LLCR ¼ Xsþn
5.4 Sensitivity Analysis and Scenario Analysis
5.4.1 Which Variables Should Be Tested in Sensitivity Analysis?
The guiding principle for advisors in generating scenarios is relevance. In fact, it makes no sense to offer scenarios produced by modifying variables with little
Variations in:
• tariffs/unit revenues
• Provisioning costs
• Other operating costs
Sensitivity analysis
IMPACT ON OPERATING CASH FLOWS
Results
SCENARIO 1 SCENARIO 2 SCENARIO ...
Debt service capacity >
Debt service requirements? F I G U R E 5-12 Logic Behind Sensitivity Analysis
Sensitivity Analysis and Scenario Analysis 141
impact on the values of operating cash flows. It is much more logical, instead, to ascertain which values, when altered only slightly, are apt to cause significant variations in total available cash flows for debt service. Normally, these variables are the ones that determine the components of operating cash flow, such as sales revenues and operating expenses Consider, for example, inflation rates to which sales prices are indexed, or the cost of sourcing input that isn’t covered by put- or-pay contracts.
Table 5-21 provides an example of variables that can be tested in sensitivity analysis. Naturally, though these variables are linked directly to the Italy Water Project, it is worthwhile to study them closely to give yourself a feel for conducting
‘‘what if’’ analysis.
Drop in Water Supply Tariffs: One of the most critical variables in choosing the preferred bidder in a call for public tender is the fee structure for the service offered, although this is the most effective tool in determining the profitability of the project. For this reason, the definitive fee structure is set up just before ‘‘the sealing of the envelopes’’ containing the offers presented to the public concession authority. In the Italy Water Project, the difference between the fee for water for nondrinking water (100 euro per 1000 mc of water supplied) and for drinking water (300 euro per 1000 mc of water supplied) is due to the cost variables for water treatment.
Drop in the Price of Green Certificates: The Italy Water Project also involves the production of around 106 GWh/year of hydroelectric power when the plant is fully functional. These facilities take advantage of the opportunity to sell Green Certificates for the first 8 years of operations at an estimated price; the actual value is contingent on market trends underlying the sales of these certificates. To compute the potential impact of a price reduction of Green Certificates in 2009, we arbitrarily decided on a percentage drop in the sales price.
Increase in Fixed Costs: Some fixed costs can be established in contracts; others, such as general expenses or personnel costs, are only estimates and as such are subject to change. The same considerations can be made as regards variable costs, in light of the fact that an increase in water treatment costs triggers a price hike for the supply of drinking water.
TABLE 5-21 Downside Scenarios in the Italy Water Case 1. Decrease in water tariffs
Tariff on drinking water 20%
Tariff on nondrinking water 20%
2. Decrease in price of Green Certificates 20%
3. Increase in operating costs þ20%
4. Increase in base tax þ100 basis points
5. Increase in investment costs þ10%
6. Decrease in public funding 20%
7. Decrease in duration of concession 5 yrs
142 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
Variation in the Interest Rate: The Italy Water simulation is based on the assumption that interest rates will rise at the same rate as inflation. The outcome of the simulation depends largely on the coverage policy adopted for interest rate risk.
If most of the debt is converted to a fixed rate, a rate increase would lead to an increase in the operating margin (assuming that costs and revenues rise proportionally to the same degree) along with a negligible upswing in interest expenses. Conversely, a drop in rates would cause the operating margin to shrink considerably, with a limited decrease in interest rates. The project tends to downslide as rates fall. The opposite occurs with variable-rate financing, for it is more likely that the growth in the operating margin will be more than compensated by the increase in interest payable.
Increase in the EPC Contract Price: Even though the EPC contract is normally a fixed-price agreement, conditions may arise that would necessitate raising the price during the construction phase. All parties might agree to an increase to pay for improvements on the initial project, for example. Or extra funds may be needed to contend with force majeure events (costs linked to implementing new safety standards, or new regulations on emissions, etc.). In any case, increases (debiting ancillary charges such as VAT and interest as well) have to be limited to the total available stand-by funds (stand-by equity and stand-by loan). If the cost increase exceeds available funds, a default event would result. Therefore, when this simulation is run, we have to make sure the stand-by facility is not entirely drained.
Cut in Public Grants: The variable that quite probably has the greatest influence on the concession authority in choosing an offer is the economic/financial equilibrium of the project. With BOT concessions for building and operating public services, private financing (meaning conferring of debt and equity) is not enough to guarantee an adequate return on investment and total reimbursement of the loan.
For this reason, this type of sensitivity plays a key role in decision-making policies of private sponsors. A cutback in public grants during the construction phase has to be compensated by a step-up in financing, where financial ratios are adequately robust, and a bigger contribution from sponsors.
Decrease in the Duration of the Concession: The length of the concession is quite a significant variable for the public concession authority when choosing the winning proposal, though this factor does not greatly impact the financial/economic equilibrium of the project. In fact, in the case of concessions running over 20 or 30 years, extending or compressing the life span of the contract does not affect the rate of return on the project or on investment capital a great deal. As regards the project’s financial sustainability, instead, despite the obvious condition that the final maturity of the loan must predate the expiration of the concession, limiting the duration of the concession increases the risk of the project. The reason is that if downside scenarios occur that call for additional funds, the possibility to refinance the loan is partly compromised.
Once variables are singled out, an accurate range of variation has to be set for each one. Whenever possible, common sense should be substantiated by assessments conducted by various consultants, for specific areas of expertise (how much operating costs could actually fluctuate, the lowest possible level of plant efficiency, the real
Sensitivity Analysis and Scenario Analysis 143
risks of price increases for the EPC contract, etc.). Simulations on single variables should not show excessive sensitivity to results of the project initially measured by DSCR, LLCR, and IRR.
An even more important result emerges from simulations that take into account several downside conditions in the same scenario. This is done to test the project’s robustness when adverse circumstances coincide. The combined downside scenario has to demonstrate that the project can repay the loan installments on the principal and interest. In terms of the model, this means that the minimum DSCR level has to be at least 1. A lower figure would imply that cash flows generated are not enough to repay the debt.
The scenario presented in Table 5-22 produces unacceptable financial results from a financial perspective and in terms of earnings (minimum DSCR 1.06x, minimum LLCR 1.08x, project IRR 7.75%, shareholders’ IRR 6.47%). However, here it’s crucial to understand the meaning of the analysis. A downside scenario has to be
‘‘validated’’ by the bank’s technical consultant, and in any case it has to be properly mitigated through commercial contracts and the concession contract.
Moreover, in these circumstances the outcome of the model should be interpreted carefully. For example, suppose we come up with a minimum DSCR of 0.95xand an average DSCR of 1.30x. On average the project can readily repay the debt in full (with a margin of 30%). However, in at least one operating year the available cash flow is inadequate. This is easily dealt with by redefining the payback plan, as we see in Section 6.9. If the new plan is also appropriate in the ‘‘normal’’ situation established
TABLE 5-22 Combined Downside Scenario in the Italy Water Case
Variables Base Case % Downside Scenario
Increase in Capex(keuro) 1,120,737 7 1,197,555.0
Decrease in Water Tariff
Tariff on potable water (Euro/000 cubic meters) 338 5 321.1
Tariff on non-potable water (Euro/000 cubic meters) 113 5 107.4
Increase in Opex(keuro) 21,701 7 23,220.1
Green Certificate (Dec. 31, 2009)(Gwh/yr) 116 5 110.2
Water Authority Fee(keuro) 5,000 10 5,500
Energy Authority Fee(keuro) 5,000 10 5,500
Public Grant (% on Capex)
Section 1 55% 2.50 52.5%
Section 2 55% 2.50 52.5%
Senior Facility Base rate 4.50% 1.50 6.00%
Results DSCR
Min 1.48 1.06
Average 1.51 1.09
LLCR
Min 1.53 1.08
Average 1.55 1.09
IRR
Project 9.54% 7.75%
Equity 12.42% 6.47%
144 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
in the base case, it can be adopted; otherwise, contract terms can be considered that allow for a certain margin of flexibility (albeit limited) in the repayment plan.13
An alternative and complementary method for verifying a project is to change each relevant variable until we find the value that gives us a minimum DSCR of 1,
1.50 1.56 1.60
1.521.53 1.511.52
1.51 1.51 1.501.50
1.50 1.50 1.49 1.48
1.69
1.57 1.57 1.55 1.56 1.54 1.55
1.54 1.54 1.53 1.53
1.53 1.53 1.53
1.53
1.30 1.40 1.50 1.60 1.70
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 1.40 1.45 1.50 1.55 1.60 1.65 1.70
F I G U R E 5-13 DSCR and LLCR Trends in the Italy Water Project
13. Modeling the optimal payback plan can be done by calculating the loan installment beginning with the available cash flow estimated by the model, rather than by carrying out endless trials. Assuming a minimum DSCR of 1.30x, the loan installment (principalþinterest) should be proportional to the available cash flow by a ratio of 1:1.30. Subtracting interest due from the figure obtained by this calculation, we get the installment on capital. See Section 6.9.7 for more information.
5.0% 5.0%
6.2%
5.4% 5.4%
7.1%
8.2% 8.7%
9.5%
8.2%
7.3%
6.6%
6.4%
5.2% 6.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 F I G U R E 5-14 Reimbursement Trend for the Senior Facility in the Italy Water Project
Sensitivity Analysis and Scenario Analysis 145
which is inherent to the situation described earlier of a missed installment payment (assuming an optimal repayment plan). If the variation needed to trigger a project default is so extreme as to be highly improbable, the project would prove sufficiently robust in the face of events that could give rise to such changes. On the other hand, if the variable stays at a plausible value, this signals the need to find adequate structures to mitigate this risk. For example, if the project tends toward default when quite plausible interest rate increases are considered, hedging policies should be reviewed, and the fixed-rate component of financing should be given more weight.
In designing the model, we should keep in mind the importance of visualizing the economic factors of the project through images and graphs. Often this makes it possible to understand the problem quickly.
The DSCR and LLCR profiles (such as the ones shown in Figure 5-13) provide a snapshot of possible inefficiencies of the payback plan.
By visualizing the repayment plan itself, instead, we can clearly see if the profile is excessively back-ended, i.e., if the final installments are too heavy. See, for example, Figure 5-14.
146 C H A P T E R u 5 Valuing the Project and Project Cash Flow Analysis
C H A P T E R
u6
Financing the Deal
Introduction
Funding a project finance deal is extremely complex. In both the case of bank loans and recourse to the capital market (bond issues), the size of projects means that a large number of banks or very many bond investors must participate. For an example, see the tombstone in Figure 6-1.
This chapter reviews how syndicated loans and bond issues are organized and also analyzes the various alternatives sponsors have for obtaining funds to invest in their projects. The first three sections investigate the structure of syndicated loans, the most common form of funding used for project finance deals. The analysis covers the activities of advisors, arrangers, and other roles and the various fees paid for organization of the pool itself. International projects syndicates often include multilateral banks (MLBs) and export credit agencies (ECAs) (Sections 6.4 and 6.5). Their involvement means private banks can enjoy privileged creditor status; this has considerable advantages from the standpoint of credit risk and equity absorption. Section 6.6 gives a summary of other financial intermediaries who may participate in a project finance deal, whereas Sections 6.7 to 6.11 analyze the various forms of funding. Section 6.7 covers equity provided by sponsors; Section 6.8 analyzes mezzanine financing and subordinated debt; senior debt and refinancing are covered in Section 6.9; and leasing is covered in Section 6.10.
The chapter ends with Section 6.11, which examines the project bond market and the process for issuing these securities.