Project finance is only possible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt. A financial model is needed to assess economic feasibility of the project.

Model's output is also used in structuring of a project finance deal. Most importantly, it is used to determine the maximum amount of debt the project company can have and debt repayment profile, so that in any year the debt service coverage ratio

Debt service coverage ratio

The debt service coverage ratio , also known as "debt coverage ratio," is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments...

 (DSCR) should not exceed a predetermined level. DSCR is also used as a measure of riskiness of the project and, therefore, as a determinant of interest rate on debt. Minimal DSCR set for a project depends on riskiness of the project, i.e. on predictability and stability of cash flow generated by it. As a rule of thumb, DSCR should not be less than 1.60. However, in some cases (such as power plant projects with strong off-take agreements) it could be set at as low as 1.15.

General structure

A general structure of any financial model is very simple: input – calculation algorithm – output. While the output for a project finance model is more or less uniform and the calculation algorithm is predetermined by accounting rules, the input is highly project-specific. Generally, it can be subdivided into the following categories:

• Variables needed for forecasting revenues
• Variables needed for forecasting expenses
• Capital expenditures
• Financing

Input for a thermal power plant model

For a thermal power plant project, a project finance model's input typically looks as follows:

• Power plant's installed capacity, MW
• Capacity utilization factor
• Internal consumption rate, %
• Power plant's gross efficiency, %
• Lower heat value of fuel, MJ/unit
• Price of fuel, $/unit
• Offtake electricity price, $/MWh
• Inflation rate, %
• Fuel price escalation, % per year
• Electricity price escalation, % per year
• Cost of consumables, $/MWh
• Equipment maintenance, $/MWh
• Depreciation period, years
• Personnel expenses, $ per year
• General and administrative expenses, $ per year
• Corporate tax rate, %
• Total CAPEX, $
• 'Buffer' for cost overruns, % of total amount to be financed
• Fuel and consumables reserve, days
• Imported equipment, % of total CAPEX
• Import duties, %
• Initial insurance premium, % of total CAPEX
• Construction period, years
• Period of commercial operation, years
• Equity portion in total financing, %
• Required return on equity, %
• Tenor of debt, years
• Grace period on debt repayment, years
• Interest rate during construction, %
• Interest rate during commercial operation, %

Excel spreadsheets

Project finance models are usually built as Excel spreadsheets and typically consist of the following interlinked sheets:

• Data input and assumptions
• Capital costs (construction)
• Insurance
• Taxes
• Depreciation
• Financings
• Income statement
• Balance sheet
• Cash flow
• Retained earnings
• Coverage ratios
• Present values

A model is usually built for a most probable (or base) case. Then, a model sensitivity analysis is conducted to determine effects of changes in input variables on key outputs, such as internal rate of return

Internal rate of return

The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...

 (IRR), net present value

Net present value

In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

 (NPV) and payback period

Payback period

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account...

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