A 60 Minute Recipe for creating a Simple Project Finance Model

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Table of Contents

Introduction ........................................................................................................................................ 3

Typical Project Finance Structure ....................................................................................................... 3

Concession Agreement (“CA”) ........................................................................................................ 3

Operations Contract ........................................................................................................................ 4

Facilities Agreement (“FA”) ............................................................................................................. 4

Shareholders Agreement (“SHA”) ................................................................................................... 4

Memorandum of Association (“MoA”) and/or the Articles ............................................................ 5

The 5 Key Ingredients for a Project Finance Model ............................................................................ 5

1) Assumptions ............................................................................................................................ 5

2) Construction ............................................................................................................................ 7

3) Operations .............................................................................................................................. 8

Revenues ..................................................................................................................................... 8

Operating Expenses .................................................................................................................... 8

Working Capital ........................................................................................................................... 8

Cash Flow Available for Debt Service (“CFADS”) ........................................................................ 9

4) Financing ................................................................................................................................. 9

Debt ............................................................................................................................................. 9

Equity ........................................................................................................................................ 10

Modelling the Financing Ingredient .......................................................................................... 10

5) Cash Flow .............................................................................................................................. 11

A cherry on top? ............................................................................................................................ 11

Making sure you’ve got all the Ingredients .................................................................................. 12

Case Study – A Simple Toll Road Financial Model ............................................................................ 14

We want to hear from you................................................................................................................ 15

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Introduction

Creating a project finance model is much like baking a cake. Use the correct ingredients and you could be the talk of the town. Don’t, and well, you know, it could be a total flop.

The first thing we should do is figure out what sort of cake we are baking right? Is it a mergers and acquisition cake, a leveraged buyout cake or another type of cake altogether?

In this case we are preparing a rich, creamy project finance cake. So the first thing we are going to do is learn a bit about a typical project finance structure.

Typical Project Finance Structure

The majority of project finance deals are structured as outlined in Figure 1.

Figure 1: Typical Project Finance Structure

Here are some quick points about each of the agreements contained in Figure 1 above.

Concession Agreement (“CA”)

- Parties: In the majority of cases the CA is between a government authority (the “Grantor”) and a special purpose company or SPC (also called Concessionaire, special purpose vehicle (SPV) or ProjCo).

- Scope: The Grantor gives the SPC rights to build, own and operate the project for a period of time, usually 30 years. Note that there are variations on this structure.

- Payment: The CA usually outlines the revenue structure for the deal. For example a toll road CA would include a mechanism or formula for adjusting the toll charge.

- Key Performance Indicator (“KPI”) Deductions: To the extent that the SPC does not perform their operational duties in accordance with the CA KPI’s there may be deductions from the SPC’s revenue payment. This performance obligation is usually passed down to the Operator.

Concession Grantor

Special Purpose Company (SPC) ShareholdersLenders

EPC Contractor Operator

Concession Agreement

Shareholders Agreement and MoAFacilities Agreement

EPC Contract Operations Contract

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Engineer, Procure and Construct (“EPC”) Contract

- Parties: The EPC Contract is between the SPC and an EPC Contractor. - Scope: To EPC Contractor must design and build the project, within a certain time

period. - Payment: The EPC Contract usually specifies a fixed price for the construction of the

project. - Payment for Delays: If a project delay occurs which is caused by the EPC Contractor

then the EPC Contractor would have to pay damages to the SPC.

Note that an EPC Contract is not required for a Brownfield project (unless an expansion is taking place), as there is no construction required.

Operations Contract

- Parties: The Operations Contract is between the SPC and an Operator. - Scope: The Operator usually has a long term obligation to operate and maintain the

project. This usually includes replacement capital expenditure. - Payment: The Operator receives payment for performing the operations and

maintenance of the project in accordance with the Operations Contract. - KPI Deductions: To the extent that the Operator does not perform their duties to the

Operations Contract KPI specifications there may be deductions from the Operators payments.

Facilities Agreement (“FA”)

- Parties: The FA is between the Lenders (for example banks) and the SPC. - Scope: The FA outlines the amount of debt which can be drawn, the purpose for the

debt and the repayment profile of the debt. - Payment: The FA outlines the commitment fees and interest rate of the debt,

payable by the SPC to the Lenders. - Covenants and Default: Outlines positive and negative covenants which the SPC

must adhere too, as well as the framework for default.

Note that there may be another agreement in place of the Facilities Agreement depending on the financing structure of the deal.

Shareholders Agreement (“SHA”)

- Parties: The SHA is between the Shareholders and the SPC. - Scope: Usually outlines the amount of the Shareholder Loan, the purpose of the loan

and the repayment terms. - Payment: The SHA outlines the interest rate due and payable by the SPC to the

Shareholders.

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Memorandum of Association (“MoA”) and/or the Articles

- Parties: Between the Shareholders and the SPC. - Scope: May include the issuance of shares, the purpose or business of the company,

the framework for appointment of the Board, dividend policy and the rights of the Board and Shareholders with respect to decision making.

Please note that we have only included a few of the main agreements which make up a project finance deal. A great resource for learning more about project finance deals is the Denton Wilde Sapte, Guide to Project Finance.

Now that we’ve got the basic structure of a project finance deal covered, let’s talk a bit about the ingredients that go into a project finance model.

The 5 Key Ingredients for a Project Finance Model

Much like a cake there are certain ingredients which a project finance model needs, to be a raving success. These include:

1) Assumptions 2) Construction 3) Operations 4) Financing 5) Cash Flows

If you’re perceptive you may see a link between the above key ingredients and the agreements discussed in the Typical Project Finance Structure section.

Yes, you guessed it; each one of the agreements’ quantitative terms feeds into the ingredients (or at least the assumptions which make up those ingredients) as follows:

• Construction– Inputs are found from the EPC Contract. • Operations – Inputs are found from the CA (for revenue) and the Operations

Contract (for operations and maintenance costs). • Financing – Inputs are found from the FA (Lenders cash flows), the SHA (shareholder

loan cash flows) and the MoA/Aritcles (equity contribution and dividend framework).

Anyway, that’s an aside; now let’s talk about each of the key ingredients.

1) Assumptions

The first key ingredient is the assumptions. The majority of good Excel financial models have their assumptions consolidated into one or two Excel sheets.

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The Video Financial Modelling team often uses one assumptions sheet when dealing with a basic financial model, and two Excel sheets when dealing with a more complex financial model. If we’re using two Excel assumptions sheets, these are usually split into:

1) A static assumptions page – one-off assumptions which do not change over time. 2) A time series assumptions page – assumptions which may change over time.

See Figure 2(a) and 2(b) for some examples of static and time series assumptions.

Figure 2(a): Static Assumptions, which don’t change over time

Figure 2(b): Time Series Assumptions, which can change over time

Why are assumptions important? Much like the self-raising flour to a cake…. the assumptions determine whether your financial model is a flop or not. Among other things consolidating your assumptions:

Assumptions don’t change over time

Assumptions can change over time

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(1) Ensures one control panel (potentially split into two Excel sheets) for all assumption adjustments to the financial model.

(2) Makes it easier for: i. internal staff, financiers and auditors to check the reasonableness of

assumptions. ii. cross checking the financing and project documents against the

financial model assumptions. (3) Enables sensitivity and scenario analysis to be incorporated into the financial model

easily.

If you don’t have reasonable assumptions, set out in an easy to manage format, there is no point in going onto the next part of the recipe, the Construction. Always remember garbage in, means garbage out. There is no exception to the rule for a financial model.

2) Construction

The Construction ingredient (aka Cocoa) is only applicable for Greenfield projects or expansions. A Greenfield project can be simply defined as a new project with a construction phase. A separate Excel sheet is usually setup to include the construction phase cash flows.

The construction phase costs usually include:

i) costs of constructing the project; ii) project related administration costs (often called SPC or SPV costs); iii) upfront costs for advisers and consultants (also called transaction costs); and iv) financing costs.

The above construction phase costs are summed together to find how much funding is required for the project during the construction phase. In most cases the construction phase costs are funded by debt and equity (see the Financing section for more details).

A typical construction phase cost build-up is shown in Figure 3 below.

Figure 3: Build-up of the Construction Funding Requirement

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3) Operations

Operations (aka eggs) are the core of the project finance model. As the core, the Operations are usually contained in a separate Excel sheet.

In most situations the Operations can be split into four main areas:

1) Revenues 2) Operating Expenses 3) Taxes 4) Working Capital

Estimations of revenues, operating expenses, taxes and working capital requirements will affect the financial models reliability.

Revenues

Revenues might include fixed payments, variable payments or a combination of both. A good example of a variable revenue stream is a toll roads revenue, which depends on the volume of traffic coming through the toll gates.

Operating Expenses

Operating Expenses may include maintenance, staff costs and administration expenses to name a few. Often, the replacement capital expenditure is also included as a part of the Operations section.

Taxes

As you’re probably well aware in most instances tax is paid on corporate profits. A project finance deal is no exception, with tax most commonly paid on profit before tax.

Despite the above tax implication, project finance deals are usually structured with very little equity. A typical project finance capital structure would include large amounts of debt and sub-debt instruments such as shareholder loans.

In most instances the debt and shareholder loan interest is tax deductible, and can lower the company’s tax burden.

Working Capital

Working capital requirements make sure the financial model correctly deals with cash receivership and payment delays related to accrued revenues and expenses. A simple example of a working capital movement is the timing between being billed for certain operational costs (i.e. the SPC has accrued the expense and an account payable is due) and actually paying these costs.

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Cash Flow Available for Debt Service (“CFADS”)

In the majority of cases netting the revenues, operating expenses, taxes and working capital movements gives you a very important project finance output called cash flow available for debt service or CFADS (we will be talking about the CFADS in an upcoming blog).

Basically CFADS is the amount available to be shared between all financiers. Senior instruments such as bank debt and bonds have first claims to these cash flows, whilst instruments like shareholder loans and ordinary equity have the lowest claim over these cash flows.

The CFADS is often used to calculate key ratios such as the debt service coverage ratio (DSCR), which are usually, included in loan agreement covenants.

Figure 4 shows an example of how CFADS is calculated.

Figure 4: Build-up of CFADS (figure taken from case study, so excludes working capital movements)

4) Financing

To spice up the mix, we need to source some funding (aka sugar) for the project finance model. Although funding can come in many forms the most common and broadest categories are debt and equity.

Debt

Debt represents a senior claim on cash flows and the company’s assets in the event of liquidation. Given:

1) debts seniority to equity (hence lower risk profile); and 2) that interest is usually tax deductible:

debt is usually less expensive than equity. Note that as gearing/leverage increases the cost of debt should converge to the cost of equity.

Unlike most corporate financings a project finance deal’s debt is usually of long tenor, maybe 10-25 years.

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Equity

Equity represents a junior claim on the firm’s cash flows and assets in the event of liquidation. Equity distributions may be paid as dividends or in many project finance deals as shareholder loan interest and principal repayments.

Modelling the Financing Ingredient

For more complex models, the Video Financial Modelling team usually has two sections for financing:

1) the Construction Funding section – this is where the equity and debt fund the construction phase costs of the project (note that these are the costs we talked about in the Construction section); and

2) the Repayment section – this is where the projects cash flows repay debt and also equity instruments such as shareholder loans (the repayment section usually coincides with the operations phase of the project).

The Construction Funding section can usually go on the Construction sheet, whilst the Repayment Section is usually put on a separate Excel sheet. Both a construction funding example and repayment example are shown in Figure 5(a) and 5(b) respectively.

Figure 5(a): Construction Funding Example

Funding required after other drawdowns

Amount Funded through Facility

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Figure 5(b): Example Repayment Sheet

5) Cash Flow

In most instances the primary concern of a project finance deal is the cash flow produced. As such an Excel cash flows sheet is like the icing on the cake.

The Excel cash flows sheet can be produced by taking calculated outputs from the Construction, Operations and Financing sheets.

It should be noted that the cash flows during construction usually net to zero in the Base Case Financial Model. This is because all the construction phase costs are fully funded by debt and equity. i.e. there is no cash-shortfall or cash-surplus.

Figure 6 shows an example of a cash flow summary build up.

Figure 6: Build-up of Cash Flow Statement (figure taken from case study)

A cherry on top?

In addition to the above five key ingredients, a number of other features can make your model much better. These are the so called cherries on top of the cake, and include:

Amortisation, Interest and Other Fees

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(1) Accounts pages – Balance Sheet and Income Statement to accompany the Cash Flow page.

(2) Summary page/s – These pages show key data and charts. i.e. gives people a project snapshot.

(3) Scenario and sensitivity analysis functionality. (4) Checks page – Checks key relationships hold. An example would be checking the

Balance Sheet balances.

It should be noted that in very simple financial models, often the construction, operations, financing and cash flow sheets can be combined onto one Excel sheet. The Case Study below uses this methodology and includes all these sections on one Excel sheet called “Calculations”.

Making sure you’ve got all the Ingredients

Prior to jumping into the case study, let’s take some time to look over our project finance model’s core ingredients.

Figure 7 shows the Excel sheets for the core and non-core ingredients of the project finance model. As you’ll note the core Excel sheets are coloured in blue and the non-core Excel sheets are coloured in grey.

Figure 7: Core and Non-Core Excel sheets The table below summarizes each of the Excel sheets in Figure 7.

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Summary of Core and Non-Core Excel Sheets Summ (Summary)

Checks Ass (Static Assumptions)

TS (Time Series Assumptions)

Ctn (Construction)

Ops (Operations)

Repay (Repayments)

CF (Cash Flow Statement)

Accounts

A snapshot of all the key inputs and outputs of the financial model. Often includes: - Sources and

Uses of Funds - Returns - Capital

Structure - Charts

Makes sure key relationships hold. For example: - The Balance

Sheet balances

- Sources of Funds equals Uses of Funds

Contains all of the static assumptions – these assumptions don’t change over time

Contains the time series assumptions – these assumptions may change over time

Contains the build-up of the construction phase costs (discussed in the Construction section)

Contains the revenue, operating expenses, taxes and working capital (discussed in the Operations section)

This sheet comprises the Repayments of any borrowed funds including interest and other fees post construction (discussed in the Financing section)

Takes all of the outputs from the Ctn, Ops and Repay sheets and combines them into a Cash Flow Statement

Takes outputs from the core pages to form a Balance Sheet and Income Statement

Houses the sensitivity and scenario analysis functionality for the static assumptions1

Houses the sensitivity and scenario analysis functionality for the time series assumptions1

Also contains funding for the construction phase costs, “Construction Funding” (discussed in the Financing section)

The above elements are required for building the CFADS

Usually occurs in line with the Operations phase

Only required if the project is a Greenfield project or an expansion

1 Despite being included in the Ass and TS these are non-core elements and are not required in a basic financial model.

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Case Study – A Simple Toll Road Financial Model In this case study we look at developing a basic toll road acquisition financial model. You can follow along and develop the financial model yourself with the Starter Excel Spreadsheet and Video below. If you have any problems with the E-Tutorial you can always access the Final Excel Spreadsheet, to see where you’re going wrong.

Prior to starting this E-tutorial we need a few basic assumptions for our financial model. Remember this is an important step, as rubbish in equals rubbish out.

For the purpose of this E-Tutorial the key assumptions are included in the table below:

Key Assumptions

Assumptions Value General Assumptions Start Date 31 December 2011 End Date 31 December 2021 Inflation 2% pa Operations Revenue Car Toll $3.25 per car @ Start Date Truck Toll $5.25 per truck @ Start Date Number of cars per day 80,000 @ Start Date Number of trucks per day 9,000 @ Start Date Number of cars growth rate (pa) 4% pa Number of trucks growth rate (pa) 2% pa Expenses Annual maintenance costs $30m pa @ Start Date Annual management costs $5m pa @ Start Date Annual capital expenditure costs1 $2.5m pa @ Start Date Tax Rate 30% Financing Interest Rate 7.5% pa Term of Debt 10yrs Equity Discount Rate 13% Target Minimum DSCR 1.25x (1) For the purposes of this analysis annual capital expenditure is treated as an expense rather than being capitalised and depreciated over time.

E-Tutorial Downloads Starter Excel Spreadsheet

Final Excel

Spreadsheet

Video

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Once you’ve had a look through these assumptions, let’s start baking our cake by accessing the Starter Excel Spreadsheet and Video.

We want to hear from you At Video Financial Modelling we would love to hear your feedback. Your feedback helps us create content that is relevant and fun for you. Please do send us an email at feedback@videofinancialmodelling.com or write a comment on our blog.

You can also keep in touch through our RSS feed, Twitter or our YouTube channel.

We hope you enjoyed this free E-Tutorial.

Best wishes and happy modelling

Brett Rankine

Vice President – Product Development

Video Financial Modelling

brankine@videofinancialmodelling.com

Like this tutorial? Check out our intermediate course, Greenfield Toll Road Financial Model