Financial Statement Analysis and Financial

Ratios for Project Finance

Financial Ratios in Project Finance December 19

Valuation and Financial Ratio Analysis Topics

• Introduction

• Financial Statement Review

• Objectives of Financial Ratios in Financial Analysis

• IRR and Valuation Analysis

• DSCRs in Credit Analysis

• LLCR and PLCR in Covenants

• DSCR in Financial Covenants

• Case Study

2 December 19
Objective of Discussion

• How projects are valued by equity sponsors and how the

creditworthiness of projects is assessed by lenders.

• Understand the main forms of financial ratios used in project finance and
be able to review typical financial covenants.

• Understand how to measure compliance with financial ratios and their

shortcomings when used to protect lenders (i.e. common methods
borrowers use to subvert them).

• The main issues boil down to:

 What is the Equity IRR required by investors

 What is the DSCR for different types of projects

 How to compute the risk rating of projects

3 December 19
 Financial Statement Review

Financial Ratios in Project Finance December 19

Objectives of Financial Statement Analysis

• How do financial analysts use information in financial statements to

make assessments of various issues related to risk assessment and
valuation:
 How can do financial analysts quickly review the income
statement, balance sheet and cash flow statement to determine
the value of a project?
 How do financial analysts look the financial statements and
assess risks associated with a project and/or whether the
company has sufficient cash flow to pay off debt?
 How do financial analysts financial statements be used to
assess the performance of a project relative to what was
initially projected?
 How should financial covenants be computed from financial
statements?

5 December 19
Financial Statement Analysis in Project Finance

A little review of financial statement analysis is necessary because the

financial ratios and the covenants are derived from financial statement data.

You should be comfortable in reading various different financial statements

for valuation and financial analysis purposes.

Financial statements will be used to relate financial statement information to

economic value drivers and evaluation of company performance.

 Example: When determining whether price adjustments are

appropriate in a PFI transaction, an IRR calculation is made from
cash flows.

6 December 19
Financial Statement Review

• Sources and Uses

• Income Statement

 EBITDA – revenues less operating expenses

 Net Income

• Cash Flow Statement

 Free Cash Flow

 Equity Cash Flow

 Cash Flow for DSCR

• Balance Sheet

7 December 19
Sources and Uses Statement

• The primary statement for analysis during the construction of a project is

the source and use statement.

• This statement demonstrates, for alternative periods, how much money

has been spent on the project and where the money for the project is
coming from.

• The sources and uses statement shows interest during construction, the
capital structure of the company, and total cost of the project.

• The sources and uses statement shows joint venture contributions, the
funding by subordinated debt and any grants from government agencies.

• There is no debt service during the construction period and the debt
service coverage ratio is not computed.

• Cash flow is negative during the construction period.

8 December 19
 Example of Sources and Uses of Funds

Uses of Funds Sources of Funds

USD’ MM Percent USD’ MM %
EPC Cost 1,630.00 71.6% Pre-operating Revenues 25.00 1.1%
Development Costs 155.00 6.8% USD tranche 540.00 23.7%
Owners Costs 100.00 4.4% US-Exim 380.00 16.7%
ESF 120.00 5.3% SAR tranche 890.00 39.1%
Contingencies 26.10 1.1% 0.0%
Total Direct Cost 2,031.10 89.3% Total Debt and Pre-operating Revenues 1,835.00 80.7%
Fees During Construction 56.00 2.5% Equity 1.10 0.0%
Interest during construction 188.00 8.3% EBL and Shareholder Loans 439.00 19.3%
Total Construction Costs 2,275.10 100.0% Total Sources 2,275.10 100.0%

Total MW 1,900
EPC Cost/kW 857.89
Total Cost/kW 1,197.42

9 December 19
Income Statement

• Focus on EBITDA, EBIT and Net Income

• Determine why these items move over time

• Revenues from price and volume – do revenues change because of

price or volume

• Revenue Items that are not due to operations

 Interest Income

 Asset Sales

 Proceeds from swap agreements

• Lease payments, amortization of loan fees, deferred taxes

10 December 19
Actual Financial Statements During Construction Period

• Actual Statements show virtually nothing on the income statement and

the build up of assets and liabilities on the balance sheet

11 December 19
Sutton Bridge Actual Income Statement

12 December 19
Accounting for Interest During Construction

• IDC is capitalized to construction cost -- this means that interest is not

included on the income statements, but it is included as a part of capital
expenditures on the cash flow statement.

• The IDC is ultimately recorded as an operating expense because capital

expenditures and therefore depreciation is higher.

• If there is a cash reserve that earns interest during the construction

period, this interest income is credited against IDC, and treated in a
similar manner to the IDC.

• IDC is accumulated and added to the depreciation base, which means

the amount of debt financing affects the cost of the project.

13 December 19
Cash Flow Statement

• Fundamental separation between operations, capital expenditures (to maintain

and grow operations) and financing.

• Add back items from the income statement that do not use cash (depreciation, dry
hole costs etc)

• Used as a basis to compute free cash flow although free cash flow not presented
on the statement

• Example

 Scrap proceeds – in capital expenditures; remove gain on sale from

operations

 Minority Interest – in financing flows; remove from operations

 Operating reserves – in financing

14 December 19
Cash Flow Statement

• Derive the amount of dividends or distributions to partners.

• Basic cash flow -- separate the statement into operating cash flows and financing
cash flows.
• Equity cash flow
 Distributions
 Contributions
• Free cash flow
 After Adjusted Tax
 Before Financing
• Cash flow for debt service
 After Actual Tax
 Before Interest Expense

15 December 19
Cash Flow Statement in Project Finance

• Operations
 Includes interest expense
 Includes all taxes
• Capital Expenditures (after plant operation)
• Add back interest
• Senior debt
 Interest
 Principal
• Debt service reserve funding
• Maintenance reserve funding
• Pre-payment of debt (covenants)
• Payment for defaulted debt
• Junior Debt
• Equity Distributions
 Joint Venture Distributions

16 December 19
Sutton Bridge Actual Cash Flow

5.250

17 December 19
Balance Sheet

• Maintains value of assets – from original cost rather than market value
and may be conservative

• Used for base for many financial ratios – debt to capital, depreciation
rates, return on average equity, return on invested capital

• Use to establish the historical analysis and where money was earned
and where it is spent

• Important as an audit tool in financial modeling

• Less significant in project finance than in corporate finance

18 December 19
Project Finance and Off-Balance Sheet

• At one time Off-balance-sheet finance was a common objective of Project

Financings where or interest expenses were not recorded on the balance sheet
as senior debt. International accounting standards have now moved just about
every obligation and indebtedness onto the balance sheet, if not formally requiring
a statement in the notes to the company’s accounts.
• The preponderance of joint ventures and consortia undertaking project
developments makes it relatively easy to hold a party’s interest to 50% or less in
the SPV, thereby enabling the project debt to be deconsolidated. Only the
investment in the SPV is booked on that party’s balance sheet.
 Case Example: In the Colowyo Project Financing in Wyoming, the project
company was owned 50:50 by W R Grace and Hanna. In addition to the
Project Finance debt not appearing on these company’s balance sheets, the
bank also did not include the debt in its legal-lending limit established for
both companies.

19 December 19
Sutton Bridge Balance Sheet

20 December 19
Project Financing and the Balance Sheet

• Three possibilities for project financing and the sponsor balance sheet

 On balance sheet

 Mentioned in Notes

 Off-balance sheet
 Hold an equity position of between 20% and 50%

21 December 19
 Objectives of Financial Ratio Analysis

Financial Ratios in Project Finance December 19

Classes of Financial Ratios

• Management Performance

 Ratios that measure the historic economic performance of

management and evaluate whether the economic performance is in
accordance with expectations (e.g. Cash to Invested Capital)

• Valuation

 Ratios that are used to give an indication of the value of the project
for purposes of making investments or for terminating the
concession agreement (e.g. equity IRR)

• Credit Analysis

 Ratios that gauge the credit quality and liquidity of the project (e.g.
DSCR, LLCR)

23 December 19
Class 1: Financial Indicators of Management Performance

• Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if
the company is appropriately valued)

 Return on Invested Capital

 Return on Assets

 Return on Equity

 Market/Book Ratio

 Market Value/Replacement Cost

• Key Issue

 Evaluate relative to risk

 ROE versus Cost of Equity

 ROIC versus weighted average cost of capital (weighted average of debt and
equity)

24 December 19
Problem with Traditional Performance Measures in Project
Finance

• Investment declines to zero at the end of the project

• Cash flow is reasonably similar over the life of the project

 Therefore, the cash flow to invested capital increases as the project

ages.

 One cannot interpret the cash flow to invested capital

• Income is influenced by depreciation charges

• Weighted average cost of capital is not constant

• Income can be negative in early years because of high depreciation

charges and because of high interest charges before debt is repaid.

 Income to invested capital and income to equity ratios are very

distorted for projects.

25 December 19
Performance Measures in Project Finance

• Projects are generally not listed

 Cannot compare market value with book value or replacement cost

• Equity IRR involves projections of cash flow

 One cannot evaluate a single year and determine if the target IRR
has been achieved.

• Alternatives

 IRR using historic and projected data (PFI)

 Cash flow to initial invested capital. (Return on Initial Investment or

return on initial equity)

26 December 19
Simple Illustration of Returns

• Alternative return measures

 Return on book equity

 Return on equity invested

 IRR on Equity

 Modified IRR on Equity

27 December 19
 IRR and Valuation Analysis

Financial Ratios in Project Finance December 19

Illustration of Return on Invested Capital and Cash Flow to
Invested Capital in Project Finance

29 December 19
Project Finance and Finance Theory

• Project Finance is a unique financial instrument in its ability to measure risk.

Projects are built as a function of the amount of debt financing that can be raised.
Project Finance is driven by the incentive to maximize debt capacity and can be
used to assess risk.

• One issue in project finance is establishing the discount rate and risk
measurement using capital asset pricing models.

• Financial principles of efficient markets, market expectations and event studies lie
behind a number of project finance modeling concepts.

• Option pricing model concepts can be used to measure value in project finance
models

• Capital structure theory and analysis is basic to project finance

• Arbitrage concepts in portions of the analysis

30 December 19
Valuation Metrics in Project Finance and Corporate Finance

• Project Finance Investment • Corporate Finance Valuation

Equity IRR P/E Ratio

Project IRR EV/EBITDA

Equity NPV Projected Dividend and Earnings

Project NPV Free Cash Flow

• Project Finance Debt • Corporate Finance Debt

DSCR Times Interest Earned

LLCR Debt to EBITDA

PLCR Debt to Capital

• Liquidity • Corporate Finance Liquidity

Debt Service Reserve Current Ratio; Quick Ratio

31 December 19
Classic Valuation

• PV of Cash Flows at the WACC gives Enterprise Value

• Enterprise Value less Net Debt is Equity Value

• IRR vs WACC is Value

• Project Finance Problems

 WACC is not constant

 Project Discount Rate not known

32 December 19
Valuation Analysis in Project Finance

• Basic Valuation
 IRR’s to value a project in base and sensitivity case
 DSCR’s to evaluate the value of debt in alternative cases
 Compute value of contract and contract prices
 Debt sizing to achieve DSCR’s
• More Subtle Valuation Issues
 Value (costs and benefits) of covenants for alternative transactions
 Evaluate the pricing on senior versus subordinated debt facilities
 Compute the cost and benefits of alternative contract provisions
 Covenant levels
 Debt service reserve amounts
 Liquidated damage levels
• Value of Equity Tranches
 Evaluate the value of options in contracts

33 December 19
IRR Issues

• Basic Notion of IRR

 Rate of return

 Number such that NPV is zero

• IRR Timing

 Use XIRR for timing issues

 Need small negative number to start

• MIRR

 Re-investment

 Value of Project

34 December 19
IRR Mathematics

• IRR is simply rate of return

 Example: Invest 100 and receive 120 in 1 year

 IRR = 120/100 = 120% - 100% = 20%

• If the cash flow is over two years

 IRR = -100 , 60 , 60  13.07%

 Modified IRR with 5% Re-investment

 60 receives 5% in year two  60 x (1.05) = 63

 Plus final 60 = 123

 MIRR = (123/100)^(1/2) - 1 = 10.9%

35 December 19
Equity Cash Flow

• Equity cash flow consists of money that is spent by owners in the

project relative to the distributions made to the owners. Equity cash
flow can be computed from the cash flow statement.
 Equity Investment During Development (negative)
 Dividends During Investment (positive)

• Since a project does not re-invest income into other activities, the
residual cash flow – the end of the cash flow waterfall -- comes in the
form of dividends.
• Equity cash flow is the negative of the equity investment during the
construction period and the positive dividends later on.
• The equity IRR is computed from the equity cash flows – it is the rate of
return earned on the investment.

36 December 19
Equity Internal Rate of Return

• Since a project does not re-invest income into other activities, the residual cash
flow comes in the form of dividends.
• Equity cash flow is the negative of the equity investment during the construction
period and the positive dividends later on.
• The equity IRR is computed from the equity cash flows – it is the rate of return
earned on the investment.
 Compute IRR on equity using the excel IRR formula on the equity cash flow
(you may have to use a guess at the end of the formula)
 It does not matter whether there are leading or trailing zeros in the IRR
formula
 The IRR formula assumes that cash flows occur at the end of each period. If
the flows do not occur at the end of the period, you can use the xirr function
and put in the dates the cash flows are assumed to occur.

37 December 19
Current Market

• Middle East

 IRR 10-12%

 DSCR 1.2-1.3

 Debt Tenor 17 ++yrs

• Africa

 IRR 19%

 DSCR 1.3-1.4

 Debt Tenor 10-15 yrs

• Vietnam

 IRR 13%

 DSCR 1.3

 Debt Tenor 15 years

38 December 19
Equity Returns for Tollroads

• The following slide shows equity returns over time and how they have
come down

39 December 19
Equity Returns and Re-Financing

Equity IRR with and without Re-financing

50.0%

44.6%
45.0% Re-Finance
No Re-Finance
40.0%
37.3%
E
q 35.0%
u
29.2%
i 30.0%
t
25.0%
y 21.7%
20.0% 18.9%
I 16.0%
R 15.0%
R
10.0% 7.8% 7.7%

5.0%

0.0%
Low Base High Very High
Traffic Scenario

40 December 19
IRR on Wind Projects per FPL

• Combination of all these elements, generally yield projects with

prospective cash-on-cash internal rates of return of 10% or better, with
10% to 12% being typical.

• The increasing availability of capital seeking PTC and accelerated

depreciation tax benefits has lowered the post-tax equity returns for non-
utility investors to about 8.5%.

41 December 19
Equity IRR Issues

• While the equity IRR is the fundamental measure of return for a project,
a number of ambiguities arise from its measurement. Some of these
include:

 Including shareholder subordinated loans in the calculation (these

may depend on the tax law regarding the deductibility of interest for
a particular country)

 Including development fees that are paid to the sponsor but do not
cover out-of-pocket costs for consultants, lawyers etc. as a cash
inflow in the equity IRR calculation

 Including assumptions with respect to debt re-financing which

accelerates cash flows to equity holders.

• Basic rule: is money going into or out of the pockets of equity investors

42 December 19
Free Cash Flow

• Free Cash Flow (un-geared after tax cash flow)

 Finance theory suggests analyzing free cash flow and the claims on
free cash flow
 PV of free cash flow discounted at the WACC defines the asset
value or the Enterprise Value
 Free cash flow is the same no matter how high or low the debt
level.
 Free cash flow determines the project IRR
 Project IRR can be compared with the after-tax interest rate to
determine the benefits from leverage
 In contrast to free cash flow, equity cash flow should be discounted
at a higher discount rate

43 December 19
Discount Rates and Valuation for Real Estate Projects

• Merrill Lynch performed a discounted cash flow (“DCF”) analysis on

Equity Office, based on projections provided by our management.

 The illustrative present value indications of unlevered free cash

flows for Equity Office for the years 2007 though 2010 using
discount rates ranging from 7.25% to 7.75%, based on the
estimated cost of capital of Equity Office, which included
consideration of historical rates of return for publicly-traded
common stocks, risks inherent in the industry and specific risks
associated with the continuing operations of Equity Office on a
standalone basis,

 The present value of the illustrative terminal value using estimated

2011 EBITDA based on terminal EBITDA multiples ranging from
17.5x to 18.5x, based upon total enterprise value to estimated 2007
EBITDA multiples for the selected comparable companies.

44 December 19
Free Cash Flow

• Free cash flow can be computed from the income statement or from the cash flow
statement. The amount of free cash flow (free after all capital expenditures and operating
expenses and taxes) is the sum of equity cash flow and debt service.
• From the cash flow statement, the formula is:
 Cash Before Financing
 Plus: Interest Expense
 Less: Tax Shield on Interest
• From the income statement, the formula is:
 EBITDA
 Less: Taxes on EBIT
 Less: Working Capital Investment
 Less: Capital Expenditures

• A complexity in measuring free cash flow is making adjustments for interest during
construction. Interest during construction would not exist with no debt financing and the tax
deductions on the depreciation portion that represents IDC would not exist.
• The first method is easier to compute, the second method is more intuitive.

45 December 19
Free Cash Flow Example

46 December 19
IRR, NPV and other Issues

• NPV calculations are misleading if used to compared two projects of

different sizes

• IRR calculations exaggerate the value of early cash flows and

understate the value of later cash flows

 Projects are exposed to non-traditional risks (discussed earlier).

 Have high and rapidly changing leverage.

 Typically have imbedded optionality.

 Projects have early, certain and large negative cash flows followed
by uncertain positive cash flows.

47 December 19
Project IRR versus Equity IRR

• A central issue in finance is equity valuation (P/E) versus enterprise valuation

(EBITDA). In project finance, the issue is whether investments should be
assessed with project IRR on free cash flow or equity IRR on equity cash flow:

 In theory valuation of a project is from free cash flow, and the capital
structure is irrelevant.

 A counter point is that financing provides essential valuation information on

the risk and value of a project, this is how of banks and insurance
companies are valued where financing drives value.

 In project finance, the level of debt tells a lot about the risk of a project – if a
project has more debt capacity, the free cash flows have less risk.

 Begin with free cash flow and the project IRR to establish the “real”
economics of the project. Then evaluate financial criteria such as
covenants with equity IRR.

48 December 19
Project Finance versus Traditional Investment Evaluation

Traditional Project Finance

 Valuation driven by assessment of  Valuation driven by the equity IRR

project IRR
 Equity IRR affected by debt
 Project IRR compared to all-equity leverage
cost of capital
 Constraint on issuing debt is risk
 Equity IRR and leverage do not assessment of financial institutions
impact investment decision
 The constrained optimization can
be used to measure risk

49 December 19
Project and Equity IRR Issue – Equity Bridge Loans and
Recourse Debt

• In some projects, equity holders provide loans to the project from their balance
sheet instead of equity. The issue arises as to whether these should be
considered equity or debt.

• Example

 Instead of providing equity, a sponsor secures a loan to the project.

 The loan will be re-paid in a bullet at the end of seven years.

 When the loan is re-paid, the sponsor provides equity to finance the loan.

• Issue

 Should the equity bridge loan be considered debt or equity for purposes of
computing IRR.

 The loan uses resources of the parent and must be guaranteed by the
parent

50 December 19
IRR’s in PFI

• IRR’s are negotiated in PFI transactions as part of the concession

agreement where the IRR drives pricing in the contract.

• Concession agreements in PFI project financings limit increases in the

IRR that come about from interest savings from re-financing. (e.g.
share excess profit 50/50).

• In concession agreements, the IRR is used to monitor the performance

of the project as well as for the investment decision.

51 December 19
Other Valuation Metrics – Payback and Discounted Payback

• The payback period measures the number of years that it takes before
the cumulative forecast of cash flow equals the initial investment. It is
criticized because it gives equal weight to cash flows before the payback
and zero weight thereafter.

• However, if you are explaining the benefits of a project and you can tell
an investor that the money he invests will be all paid back in three years,
and everything else is gravy, the payback can be an effective analysis
tool.

• The payback can be modified where cash flows are accumulated and
the payback is measured using discounted cash flows. This is the
discounted payback.

52 December 19
Hypothetical Investment Decision and Equity IRR Criteria

• Begin with the notion that management has a rate of return criteria where only projects that
have an IRR of above 14% are approved for investment and projects that have an IRR below
14% are not. Further, assume that this rate of return is measured using equity cash flow
rather than free cash flow, due to corporate objectives related to earnings per share (“EPS”)
growth. In this hypothetical situation as long as free cash flow from the project is expected to
yield a higher rate of return (project IRR) than the after tax cost of debt, the equity return can
be increased if more debt is used to finance the asset. (Magnifying asset returns to increase
equity return is the where the term leverage comes from). If, because of the reluctance of
bankers to take credit risk, debt cannot be raised for the project, the equity return criteria will
probably not be met. On the other hand, if a significant amount of project debt can be raised,
the equity IRR will exceed 14% and the investment will be made. Therefore, in this
hypothetical example the amount of debt directly affects the investment decision. Indeed, the
investment is driven by the amount of debt that can be raised rather than by the beta of the
project or the risk adjusted all-equity cost of capital relative to the project IRR.
• The notion that the leverage of a project affects cost of capital is demonstrated in the following
quote from a rating agency:
 Nonetheless, a project's leverage level is often an indication of its creditworthiness. For
instance, a merchant project's ability to produce a stable and predictable revenue
stream will never match that of a traditional contract revenue-driven project. Projects
with merchant exposure may find that leverage cannot exceed 50% if investment-grade
rated debt is sought. Contract-revenue driven projects, on the other hand, typically
have had leverage levels around 70% to 80%.

53 December 19
Middle East Example

• Qurayyah IPP/Hajr Electricity Company

• 4,000 MW (Only Power No Water)

• PPA 20 years/ Energy Conversion Agreement

• Financing

 19.5 Years

 DSCR 1.20

 Debt to Equity at Commercial Operation: 80:20

 Balloon and cash trap

 Levelized tariff low because of financing

 Average Loan Life 13.32

 Credit Spread
 Pre-completion: 125 BPS

 Post completion: 130-175 BPS

• IRR 12% to 16%

54 December 19
 Loan Terms - Continued

• Loan tenor is explained by

 the repayment period is still

within the PPA terms (i.e. 20
years from PCOD), giving a
one year tail, and

 the project is a Build, Own

and Operate (BOO) and a
BOOT.

• Debt Service Reserve Account

(DSRA) covering debt service for
6 months or a letter of credit of the
same amount;

55 December 19
Example of Pricing and Changing Credit Spreads

56 December 19
Example of Covenants

• Minimum Senior DSCR of 1.20x in Base Case,

• Minimum Senior DSCR for the previous 12 months to be greater than

1.10x for distribution,

• Minimum Senior DSCR of 1.05x for Event of default,

• Senior Debt not to exceed 80% of the total project costs

57 December 19
Off-Taker

• Saudi Electricity Company is a strong credit:

 74% ownership by the Government of Saudi Arabia (which has a

rating of AA- S&P and Fitch and Aa3 from Moody’s – all rating for
Long Term Foreign Currency Debt of KSA) and

 7% by Saudi Aramco and Is rated AA- (stable outlook) by S&P and

Fitch and A1 (positive outlook) by Moody’s;

• Project is 50% owned by the off-taker

• PPA of 20 years

• Build own and operate

58 December 19
 DSCRs in Project Finance

Financial Ratios in Project Finance December 19

DSCR - General Discussion

• Basic Definition – Cash into the project divided by debt paid to the bank

• Should find in the cash flow statement

• The rule is that the higher the risk, the higher the DSCR, since a larger
multiple of cash flow has to be held in relation to debt-service.

• The DSCR used in Credit Rating and in Covenants – Measures the

possibility of default

 For example, if a wind project generates a net income of a1 million

per annum and the bank requires a DSCR of 1.3, the project could
take out a loan for which the debt service would be a770,000 per
annum.

60 December 19
Use of DSCR, LLCR and PLCR Formula

• Basic Formula: DSCR

 Percent Reduction in one year:

 Percent Reduction = (DSCR-1)/DSCR

• Same formula for LLCR and PLCR

 Percent Reduction over Loan Life

 Percent Reduction = (LLCR-1)/LLCR

 Percent Reduction over Project Life

 Percent Reduction = (PLCR-1)/PLCR

• Be Careful with Fixed Costs

61 December 19
Debt Sizing

• Borrowed amount is based on a conservative commercial case

 Lenders will analyze conservative assumptions because their only

recourse is to the project and its cash flow:

 Conservative reserves estimate (in case of oil & gas)

 Product price forecast – low

 Capital and Operating Costs – high

• Debt sized by conservative case Debt Service Coverage Ratio

62 December 19
Determining the Credit Classification of Project Finance Debt

• Determining the credit classification is important because:

 Credit classification is probability of default
 Credit classification and risk drives the credit spread
 Credit classification drives the ability to gain bank financing
 Achieving an investment grade bond rating or above drives access
to investors in bonds
• Other than being used for covenants, the primary purpose of credit ratios
such as the DSCR is to gauge the credit risk of a project loan.
• Credit risk in turn is determined by the probability of default of a loan.
• The reason a PFI project with a 1.2x DSCR and a merchant power plant
with a 2.5x DSCR may have the same credit rating is that they both have
similar probability of default.

63 December 19
Banks or Rating Agencies Value Debt with Risk Classification
Systems

Map of Internal Ratings to Public Rating Agencies

Internal
Credit Corresponding
Ratings Code Meaning Moody's
1 A Exceptional Aaa
2 B Excellent Aa1
3 C Strong Aa2/Aa3
4 D Good A1/A2/A3
5 E Satisfactory Baa1/Baa2/Baa3
6 F Adequate Ba1
7 G Watch List Ba2/Ba3
8 H Weak B1
9 I Substandard B2/B3
10 L Doubtful Caa - O
N In Elimination
S In Consolidation
Z Pending Classification

64 December 19
Risk Classification and Target of BBB in Project Finance
from S&P website

65 December 19
Updated S&P Stats

66 December 19
Traditional Credit Analysis – Backward Looking Credit Ratios
to Gauge Bond Ratings and Bank Ratings

• Credit ratios are used gauge the credit classification from financial
statements such as the debt service coverage benchmarks in project
finance.

67 December 19
 General Use of Financial Ratios in Establishing Credit Quality

Business Risk/Financial Risk

—Financial risk profile—

Business risk profile Minimal Modest Intermediate Aggressive Highly leveraged

Excellent AAA AA A BBB BB
Strong AA A A- BBB- BB-
Satisfactory A BBB+ BBB BB+ B+
Weak BBB BBB- BB+ BB- B
Vulnerable BB B+ B+ B B-
Financial risk indicative ratios* Minimal Modest Intermediate Aggressive Highly leveraged
Cash flow (Funds from operations/Debt) (%) Over 60 45–60 30–45 15–30 Below 15
Debt leverage (Total debt/Capital) (%) Below 25 25–35 35–45 45–55 Over 55
Debt/EBITDA (x) <1.4 1.4–2.0 2.0–3.0 3.0–4.5 >4.5

Key Industry Characteristics And Drivers Of Credit Risk

Credit risk impact: High (H); Medium (M); Low (L)
Regulatory/Gov Energy
Risk factor Cyclicality Competition Capital intensity Technology risk ernment sensitivity
Industry H H H L M/H H
Airlines (U.S.) H H H M M H
Autos* H H H M M M
Auto suppliers* H H M H L L/M
High technology* H H H M M/H H
Mining* H H H L M L
Chemicals (bulk)* H H H L M H
Hotels* H H H L L M
Shipping* H H H L L M
Competitive power* H H M L H H
Telecoms (Europe) M H H H H L

68 December 19
Strong Ratings

• Characteristics of Strong Ratings

 Capacity to generate sufficient cash flow to maintain DSCR’s within industry
norms for investment grade ratings.
 Fully amortizing debt
 Lender has control over cash flows and collateral
 Strong management with track record of meeting budgets in the country
 Comprehensive risk mitigation
• Characteristics of Weak Ratings
 DSCR below 1.0 under moderate stress test scenarios
 Bullet maturities
 Reserve funds from operating cash flow
 Lender has limited control over cash flow
 Management has limited experience in the country

69 December 19
Ratings Assignment – Basel II Document

• Template of objective benchmarks that measure risk factors, such as

DSCR’s, LLCR’s and break-even oil prices.

 Simulation model that alters critical inputs changed that measures

the likelihood of default (Monte Carlo Simulation with oil price varied
to measure the potential for the DSCR to fall below 1.0)

 Stress test to evaluate whether the transaction can withstand

in a critical revenue or expense. Determine financial flexibility in
the face of adversity.

 Judgmental criteria and weighting systems that use descriptions

to distinguish credit quality.

70 December 19
DSCR Drives the Debt Capacity

• The debt service coverage ratio is a

financial output in a project finance
transaction which cannot be determined by
sponsors of a project in advance. The
Debt Ratio and Debt Service Coverage
debt service coverage ratio statistic can be
driven my many factors including the debt 3.5
to capital ratio. Unlike the DSCR, the debt 3 Average
2.74
to capital ratio is driven by a decision by 2.5 2.43 Minimum
sponsors and lenders. 2.22 2.19

DSCR
2 1.97 1.98
1.82
1.76 1.68
1.59
• There is a direct relationship between debt 1.5 1.45 1.34
1.55
1.24
1.45
1.15
service coverage ratios and the debt to 1
capital ratio once free cash flows have 0.5
been established. The table above shows 0
the average and minimum debt service 40% 45% 50% 55% 60% 65% 70% 75% 80%
coverage ratio for the combined cycle Debt to Capital Ratio
plant assuming that price levels for the
plant result in a project IRR of 11.09%.
The graph illustrates that a debt service
coverage ratio of 50% is consistent with a
minimum debt service coverage ratio of
1.76x and an average debt service
coverage ratio of 2.19x.

71 December 19
General DSCR Criteria to Establish Debt Levels

• Electric Power: 1.3-1.4

• Resources: 1.5-2.0
• Telecoms: 1.5-2.0
• Infrastructure: 1.2-1.6
• Minimum ratio could dip to 1.5
• At a minimum, investment-grade merchant projects probably will have to exceed
a 2.0x annual DSCR through debt maturity, but also show steadily increasing
ratios. Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied
that the scenarios behind such forecasts are defensible. Hence, Standard &
Poor's may rely on more conservative scenarios when determining its rating
levels.
• For more traditional contract revenue driven projects, minimum base case
coverage levels should exceed 1.3x to 1.5x levels for investment-grade.

72 December 19
More on DSCR Targets for Alternative Industries

• Ranges in DSCR estimates

73 December 19
Example: DSCR for Wind Power

• Typically, we want revenues after all operating costs and taxes to be

about 50% higher than what we actually need to repay the debt. This
means that on any given period, revenues can be a third lower for any
reason (whether lower wind, poor operating performance, or lower
electricity prices) and we will still have enough money to repay debt.

• This implies 1.5x DSCR

• Wind is highly predictable in the long run but highly volatile and uncertain
in the short term, thus leading to strong comfort that the long term
average will be close to predictions, but with an also strong likelihood
that some seasons or even some years could see significantly lower
production levels.

• The DSCR has increased from 1.40x to 1.45x according to a study by

LBL.

74 December 19
DSCR Criteria (Reference)

• At a minimum, investment-grade merchant projects probably will have to

exceed a 2.0x annual DSCR through debt maturity, but also show
steadily increasing ratios. Even with 2.0x coverage levels, Standard &
Poor's will need to be satisfied that the scenarios behind such forecasts
are defensible. Hence, Standard & Poor's may rely on more conservative
scenarios when determining its rating levels.

• For more traditional contract revenue driven projects, minimum base

case coverage levels should exceed 1.3x to 1.5x levels for investment-
grade.

75 December 19
Example of Project Finance as Risk Measurement Survey of
Electric Plants

76 December 19
DSCR Criteria in PFI Transactions

• The DSCR in PFI transactions can be very low – in the range of 1.05 –
1.2. The low DSCR results from the tight coverage of revenue and
expense fluctuations with contracts.

• With the low DSCR, small risks in other transactions can become large
risks for project loans.

• For example, interest rate fluctuations may have a small effect on

transactions where the DSCR is 1.8, but the fluctuations in interest
rates can cause default in the very tight PFI transactions. This is why
there are 100% interest rate swaps in PFI.

77 December 19
Detailed Issues in Computing the DSCR

• There are many intricacies in computing the DSCR despite it being a simple ratio.

• First, some general discussion

 DSCRs are the primary quantitative measure of project financial credit

strength. The DSCR is the ratio of net cash flow to principal and interest
obligations. Cash from operations is calculated strictly by taking cash
revenues and subtracting expenses and taxes, but excluding interest and
principal needed to maintain ongoing operations.

 Should also subtract changes in working capital and sustaining capital

expenditures

 To the extent that a project has tax obligations, such as host country income
tax, withholding taxes on dividends and interest paid overseas, etc., these
taxes are treated as ongoing expenses needed to keep a project operating.

78 December 19
Alternative DSCR Calculations

• Minimum DSCR
 The most important ratio that measures the minimum DSCR the project will
see through debt maturity. The minimum DSCR will likely point to the
project's greatest period of financial stress.
• Short-term DSCR
 looks forward three years, as a near-term measure of financial strength.
• The Average DSCR
 averages all of the minimum DSCRs remaining through maturity (as
opposed to calculating the average CFO and dividing by the average annual
debt service). The average DSCR provides a general measure of a project's
cash flow coverage of debt obligations.
• The average DSCR, when viewed alongside the long-term and short-term
minimum DSCR, does provide another measure of project comparability.
• Generally, stronger projects will show annual DSCRs that steadily increase with
time to partially offset the risk that future cash flows tend to be less certain than
near term cash flows.

79 December 19
Difference Between Free Cash Flow and Cash Flow for the
DSCR

• Free cash flow

 Excludes interest income

 Adjusts taxes to remove benefits of interest income

 Includes proceeds from asset sales and insurance proceeds

 Determines the amount the project would earn if there was no debt
financing

 Should make adjustments for interest during construction

• Cash flow for debt service

 Includes interest income

 Uses actual taxes

 Excludes amounts that will not be available on an on-going basis to pay

debt service

80 December 19
Issue 1: DSRA Balances in the DSCR

• A project has better quality if it has a debt service reserve account

• Why not include all cash available to pay bank, including cash in
accounts

• According to S&P

• The ratio calculation also excludes any cash balances that a project
could draw on to service debt, such as the debt service reserve fund
or maintenance reserve funds.

81 December 19
Issue 2: Senior and Subordinated DSCR

• Senior DSCR:
 For the senior DSCR, divide the net cash flow by the senior debt service
obligations, exactly as it would if only one class of debt existed.
• Subordinated DSCR – Two Methods.
 The first method calculates the ratio of the total net cash flow to the project's
total debt service obligations (senior plus subordinated). This consolidated
calculation provides the only true measure of project cash flow available to
service subordinated debt.
 The second method takes the net cash flow and then subtracts the senior
debt service obligation to determine the residual cash flow available to cover
subordinated debt service. This method, does not, however, provide a
reliable measure of credit risk that subordinated debt faces. A combination
of small subordinated debt service relative to the residual CFO could result
in a much higher subordinated DSCR relative to the consolidated DSCR
calculation. Moreover, the ratio of residual CFO to subordinated debt is
much more sensitive to small changes to a project's total CFO than the
consolidated measure.

82 December 19
Issue 3: Operating Reserves and Debt Service Reserve
Account Movements

• Operating Reserves

 If cash must be put aside into a reserve account for major maintenance or
other lumpy expenditures, the cash that goes into the accounts should be
treated as a cash outflow, like an operating expense.

 When the operating expense occurs and funds are withdrawn, then the cash
withdrawn is included as an inflow in the DSCR.

 Therefore, the DSCR is smoothed out

• Debt Service Reserve Account

 Sometimes, money is put aside in a DSRA account from operating cash

flows.

 If there are cash short-falls, then cash is taken out of the DSRA.

 Is the issue the same

83 December 19
Other DSCR Issues

• In reviewing various transactions, various DSCR issues arise. Some of

these include:

 If there is a cash flow sweep, should an interest only ratio be

computed, or should alternative ratios be used.

 In computing break-even analysis should debt service reserves be

included in the ratio.

 If there are breakage costs for interest rate swaps, how should
breakage costs be treated.

 Should different ratios be used for backward looking analysis and

forward looking analysis.

 In using DSCR’s as triggers to limit dividends or to sweep cash

flow, which ratios should be used.

84 December 19
Timing of DSCR Calculations

• The DSCR is not generally computed before the date of project completion.
Therefore, language related to the definition of the completion of the project must
be included in the loan agreement:

 "Completion Date" means the first date on which the Agent receives
notification from the Lenders' Technical Adviser that the following conditions
have been fulfilled to the satisfaction of the Lenders' Technical Adviser:
 [the completion tests under the Concession Agreement have been completed,
the Authority has issued to the Borrower the [Completion Certificate] pursuant to
Clause {cross-reference} of the Concession Agreement and the [Operating
Commencement Date] under the Concession Agreement has occurred]; [and]

 [the completion tests under the Construction Contract have been completed and
the Borrower has issued to the Contractor the [Final Acceptance Certificate]
pursuant to Clause {cross-reference} of the Construction Contract]; [and

 {describe other Completion Date conditions}][;

85 December 19
Fundamental Events of Default

• The primary function of the DSCR is to measure the probability of defalut

– a ratio of 1.0 implies a default. Fundamental events of default include

 the failure of the borrower to pay debt service;

 failure to comply with insurance requirements;

 entry of a final court judgment in excess of a significant dollar

amount which is not paid or stayed after a certain period;

 abandonment of the project;

 bankruptcy of the borrower;

 failure of the sponsor to maintain ownership of the project (if the

sponsor's ownership is a critical component of the evaluation of the
project's credit risk).

86 December 19
Other Events of Default - Reference

• Other Events of Default Include:

 operational covenants,
 a merger or sale of assets
 failure to deliver notices
 failure to obtain or comply with governmental permits.
• Depends on Materiality
• Negotiated ad hoc.
• Agreements should provide for a clear and adequately described mechanism for allowing the
parties to deal with the defaulted project.
• The hardest part of any negotiation is the definitions of the triggers (called "events of default")
which allow banks, in theory, to have the right to take the project from the investors. It is not a
simple task, as banks want to be able to step in as soon as something fishy appears, but on
the other hand, they do not want to get too closely involved in the running of a project and the
inevitable hiccups that happen; it also makes sense to step in only if there is a real problem
which the investors seems unable or unwilling to solve. Investors emphatically do not want the
banks to have the right to stp in the project, but they know that it is the price to pay to get the
leverage they want (in the wind sector, banks usually provide 70-80% of the investment
amount upfront)

87 December 19
 LLCR and PLCR in Credit Analysis

Financial Ratios in Project Finance December 19

DSCR versus LLCR versus PLCR

89 December 19
LLCR and PLCR

• Loan Life Coverage Ratio (LLCR):

 The LLCR computes the present value of cash flows over the debt tenor at
the interest rate on debt as the numerator of the ratio. The denominator of
the ratio is the present value of debt service at the debt rate. The
denominator should equate to the amount of the debt.

 The denominator should be reduced for debt service and other reserves

• Project Life Coverage Ratio (PLCR):

 The PLCR is similar to the LLCR except that the present value of cash flows
is computed over the economic life rather than over the debt tenor. As with
the LLCR, the denominator of the PLCR is the present value of debt service
at the debt rate.

 The PLCR measures how much “tail” the project has from cash flows after
the loan is re-paid.

90 December 19
General Mathematics of LLCR

• To see how the LLCR works, consider the following points

 If all cash flow were invested at the interest rate in a bank account,
and there was a bullet payment, then one could measure if that
cash account was high enough to cover debt payments.

 If the cash account in the above example were reduced by maturity

payments, the end result would be no different.

 If there is money in a DSRA, this could be used to make the

requirement less, it is just like the concept of net debt in corporate
finance.

 The present value of debt service at the interest rate is the same as
total debt

91 December 19
Loan Life Coverage Ratio (LLCR)

• Loan Life Coverage Ratio – the present value of cash flow before debt
service – using the interest rate; divided by the remaining debt balance:
• LLCR = PV (debt rate, cash before debt service)/Debt Balance - DSRA
 Essentially the LLCR is DSCR on a present value basis so that the
credit quality of the whole project is measured.
 LLCR numerator is the PV of the cash available for debt service,
discounted at the pre-tax debt rate
 LLCR denominator is the PV of debt service at the debt rate, which
is the same as the initial debt issued for the project
 The LLCR does not have a standard definition – it would make most
sense to use free cash flow rather than the numerator of the DSCR

92 December 19
LLCR and Credit Quality

• The LLCR Concept can be used to gauge the economics of the project
relative to the amount of debt outstanding:
If no dividends can be paid until all of the debt is paid, the present
value of cash flow can be compared to the present value of the debt.
If the present value of the debt exceeds the present value of the free
cash flow at the debt rate, there is no way the project can payoff the
debt – the project has too much gearing.
If the debt holders get all of the cash flow before any equity, the
present value of the debt relative to the present value of cash is an
effective statistic that can measure how much a variable changes
before a debt default occurs.
 For example, if the cost increases by a certain amount, a LLCR of 1.0
measures the break-even point before which the debt cannot be
repaid.

93 December 19
Project Life Coverage Ratio (PLCR)

• The PLCR or project life coverage ratio covers the residual cash flow of
the project as well as the loan life period.

In the PLCR, the numerator uses the present value of cash flow over
the life of the project rather than over the life of the debt.

The PLCR is related to the loan to value ratio if one assumes that the
present value of the cash flow is the value of the project:
 PLCR = Value/Loans

 Debt to Value = Loan/Value

 Debt to Value = 1/PLCR

As a rule of thumb, the present value of the operating cash flows
before tax should be 1.5x the debt amount.

94 December 19
LLCR and PLCR

• The PLCR or project life coverage ratio covers the residual cash flow of the
project as well as the loan life period.

 As a rule of thumb, the present value of the operating cash flows before tax
should be 1.5x the debt amount.

• Loan Life Coverage Ratio

 Essentially the DSCR on a present value basis

 LLCR numerator is the PV of the cash available for debt service, discounted
at the pre-tax debt rate

 LLCR denominator is the PV of debt service at the debt rate, which is the
same as the initial debt issued for the project

 The LLCR does not have a standard definition – it would make most sense
to use free cash flow rather than the numerator of the DSCR

• Prospective DSCR and Borrowing Base

95 December 19
Debt Tenor and Average Life

• Lenders want to know how their risk reduces over the life of a project.
• If the loan was only for one year, the risks are less than a 20 year loan, if
the cash flows are the same and the cash flow can support the debt
repayment.
• In project finance, the risk associated with longer terms is measured by
the average loan life.
• Average loan life is used in a similar manner to the payback period to
check that the loan is not over-extended.
• The Average loan life accounts for the manner in which a loan is paid
back – if the loan has a bullet payment, the loan life is the same as the
tenor.
• The formula is simply the average outstanding amount of the loan
divided by the initial balance of the loan.

96 December 19
 Credit Ratings, Loan Pricing and Loan Value

Financial Ratios in Project Finance December 19

Default Rates and Credit Spreads -- Note that Credit Spreads
Increase When Default Rates Increase

98 December 19
 Credit Spreads

Increase of 5% Credit Crisis

99 December 19
Bond Ratings and Yield Spread

• Credit classification is very important in establishing the access to

funding and the cost of funding as illustrated on the graphs below:

10 December 19
0
Table of Bond Spreads

• The following is an example of bond spreads at a point in time

(bondsonline.com). These spreads change over time.

Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
Aaa/AAA 5 10 15 22 27 30 55
Aa1/AA+ 10 15 20 32 37 40 60
Aa2/AA 15 25 30 37 Note
44 the Jump50
at 65
Aa3/AA- 20 30 35 45 BB+
53 to BB 55 70
A1/A+ 30 40 45 58 62 65 79
A2/A 40 50 57 65 71 75 90
A3/A- 50 65 79 85 82 88 108
Baa1/BBB+ 60 75 90 97 100 107 127
Baa2/BBB 65 80 88 95 126 149 175
Baa3/BBB- 75 90 105 112 116 121 146
Ba1/BB+ 85 100 115 124 130 133 168
Ba2/BB 290 290 265 240 265 210 235
Ba3/BB- 320 395 420 370 320 290 300
B1/B+ 500 525 600 425 425 375 450
B2/B 525 550 600 500 450 450 725
B3/B- 725 800 775 800 750 775 850
Caa/CCC 1500 1600 1550 1400 1300 1375 1500

10 December 19
1
 Theory of Credit Spreads: Credit Spread on Debt Facilities

• The spread on a loan is directly related to the probability of default and

the loss, given default.
S

The Credit Triangle

S = P (1-R)

P R

 The credit spread (s) can be characterized as the default probability (P)
times the loss in the event of a default (R).
10 December 19
2
 Expected Loss Can Be Broken Down Into Three Components

Borrower Risk Facility Risk Related

EXPECTED Probability of Loss Severity Loan Equivalent

LOSS Default x Given Default x Exposure
=
(PD) (Severity) (Exposure)
$$ % % $$

What is the probability If default occurs, how If default occurs, how

of the counterparty much of this do we much exposure do we
defaulting? expect to lose? expect to have?

The focus of grading tools is on modeling PD

10 December 19
3
Comparison of PD x LGD with Precise Formula
Case 1: No LGD and One Year

• .

10 December 19
4
Comparison of PD x LGD with Precise Formula
Case 2: LGD and Multiple Years

• .
Assumptions
Years 5 BB 5
Risk Free Rate 1 5% 7
Prob Default 1 20.8% PD 20.80%
Loss Given Default 1 80%

Alternative Computations of Credit Spread

Credit Spread 1 3.88%
PD x LGD 1 16.64%

Proof
Opening Closing Value
Risk Free 100 127.63 127.63

Prob Closing Value

Risky - No Default 100 0.95 153.01 145.36

Risky - Default 100 0.05 30.60 1.53

Total Value 146.89 FALSE

Credit Spread Formula

With LGD
cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1

10 December 19
5
Probability of Default

• This chart shows rating migrations and the probability of default for
alternative loans. Note the increase in default probability with longer
loans.

10 December 19
6
Updated Transition Matrix

10 December 19
7
Project Finance and Default History

Market participants consistently report lower default rates, and

especially lower loss rates on project finance than on other equivalent
corporate exposure, largely because of the effect of transaction
structuring and transparency and control of collateral.

Project finance transactions are by their nature, complex and require a

strong understanding of the underlying markets and their risk drivers.
Only a limited number of banks have dedicated project finance credit
teams.

10 December 19
8
Study of Probability of Default for Project Finance

10 December 19
9
Default Rates by Industry

11 December 19
0
 Moody’s Forecast of Default Rates

Defaults versus Long-term Average

Moody's Speculative Grade Trailing 12-Month Default Rates

Actual Jan. 2000 to Aug. 2002 / Forecasted Sept. 2002 to Feb. 2003

12.0%
10.7%
11.0% 10.5% 10.5%
10.3% 10.3%
10.5%
10.3%
10.1% 10.0% 10.0% 10.0% 10.0% 9.8%
9.8% 9.3%
10.0% 9.6%
9.0% 8.8%
8.8%
9.0% 8.5%
7.9%
7.7% 7.7%
8.0%
7.1%
6.7%
7.0% 6.2%
% 6.0%
5.0%
4.0% 3.77%*
3.0%
2.0%
1.0%
0.0%
Jul-01

Jul-02
Feb-01

Mar-01

Feb-02

Mar-02

Feb-03
Jan-01

Jun-01

Jan-02

Jun-02

Jan-03
Dec-01

Dec-02
Sep-01

Nov-01

Sep-02

Nov-02
May-01

May-02
Oct-01

Oct-02
Aug-01

Aug-02
Apr-01

Apr-02

11 Months December 19
Note: *Long run annual default rate is 3.77%
1
Project Finance and Basel II

• The table below shows the default rates in a study conducted for Basel II

11 December 19
2
Recovery rates

• Estimating recovery rates

 There is no market or highly illiquid market
 Immediately upon announcement of default, after some reasonable period for
information to become available, or after a full settlement has been reached
• Recovery rates of bond
 Subordinated classes are appreciably different from one another in recovery realization
 Difference between secured vs. unsecured senior is not statistically significant
• Recovery rates of bank facilities
 Bank facilities( loans, commitments, letter of credit) are senior to all public senior bonds
 Bankruptcy law and practices differs from jurisdiction to jurisdiction
• Distribution of recovery rates
 Consistently wide uncertainty
 Beta distribution

11 December 19
3
Recovery Rates

11 December 19
4
Project Finance Ratios

• Net cash from operations before debt service (CFO)

 Revenues minus cash expenses, including taxes, but excluding debt service

• Minimum debt service coverage ratio (MDSCR)

 Lowest CFO to annual principal and interest payment ratio

• Short-term minimum DSCR (STDSCR)

 Lowest DSCR over the next three years

• Average debt service coverage ratio (ADSCR)

 Average of annual DSCRs through debt maturity

• Loan life coverage ratio (LLCR)

 Total remaining present value CFOs divided by outstanding principal

balance

11 December 19
5
Debt Capacity and Pricing

11 December 19
6
Returns on Project Finance Loans

• The probability of default and the loss given default

 Probability of default through 2002 – 13.3%

 Large defaults in 2002 from telcom and merchant power

11 December 19
7
Project Finance and Basel II – Pre 2003

• Three approaches
 Basic
 PD and LGD defined from four supervisory ratings categories

 Foundation
 Bank estimates PD or other risk parameters and uses basic approach
for other parameters

 Advanced
 Bank estimates PD, LGD, EAD

• Correlation of LGD and PD

• LGD 2001: Initial evidence on realised losses suggests that losses
during difficult periods exceeds those of senior, unsecured corporate
exposures.

11 December 19
8
 Mathematical Credit Analysis

Financial Ratios in Project Finance December 19

General Payoff Graphs from Holding Investments with Future
Uncertain Returns

Stock Payoff versus Price if Purchased or Sold Stock at $40

50
40
30
20
10
Payoff

Ending Stock Price

0
-10 0 10 20 30 40 50 60 70 80
-20
-30
-40
-50
Purchase at $40 Sell Stock Short

12 December 19
0
Payoff Graphs from Call Option – Payoffs when Conditions
Improve

Call Option Payoff Patterns

40
30
20
10
Payoff

0
0 20 40 60 80
-10 Ending Value
-20 Bought call Sold Call
-30
-40

12 December 19
1
Payoff Graphs from Buying Put Option – Returns are realized
to buyer when the value declines

12 December 19
2
Payoff Graphs from Selling Put Option – Value Changes with
Value Decreases

Put Option Payoff Pattern from

Selling Put -- Lender Perspective
10
5
0
Payoff

-5 0 20 40 60 80 100 120
-10 Ending Firm Value
-15
-20
-25
-30
-35
-40

12 December 19
3
The Black-Scholes/Merton Approach

• Consider a firm with equity and one debt issue.

• The debt issue matures at date T and has principal F.

• It is a zero coupon bond for simplicity.

• Value of the firm is V(t).

• Value of equity is E(t).

• Current value of debt is D(t).

12 December 19
4
 Payoff to
claimholders At maturity date T, the
debt-holders receive
face value of bond F
as long as the value of
Value of the company and the firm V(T) exceeds
changes in value to equity and F and V(T) otherwise.
debt investors
They get F - Max[F -
V(T), 0]: The payoff of
Nominal Debt riskless debt minus the
payoff of a put on V(T)
Repayment
Equity with exercise price F.

F Equity holders get

Max[V(T) - F, 0], the
payoff of a call on the
firm.

Debt

Value of Firm in Time T

V(T)
12 December 19
5
Payoff to
debt holders

Credit spread is the payoff from selling

a put option

A1 B A2 Assets

The payoffs to the bond holders are limited to the amount lent B
at best.

12 December 19
6
Merton’s Model

• Merton’s model regards the equity as an option on the assets of the firm

• In a simple situation the equity value is

max(VT -D, 0)

where VT is the value of the firm and D is the debt repayment required

Assumptions

 Markets are frictionless, there is no difference between borrowing and

lending rates

 Market value of the assets of a company follow Brownian Motion Process

with constant volatility

 No cash flow payouts during the life of the debt contract – no debt re-
payments and no dividend payments

 APR is not violated

12 December 19
7
Merton‘s Structural Model (1974)

• Assumes a simple capital structure with all debt represented by one zero
coupon bond – problem in project finance because of amortization of
bonds.
• We will derive the loss rates endogenously, together with the default
probability
• Risky asset V, equity S, one zero bond B maturing at T and face value
(incl. Accrued interest) F
• Default risk on the loan to the firm is tantamount to the firm‘s assets VT
falling below the obligations to the debt holders F
• Credit risk exists as long as probability (V<F)>0
• This naturally implies that at t=0, B0<Fe-rT; yT>rf, where πT=yT-rf is the
default spread which compensates the bond holder for taking the default
risk

12 December 19
8
Merton Model Propositions

• Face value of zero coupon debt is strike price

• Can use the Black-Scholes model with equity as a call or debt as a put option to directly
measure the value of risky debt
• Can use to compute the required yield on a risky bond:
 PV of Debt = Face x (1+y)^t
 or
 (1+y)^t = PV/Face
 (1+y) = (PV/Face)^(1/t)
 y = (PV/Face)^(1/t) – 1
 With continual compounding = - Ln(PV/Face)/t
• Computation of the yield allows computation of the required credit spread and computation of
debt value
• Borrower always holds a valuable default or repayment option. If things go well repayment
takes place, borrower pays interest and principal keeps the remaining upside, If things go
bad, limited liability allows the borrower to default and walk away losing his/her equity.

12 December 19
9
 Default Occurs at Maturity of Debt if V(T)<F

Asset Value

E (VT )  V0 e T 2
VT  V0 exp{[   ]T   T ZT }
2
VT

V0

Probability of default

T Time

13 December 19
0
Black-Scholes Assumptions with Respect to Firm Value

• Firm value is lognormal; constant volatility; deterministic interest rate; no frictions.

 E(t) = Call[V(t),F,T]
 D(t) = Exp[-r(T-t)]*F – Put[V(t),F,T]
• Put-call parity implies also:
 D(t) = V(t) – Call[V(t),F,T]
• Firm value is simply sum of equity and debt:
 V(t) = E(t) + D(t).
• Merton showed value of a risky loan
• F(t) = Be-it[(1/d)N(h1) +N(h2)]
• Written as a yield spread
• k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
• where k(t) = Required yield on risky debt
• ln = Natural logarithm, i = Risk-free rate on debt of equivalent maturity

13 December 19
1
Merton Model and Recovery Rate

• If Merton’s model applies, the probability of default can be computed.

• It is the probability that firm value will exceeds debt face value at T.
 Debt Value = Face at Risk Free Rate less Value of Put Option
 Put Option Value = Probability of Default x Cost When Default
• Black-Scholes formulation allows one to divide the value of the put option into
probability of default and recovery rate

13 December 19
2
 Reference Slides on Financial Ratios

Financial Ratios in Project Finance December 19

Telecom DSCR Criteria (Reference)

• Standard & Poor’s believes that a project’s credit is generally

strengthened by covenants that limit, or even preclude, distributions to
sponsors unless both robust historic and projected DSCRs are met, and
reserve funds are fully funded.

• Given the merchant-type risk associated with most telecom deals,

Standard & Poor’s would generally require that distribution test DSCRs
be computed on a 12-months-back and 24-months-forward basis, using
forecasts made by independent consultants, and be at least 2 times (x)
for low speculative- and investment-grade projects.

13 December 19
4
Debt Service Coverage Criteria

• Standard & Poor's considers that minimum DSCR threshold tests for most
contract-driven projects to be around 1.30 times (x), provided that this figure holds
under stress analysis.
• Such levels are too low for merchant projects. Instead, minimum DSCR levels for
equity distributions may need to exceed 1.70x for investment-grade transactions,
depending on the industry.
• For example, one financial institution suggests that under base case assumptions
the DSC should show not less than 1.2:1 for every year of operation during the
loan life, and no less than 1.4 on average.
• Under a Downside Case, with up to 5 years added to the repayment period, the
DSC should be no less than 1.0:1 for every year or less than 1.15:1 on average
during the life of the loan.
• Projects with merchant exposure may find that leverage cannot exceed 50% if
investment-grade rated debt is sought. On the other hand, contract-revenue
driven projects, on the other hand, typically have had leverage levels around 70%
to 80%.

13 December 19
5
Effect of Financing on the Required Cost of Electricity

13 December 19
6
Investment Grad Bond Ratings

Moodys S&P

Aaa AAA The debt has the highest rating. Capacity to pay interest and principal is extremely strong.
Regarded as having maximum safety and gilt-edged.

Aa AA The debt has a very strong capacity to pay interest and repay principal. Regarded as ‘high-
quality.’

A A The debt has a strong capacity to repay interest and principal. However, it is somewhat
susceptible to adverse changes in circumstances and economic conditions. Regarded as
upper-medium grade in terms of creditworthiness.

Baa BBB The debt is regarded as having adequate capacity to pay interest and repay principal.
Whereas it normally exhibits adequate protection parameters, adverse economic conditions or
changing circumstances may lead to a weakened capacity to pay interest and repay principal
for debt. These bonds/loans are lower-medium grade in therms of creditworthiness.

13 December 19
7
 Non-Investment Grade Bond Ratings

Moodys S&P Debt rated in the categories below are regarded as low grade and predominantly speculative.

Ba BB The ability of these entities to meet obligations may be moderate and not well safeguarded in the future.
The lowest degree of speculative.
Investment-grade cutoff

B B These issues offer poor financial security. Assurance of payment of obligations over the long term is small.

Caa CCC Very poor financial security. They may be in default of their obligations or there may be dangers present
with respect to timely debt repayment.

Ca CC These entities are often in default or have other marked shortcomings. The highest degree of speculation.

C C This rating is preserved for debt that may have substantial risk; be in default; or extremely speculative.
Potential recovery values are low.

D D The debt is in default and payment of interest and/or repayment of principal is in arrears.

13 December 19
8
Sutton Bridge Financial Ratios

13 December 19
9
Pre-2003 Basel II Proposal

• The pre-2003 proposal was harmful to project finance

14 December 19
0
Correlation of PD and LGD in Basel II

14 December 19
1