantifies these penalties, which are normally expressed as a percentage of the contract value per week of delay with a maximum value, or cap, on these damages. This is computed on the basis of costs incurred every week that plant completion is postponed, naturally including financial charges.
Once minimal performance levels have been verified, the plant is tested to ascer- tain guaranteed levels (which, of course, are higher than minimum levels) correspond- ing to plant design. In some cases, the two types of testing are run simultaneously.
Table 5-2 shows the levels of water supplied by the Italy Water plant and the amount of power generated by the hydroelectric plants.
TABLE 5-1 Input Variables Underpinning the Timing on the Italy Water Project
Project Timing
Start date Jan 1, 2006
End date Dec 31, 2040
Concession duration 35.0 yr
Duration of entire operating phase 30.0 yr
Construction Period Operating Period
Total duration 5.0 yr Start of operations Jan 1, 2009
Section 1 1st Supply Level
Start date Jan 1, 2006 Start date Jan 1, 2009
End date Dec 31, 2008 End date Dec 31, 2010
Duration of Section 1 3.0 yr Duration 2.00 yr
Section 2 2nd Supply Level
Start date Jan 1, 2006 Start date Jan 1, 2011
End date Dec 31, 2010 End date Dec 31, 2040
Total duration 5.0 yr Duration 30.00 yr
TABLE 5-2 Technical Inputs for the Italy Water Project
Nonpotable water supplied prior 209 Mln mc/yr Energy produced at full capacity
106.111 GWh/yr Potable water supplied prior 123 Mln mc/yr Capacity in start-up phase 80%
1st Supply Level
Nonpotable water: Supplementary volume supplied 30 Mln mc/yr Potable water: Supplementary volume supplied 90 Mln mc/yr 2nd Supply level
Nonpotable water: Supplementary volume supplied 40 Mln mc/yr Potable water: Supplementary volume supplied 170 Mln mc/yr Total water supplied at full capacity
Nonpotable water 249 Mln mc/yr
Potable water 293 Mln mc/yr
106 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
Establishing a plant’s functional life span depends on the projections relating to its technical or economic obsolescence. Generally, this time frame runs from 15 to 25 years. It should be noted that as regards to BOT or BOOT concession schemes, normally the period used in the relative models does not exceed the length of the contract itself. In fact, when the works in these cases are completed, the plant is transferred back to the public administration free of charge; therefore the concession holder no longer serves any useful purpose. The time horizon taken into consideration has a major impact on IRR (see Section 5.2.5). The longer the time period, the better the IRR, because once the debt has been completely paid off, in the final years of the project’s life the venture produces cash flows earmarked exclusively for sponsors.
5.1.1.2 Initial Investment Cost
The price of the construction contract is only one of the components of the overall investment, and it is the simplest to quantify. In fact, this figure is specified in the turnkey construction contract. Seeing that this contract is normally signed only when the project development phase is complete, it is not unusual for the price to be changed in the interim. Along with the cost of the turnkey contract, other values that need to be estimated for the financial model are the following:
. Cost of purchasing the land where the facility will be built
. Owners’ costs
. Development costs
In addition to these factors, which we can call the project’s direct investments, the following indirect investments must also be taken into account:
. VAT on the value of direct investments
. The cost of guarantees and insurance policies (see Chapter 4)
. Capitalized interest
Figure 5-3 shows the logic behind the capital budgeting of the initial investment cost of a project finance initiative.
While the cost of plant construction (real estate and plant facilities) is not usually difficult to estimate, it is more complicated to identify all the cost items associated with plant construction. Usually all the outlay that derives from investments linked to building the plant are categorized under the heading ‘‘Owners’ Costs,’’ for example, the cost of excavating the land before beginning construction or of building access roads to the facility.
Development costs, in contrast, are related directly to realizing a project finance initiative. As we know, this form of financing is particularly onerous due to the high number of consultants needed for project development. The fees paid to these professionals are the most sizeable component of this cost category.
Beyond computing the absolute value of costs, it is also necessary to clarify the timing for each investment cost. For example, the construction contract normally stipulates that payments will be made when specific milestones are reached. These preset deadlines ensure that the construction plan is respected and verified. Clearly, the higher the concentration of costs in initial construction phases, the higher the interest that the project company will have to pay during the construction phase.
Deferred installments can lead to significant benefits for the economy of the project.
Analysis of Operating Cash Flows and Their Behavior 107
In some cases, EPC contracts include terms for deferred or advanced payments that impact the project’s financial needs. In fact, the following payment clauses are commonly found.
. Advance payment, which is usually 10% of the contract value. This is paid by the SPV to the contractor, who invoices this amount with later milestones.
. Retention payment, normally 5% of the contract value. The SPV withholds this sum from each milestone payment and makes it available only when the plant is successfully tested.
. Final settlement, which is a variable percentage of the contract value. This is paid by the SPV only when the testing phase is complete.
These advanced and/or deferred terms of payment may be included in an EPC contract, but they must be taken into account in the financial model when the cash flow analysis during the construction period is run. Table 5-3 shows the Capex figures on the Italy Water Project.
5.1.1.3 Vat—Value-Added Tax
As mentioned in the previous section, one of the factors the financial model has to estimate in order to quantify the initial investments of a project is VAT, which is an indirect investment. Since the direct investment items are quantified, the VAT rate that applies to these costs must also be determined. In many countries, refunds to taxpayers are often delayed. As a result, the reimbursement for VAT paid by the SPV during the construction period normally takes time. This is financed with a specific loan (VAT facility; see Section 6.9.4), the cost of which clearly impacts the project.
Construction costs (TKCC)
Purchase of land Owners’ costs Development costs
BUDGET OF DIRECT INVESTMENTS
BUDGET OF INDIRECT INVESTMENTS +
Capitalized interests VAT on direct
investments
Cost of guarantees and insurance during construction
%
%
%
%
%
%
%
TOTAL INITIAL COST
F I G U R E 5-3 Items Included in the Construction Cost
108 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
During the first year of construction, the project company will incur investment costs subject to VAT. Since the project company is not yet operational from a commercial standpoint, it cannot issue invoices and, consequently, collect VAT. For this reason, any VAT payments the SPV makes to suppliers are a credit toward the VAT Authority, and the SPV has to finance these expenditures until the VAT Office reimburses them or until VAT credits are offset by VAT debts from invoices to SPV customers.
The legislation of various countries allows for different options regarding VAT, and these alternatives impact the financial model in various ways.
1. A sponsor (holding at least 51% shares), which is normally in a position of debt toward the VAT Office due to its business, can offset the VAT credit of the controlled company on its own tax return. The SPV will have its VAT debt paid by the parent company, which will receive compensation in the form of a lower payment to the VAT Office when taxes fall due. Whenever possible, this is the optimal solution, since the SPV would not have to pay interest expenses to service the VAT facility.
2. When the VAT statement is compiled, the SPV requests immediate reimburse- ment for VAT credit, offering a suitable guarantee (for example, a letter of credit). Generally, this option implies that once the VAT reimbursement is requested, it would no longer be possible at a later date to compensate this credit with VAT debts that may arise in the interim (and that normally emerge when the company is operational).
3. The third option involves offsetting the SPV’s VAT credits with VAT debts during the operating phase.
Some laws allow companies to compensate VAT credits with other debts toward certain public bodies. For example, in certain cases VAT debts collected on public
TABLE 5-3 Capex on the Italy Water Project 1st Section
Capex 1 260,687 keuro 22.3%
Doubling YYYY 134,551 keuro 11.5%
Potable water system YYYY 143,332 keuro 12.3%
Design and other costs 64,445 keuro 5.5%
Expropriation 11,653 keuro 1.0%
TOTAL CAPEX 1st Section 614,668 keuro 52.5%
2nd Section
Capex 2 80,417 6.9%
Doubling XXXX 91,414 keuro 7.8%
Potable water system XXXX 259,548 keuro 22.2%
Design and other costs 51,352 keuro 4.4%
Expropriation 23,337 keuro 2.0%
TOTAL CAPEX 2nd Section 506,068 keuro 43.3%
Total Capex 1,120,736 keuro 95.8%
Life-cycle cost 49,127 keuro 4.2%
Total Investment 1,169,863 keuro 100.0%
Analysis of Operating Cash Flows and Their Behavior 109
grants awarded to the SPV can be deducted from VAT credits accrued during construction. In other situations, compensation can also be made between VAT and corporate income tax.
5.1.1.4 Public Grants
In PPP projects, public grants represent a key source of financing for building and operating facilities that serve the needs of the public. Legislation in several countries can establish the fee the concession authority pays to the concession holder/SPV as the concession price for partial funding of the project in question. The payment of this sum can be made contingent on milestones (in exchange for a guarantee provided by the shareholders of the concession holder/SPV for the amounts collected). Pay- ment can also be made at the end of the construction phase, after plant testing, or according to other parameters based on the actual availability of funds.3
The different terms of payment are reflected in the project’s financial model in various ways.
. Testing grant:When the public funding earmarked for a project is paid out at the end of the construction period, provisions are made for bridge financing, which is reimbursed in a bullet payment from the funds collected.
. Milestone grant: Here, loans are used on the basis of the milestones achieved, net of the portion of the grant received and the quota of equity conferred. The SPV’s cash flows can be used to pay the contractor only after grants are collected during the construction phase.4 In these cases, the shareholders and the SPV are often called on to provide bank guarantees or insurance coverage to the concession authority for reimbursement of the funds received. Fees incurred for this letter of credit, which has the same implicit risk as senior debt, are also included when the economic/financial plan is drawn up.
In the Italy Water Case, the public grant is calculated as a percentage of construction costs and paid out during the construction phase for each work section (see Table 5-4).
5.1.1.5 Analysis of the Sales Contract, the Supply Contract, and Operating Expenses When the financial model is being built, contracts pertaining to the sale of the product, the supply of raw materials, and maintenance and operations are still in the drafting stage.
In terms of financial models, it is simple to verify how effective risk allocation can improve the inherent quality of a project. See Figure 5-4, where operating cash flows are illustrated along with the major forms of coverage for project risks.
When the advisor sets up the financial model and contract terms are not yet definitive, standard prices and conditions applied by the market for similar initiatives are included in the calculations. In the Italy Water case, the concession holder has to sign off taking contracts with a water supplier who buys the potable water and then
3. Some laws may oblige the concession authority to divest assets in order to source public grants.
Therefore, the availability of funds for grants depends on the timing of the divestitures and the ability of the concession authority to carry out the public procedures required to sell off the assets in question.
4. When the percentage of grants is sizeable with respect to the project requirements, banks can issue a standby facility on a revolving basis that covers temporary lack of liquidity due to delays in grant disbursement by the concession authority.
110 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
pipes it through a water supply network to end users. The concession holder commits to delivering a certain quantity of water at preset contract prices, which are read- justed annually on the basis of prices indices (production or consumption). A similar situation applies for untreated water, which is sold to agricultural consortia on the basis of variable-length contracts with preset prices. Moreover, Italy Water will also TABLE 5-4 Payment of Public Grants in the Italy Water Case
Year/Progr.
2006 2006 2007 2008 2009 2010 2011 2012
1 2 3 4 5 6 7 8
Public Installments 616,405
1st Section (keuro) 72,376 240,028 296,938 5,327 — — — —
TOTAL CAPEX 1st Section
55% 55% 55% 55% 55% 55% 55% 55%
GRANT 1st Section (keuro)
39,807 132,015 163,316 2,930 — — — —
2nd Section (keuro) 6,277 7,099 118,686 150,490 151,703 71,813 — —
TOTAL CAPEX 2nd Section
55% 55% 55% 55% 55% 55% 55% 55%
GRANT 2nd Section (keuro)
3,452 3,904 65,277 82,770 83,437 39,497 — —
Total Grants (keuro) 43,259 135,920 228,593 85,699 83,437 39,497 — —
+ Revenues from sales
− Raw materials and other operating costs
− O&M fees
− Insurance costs
− Taxes
= Operating cash flow—gross +/− Increase in working capital
− Capital expenditures (Capex)
= Operating cash flow−−net (Unleveraged free cash flow)
Possible reduction of cash flow
volatility Offtake agreements
Put or pay agreements O&M agreements
Insurance contracts
EPC contract
F I G U R E 5-4 Operating Cash Flows and Contractual Agreements
Analysis of Operating Cash Flows and Their Behavior 111
be able to use the water for power production, which can be sold on the basis of long- term take-or-pay contracts with utilities operating in the power sector. In this regard, see the inputs at the basis of sales revenues on water and energy used for the Italy Water Case (Table 5-5).
An important feature in fixed-price contracts is the escalation mechanism that updates prices on the basis of inflation. Clearly, the project is subject to risk associ- ated with the different formulae for cost and revenue indexation (which the model must be able to identify). Forecasts adopted in the Italy Water model index revenues on the sale of water to a cautious estimate of a 2% annual rate; revenues from power are escalated at 1.5% annually. The importance of these predictions derives from the fact that the concessions in question last a considerable length of time, and the multiplying effect of a high inflation rate, in the long run, could lead to an overestimation of the project’s profitability potential.
As regards determining annual cost items, this process depends to a great extent on the choice of the plant operator. This may be an external company or the SPV itself (though less often). While in the latter case the project company will bear all types of costs inherent to plant operations and maintenance, in the former situation
TABLE 5-5 Inputs Used to Quantify Revenues for the Italy Water Case
REVENUES FROM WATER
Annual escalation 2.0%
REVENUES FROM POTABLE WATER
Potable water already supplied (Min mc/yr) 123
Tariff Dec. 31, 2009 (Euro/000mc) 225.2
Additional potable water at full capacity (Min mc/yr) 170
Tariff Dec. 31, 2009 (Euro/000mc) 337.8
REVENUES FROM NONPOTABLE WATER
Nonpotable water already supplied (Min mc/yr) 209
Tariff Dec. 31, 2009 (Euro/000mc) 0.0
Additional nonpotable water at full capacity (Min mc/yr) 40
Tariff Dec. 31, 2009 (Euro/000mc) 270.3
VAT 10%
REVENUES FROM POWER
Annual escalation 1.5%
Tariff—flowing water
Power at capacity (base calculation) (GWh/yr) 32.8
Tariff Dec. 31, 2009 (Euro (000)/GWh) 57
Tariff Dec. 31, 2009 (Euro (000)/GWh) 62
Tariff 25% F4
Power at capacity (base calculation) (GWh/yr) 73.3
Tariff Dec. 31, 2009 (Euro (000)/GWh) 63
Tariff Dec. 31, 2009 (Euro (000)/GWh) 69
Green Certificate Tariff
Power at capacity (base calculation) (GWh/yr) 106.1
Green Certificate Tariff (Dec. 31, 2009) (Euro (000)/GWh) 116
VAT 20%
112 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
the key cost item for the project company is the O&M fee paid to the operator.
At most, there may also be additional cost items such as insurance premiums and other costs for other, less important input used in the process.
However, it’s rare that a definitive agreement already exists with the future operator when a project is initially being structured. So, from a financial modeling standpoint, it’s best to detail all applicable categories of operating and maintenance costs, irrespective of the fact that some of these will be absorbed in the total remuneration paid to the third-party operator in the form of an O&M fee.
As regards the Italy Water Case, Tables 5-6, 5-7, and 5-8 respectively show inputs for estimating fixed costs, variable costs, and payments made to the public adminis- tration that assigns the concession.
A dummy item, general plant expenses, is often used. Normally calculated as a percentage of budgeted costs, it’s slotted into the model under both annual costs and investment costs. This item, which is usually no more than 5% of the cost breakdown, serves as a ‘‘cushion’’ that can absorb small changes in cost or additional costs, when applicable.
TABLE 5-6 Inputs for Estimating Annual Fixed Costs for the Italy Water Case
VAT WATER
1. Personnel costs
Employees 130 0%
Annual cost (Euro (000)) 60.48
2. Ordinary maintenance (Euro (000)) 5,355 20%
Percentage of investment 0.50%
3. Other services (Euro (000)) 2,066 20%
4. General plant expenses (Euro (000)) 1,379 20%
Percentage of operating and personnel costs 5%
POWER
1. Operating cost of power plants (Euro (000)) 1,350 20%
TABLE 5-7 Inputs for Calculating Annual Variable Costs for the Italy Water Case
VAT Water purification equipment
Annual cost of potable water (mc) (Euro/000mc) 60 20%
TABLE 5-8 Costs Related to Annual Payments to the Public Administration for the Italy Water Case
Operating fee for existing aqueduct (euro) 2.5 million
Operating fee for the new aqueduct (euro) 5 million
Operating fee for exploitation of hydroelectric power (euro) 5 million
Analysis of Operating Cash Flows and Their Behavior 113