For reference

1. Project Finance Modeling
An Introduction

2. 2
What is a “project”?
 A project is a temporary, one-time activity
undertaken to create a unique product or
service, which is intended to bring about
beneficial change or added value.

3. 3
What is a “project”?
 A project’s characteristic of being a temporary,
one-time event contrasts with processes or
operations, which are ongoing activities
intended to create the same product or service
over and over again.

4. 4
What is “project finance”?
 Project finance is the financing of long-term
infrastructure and industrial projects based
upon a complex financial structure.
 Both project debt and equity are used to finance
the project.
 Debt is repaid using the cash flow generated by
operation of the project, rather than other
resources of the project owners.

5. 5
What is “project finance”?
 Financing is typically secured by all project
assets, including any revenue-producing
contracts intended to be fulfilled by future
activities of the completed project.
 Lenders are also given the right to assume
control of a project if the project company has
difficulties complying with loan terms.

6. 6
What is “project finance”?
 Generally, a special purpose entity is created
for each project.
 This shields other assets owned by a project
sponsor from failure of the project.
 As a special purpose entity, the project
company has no assets other than the project

7. 7
What is “project finance
modeling”?
 Project modeling is the development of
analytical models to assess the risk-reward,
cost-benefit or feasibility of a project.
 Project finance modeling is the development of
analytical models to assess the risk-reward of
lending to or investing in a project.

8. 8
What is “project finance
modeling”?
 All financial evaluations of a project depend
upon projections of expected future cash flows
generated by activities of the completed project.
 Forecasting project cash flows requires a
thorough understanding of the methods,
techniques and computer software commonly
used in such projections.

9. 9
What is “project finance
modeling”?
 The analytical challenge is to design financial
projection models that are:
– Thorough in scope
– Accurate and reliable
– Flexible in accommodating revisions
– Quick to develop and maintain

10. 10
Course Outline
 Project lending: Credit considerations
 Project investing: Measures of return
 Lending or investing: Free cash flow
 Modeling issues
 Dealing with data

11. 11
Project Lending
 Expected from owner before approval:
– Economic justification for project
 Feasibility study
 Cost – benefit analysis
– Demographics
– Assumptions
– Projections
– IRR, NPV, etc.
– Identified risks

12. 12
Project Lending
 Expected from owner before approval:
– Detailed cash flows
– Detailed project time schedule
 Together, cash flows and time schedule dictate
borrowing and repayment schedule

13. 13
Project Lending
 Expected from bank before approval:
– Evaluation of project benefits and risks
 Is economic justification believable?
– Are assumptions logical and believable?
– Are financial projections, especially cash flow, realistic?
– Have all risks been adequately identified?
 Does company management have sufficient expertise?
 Can any risks be mitigated by insurance or “bonding”?
 If recourse, can owner survive failed project and repay
bank?

14. 14
Project Lending
 Expected from bank before approval:
– Is project time schedule realistic?
– Is cost overrun contingency adequate?
– Proposal for loan structure
 Collateral
 Covenants
 Recourse
– Preparation of borrowing schedule
– Can bank manage failed project to recover loan?

15. 15
Project Lending
 Expected from owner after approval:
– Project status reports
 Percentage completion
 Actual expenditures versus budgeted expenditures
 Cash flow re-forecasts
 Changes to project
 Increases or decreases in risk
– Borrowing requests … based on scheduled
expenditures

16. 16
Project Lending
 Expected from bank after approval:
– Ongoing review of status reports provided by owner
– Regular on-site inspections of project progress by
experts
– Careful “yes or no” decision to fund each borrowing
request based on project progress and known risks
– If recourse, ongoing review of owner’s other “normal”
business operations through ordinary credit analysis

17. 17
Project Lending
 Loan structure
– Recourse (guarantees, etc.)
 Bank wants recourse to owner and owner’s assets
– Moral value even if limited economic value
[partner/ sophisticated investor theory]
– Exercising rights of recourse expensive, time consuming
 Owner wants “non-recourse” financing

18. 18
Project Lending
 Loan structure
– To completion versus through completion:
 To completion
– Acquisition/ development/ construction only
– Completion guarantee
 From owner to bank
 From general contractor to owner, assigned to bank
 Liquidated damages
– Standby or “take out” financing

19. 19
Project Lending
 Loan structure
– To completion versus through completion:
 Through completion
– Financing ongoing operations
– Clear conditions for if/ when working capital line/ loan begins
– Clear conditions for if/ when acquisition/ construction loan
converts into permanent term loan for property/ equipment
– Revised set of operating covenants

20. 20
Project Lending
 Loan structure
– Covenants
 Acquisition/ construction
– Restrictive covenants to prevent loss of collateral value
– Prescriptive covenants to promote successful completion
– Tangible Net Worth
– Net Working Capital
 Permanent/ operational financing
– Debt/ Worth
– Current Ratio
– EBITDA

21. 21
Credit Analysis
 What factors influence the ability of a borrower
to repay a loan?
– External factors
– Internal factors

22. 22
Credit Analysis
 External versus internal factors:
– Good external factors can not offset poor internal
factors.
– Good internal factors can often mitigate weak
external factors.

23. 23
Credit Analysis
 External factor analysis — a caution:
– There are vast amounts of macro economic data
available. The amount of industry-specific data is
overwhelming. Analyzing these external factors is
time consuming and often expensive. Decisions
about how much analysis of external factors to
include in a credit report should be based on the
degree to which the analyst thinks these factors will
affect a borrower’s ability to repay its loans.

24. 24
PEST Analysis
 Political Factors
– Political factors include governmental laws and
regulations which define the rules of commerce.
 Political stability
 Labor laws
 Tax laws
 Trade restrictions
 Environmental regulations

25. 25
PEST Analysis
 Economic Factors
– Economic factors include basic characteristics that
affect consumer purchasing power and corporate
capital costs.
 Economic growth
 Wage rates
 Inflation rate
 Interest rates
 Exchange rates
 Energy costs

26. 26
PEST Analysis
 Social Factors
– Social factors include demographic and cultural
attitudes of a population that can influence issues as
diverse as work force flexibility and market potential.
 Population demographics
 Educational quality
 Labor unions
 Healthcare
 Work attitudes

27. 27
PEST Analysis
 Technological Factors
– Technological factors include research and
development activities that can lower barriers to
entry, reduce minimum efficient production levels,
and influence outsourcing decisions.
 Basic academic research
 Applied research and development
 Automation potential
 Information systems
 Technology incentives

28. 28
Sector Analysis
 Industry sector analysis:
– If a borrower has a significant share of industry
sales, say 10% or more, it is then very important to
fully review available information regarding the
outlook for the industry. (Many government agencies and
investment banks publish a variety of sector reviews.)

29. 29
SWOT Analysis
 Strengths
– A company’s strengths are its resources and
capabilities that can be used as a basis for
developing a competitive advantage.
 Good reputation
 Strong brand names
 Patents
 Proprietary cost advantages
 Access to high-grade natural resources
 Favorable access to distribution networks

30. 30
SWOT Analysis
 Weaknesses
– The absence of certain strengths usually results in
weaknesses.
 Poor reputation
 Weak brand names
 Lack of patent protection
 High cost structure
 Lack of access to natural resources
 Lack of access to key distribution channels

31. 31
SWOT Analysis
 Opportunities
– The external environment may offer certain new
opportunities for profit and growth.
 Unfulfilled customer need
 Development of new technologies
 Loosening of regulations
 Removal of trade barriers

32. 32
SWOT Analysis
 Threats
– Changes in the external environment may also
present threats to a company.
 Shifts in consumer tastes away from company’s products
 Emergence of substitute products
 New regulations
 Increased trade barriers

33. 33
Strengths and Weaknesses
S – W > U

34. 34
Strengths and Weaknesses
Strengths – Weaknesses > Uncertainty

35. 35
Credit Analysis
 Internal factor analysis:
– Financial information
 Ratios
 Trends
 Cash flow
– Management information
 Background and experience
 Behavior as reflected in financial performance

36. 36
Liquidity Ratios
 Current Ratio
sLiabilitieCurrentTotal
AssetsCurrentTotal
 This ratio is a rough indication of a company’s ability to
service its current liabilities when due. A high value is better
than a low value. A ratio larger than one means there are
more assets that are already cash or that can be converted
into cash within a year than there are liabilities that will have
to be paid with cash. However, the composition and quality
of current assets is a critical factor in the analysis of an
individual company’s liquidity.

37. 37
Leverage Ratios
 Debt/ Worth
 This ratio measures the relationship between capital
contributed by creditors and that contributed by owners
(minus any intangibles). It expresses the degree to which
owners’ equity provides protection for creditors. A value that
is lower than the industry norm is better than a value that is
higher than the industry norm. A lower ratio generally
indicates greater long-term financial safety and greater
flexibility to borrow in the future.
WorthNetTangible
sLiabilitieTotal

38. 38
Project Investing
 Common measures of return
– Cost-benefit analysis (CBA)
– Payback period
– Net present value (NPV)
– Internal rate of return (IRR)

39. 39
Project Investing
 Cost-benefit analysis
– Compare total costs to total benefits
– If competing projects, choose:
 Most profitable
 “Best”
– Not always financial

40. 40
Project Investing
 Payback period
– Period of time it takes to recover the initial
investment
– Does not properly account for:
 Time value of money
 Inflation
 Risk
 Financing costs
– Managers like it because it is easy

41. 41
Project Investing
 Internal Rate of Return
– Potential problems:
 Understates reinvestment value of future positive cash flows
 Cannot deal with negative cash flows near end of a project
(e.g., environmental cleanup costs)
 Cannot deal with changing degrees of risk over life of a
project
– Managers like it because it can be used to compare
projects of different size

42. 42
Project Investing
 Mutual exclusivity
– Assume a limit on availability of capital at
an acceptable cost
– Corresponding limit on the number of investments
that can be made
 If projects are mutually exclusive, academics argue that
NPV is a better analytical measure than IRR
 Ex: High initial cost versus high future cash flows

43. 43
Project Investing
 Complex measures of return
– Modified internal rate of return (MIRR)
 Positive cash flows discounted at weighted average cost of
capital (WACC) instead of discount rate making positive
cash flows more valuable
 Future negative cash flows discounted separately and
added to initial cost of project

44. 44
Project Investing
 Complex measures of return
– Real options analysis
 Each separate cash flow assumed to have unique
uncertainty or risk
 Uncertainty of each separate cash flow accounted for using
“risk-adjusting probabilities”
 Risk-adjusted cash flows then discounted at risk-free rate