Post on 09-Apr-2017
transcript
Project Finance Modeling
An Introduction
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What is a “project”?
A project is a temporary, one-time activity undertaken to create a unique product or service, which is intended to bring about beneficial change or added value.
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What is a “project”?
A project’s characteristic of being a temporary, one-time event contrasts with processes or operations, which are ongoing activities intended to create the same product or service over and over again.
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What is “project finance”?
Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure.
Both project debt and equity are used to finance the project.
Debt is repaid using the cash flow generated by operation of the project, rather than other resources of the project owners.
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What is “project finance”?
Financing is typically secured by all project assets, including any revenue-producing contracts intended to be fulfilled by future activities of the completed project.
Lenders are also given the right to assume control of a project if the project company has difficulties complying with loan terms.
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What is “project finance”?
Generally, a special purpose entity is created for each project.
This shields other assets owned by a project sponsor from failure of the project.
As a special purpose entity, the project company has no assets other than the project
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What is “project finance modeling”?
Project modeling is the development of analytical models to assess the risk-reward, cost-benefit or feasibility of a project.
Project finance modeling is the development of analytical models to assess the risk-reward of lending to or investing in a project.
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What is “project finance modeling”?
All financial evaluations of a project depend upon projections of expected future cash flows generated by activities of the completed project.
Forecasting project cash flows requires a thorough understanding of the methods, techniques and computer software commonly used in such projections.
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What is “project finance modeling”?
The analytical challenge is to design financial projection models that are:– Thorough in scope– Accurate and reliable– Flexible in accommodating revisions– Quick to develop and maintain
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Course Outline
Project lending: Credit considerations Project investing: Measures of return Lending or investing: Free cash flow Modeling issues Dealing with data
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Project Lending
Expected from owner before approval:– Economic justification for project
Feasibility study Cost – benefit analysis
– Demographics– Assumptions– Projections– IRR, NPV, etc.– Identified risks
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Project Lending
Expected from owner before approval:– Detailed cash flows– Detailed project time schedule
Together, cash flows and time schedule dictateborrowing and repayment schedule
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Project Lending
Expected from bank before approval:– Evaluation of project benefits and risks
Is economic justification believable?– Are assumptions logical and believable?– Are financial projections, especially cash flow, realistic?– Have all risks been adequately identified?
Does company management have sufficient expertise? Can any risks be mitigated by insurance or “bonding”? If recourse, can owner survive failed project and repay
bank?
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Project Lending
Expected from bank before approval:– Is project time schedule realistic?– Is cost overrun contingency adequate?– Proposal for loan structure
Collateral Covenants Recourse
– Preparation of borrowing schedule– Can bank manage failed project to recover loan?
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Project Lending
Expected from owner after approval:– Project status reports
Percentage completion Actual expenditures versus budgeted expenditures Cash flow re-forecasts Changes to project Increases or decreases in risk
– Borrowing requests … based on scheduled expenditures
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Project Lending
Expected from bank after approval:– Ongoing review of status reports provided by owner– Regular on-site inspections of project progress by
experts – Careful “yes or no” decision to fund each borrowing
request based on project progress and known risks– If recourse, ongoing review of owner’s other “normal”
business operations through ordinary credit analysis
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Project Lending
Loan structure– Recourse (guarantees, etc.)
Bank wants recourse to owner and owner’s assets– Moral value even if limited economic value
[partner/ sophisticated investor theory]– Exercising rights of recourse expensive, time consuming
Owner wants “non-recourse” financing
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Project Lending
Loan structure– To completion versus through completion:
To completion– Acquisition/ development/ construction only– Completion guarantee
From owner to bank From general contractor to owner, assigned to bank Liquidated damages
– Standby or “take out” financing
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Project Lending
Loan structure– To completion versus through completion:
Through completion– Financing ongoing operations– Clear conditions for if/ when working capital line/ loan begins– Clear conditions for if/ when acquisition/ construction loan
converts into permanent term loan for property/ equipment– Revised set of operating covenants
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Project Lending
Loan structure– Covenants
Acquisition/ construction– Restrictive covenants to prevent loss of collateral value– Prescriptive covenants to promote successful completion– Tangible Net Worth– Net Working Capital
Permanent/ operational financing– Debt/ Worth– Current Ratio– EBITDA
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Credit Analysis
What factors influence the ability of a borrower to repay a loan?– External factors– Internal factors
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Credit Analysis
External versus internal factors:– Good external factors can not offset poor internal
factors.– Good internal factors can often mitigate weak
external factors.
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Credit Analysis
External factor analysis — a caution:– There are vast amounts of macro economic data
available. The amount of industry-specific data is overwhelming. Analyzing these external factors is time consuming and often expensive. Decisions about how much analysis of external factors to include in a credit report should be based on the degree to which the analyst thinks these factors will affect a borrower’s ability to repay its loans.
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PEST Analysis
Political Factors– Political factors include governmental laws and
regulations which define the rules of commerce. Political stability Labor laws Tax laws Trade restrictions Environmental regulations
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PEST Analysis
Economic Factors– Economic factors include basic characteristics that
affect consumer purchasing power and corporate capital costs.
Economic growth Wage rates Inflation rate Interest rates Exchange rates Energy costs
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PEST Analysis
Social Factors– Social factors include demographic and cultural
attitudes of a population that can influence issues as diverse as work force flexibility and market potential.
Population demographics Educational quality Labor unions Healthcare Work attitudes
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PEST Analysis
Technological Factors– Technological factors include research and
development activities that can lower barriers to entry, reduce minimum efficient production levels, and influence outsourcing decisions.
Basic academic research Applied research and development Automation potential Information systems Technology incentives
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Sector Analysis
Industry sector analysis:– If a borrower has a significant share of industry
sales, say 10% or more, it is then very important to fully review available information regarding the outlook for the industry. (Many government agencies and investment banks publish a variety of sector reviews.)
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SWOT Analysis
Strengths– A company’s strengths are its resources and
capabilities that can be used as a basis for developing a competitive advantage.
Good reputation Strong brand names Patents Proprietary cost advantages Access to high-grade natural resources Favorable access to distribution networks
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SWOT Analysis
Weaknesses– The absence of certain strengths usually results in
weaknesses. Poor reputation Weak brand names Lack of patent protection High cost structure Lack of access to natural resources Lack of access to key distribution channels
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SWOT Analysis
Opportunities– The external environment may offer certain new
opportunities for profit and growth. Unfulfilled customer need Development of new technologies Loosening of regulations Removal of trade barriers
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SWOT Analysis
Threats– Changes in the external environment may also
present threats to a company. Shifts in consumer tastes away from company’s products Emergence of substitute products New regulations Increased trade barriers
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Strengths and Weaknesses
S – W > U
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Strengths and Weaknesses
Strengths – Weaknesses > Uncertainty
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Credit Analysis
Internal factor analysis:– Financial information
Ratios Trends Cash flow
– Management information Background and experience Behavior as reflected in financial performance
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Liquidity Ratios
Current Ratio
sLiabilitieCurrentTotalAssetsCurrentTotal
This ratio is a rough indication of a company’s ability to service its current liabilities when due. A high value is better than a low value. A ratio larger than one means there are more assets that are already cash or that can be converted into cash within a year than there are liabilities that will have to be paid with cash. However, the composition and quality of current assets is a critical factor in the analysis of an individual company’s liquidity.
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Leverage Ratios
Debt/ Worth
This ratio measures the relationship between capital contributed by creditors and that contributed by owners (minus any intangibles). It expresses the degree to which owners’ equity provides protection for creditors. A value that is lower than the industry norm is better than a value that is higher than the industry norm. A lower ratio generally indicates greater long-term financial safety and greater flexibility to borrow in the future.
WorthNetTangiblesLiabilitieTotal
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Project Investing
Common measures of return– Cost-benefit analysis (CBA)– Payback period– Net present value (NPV)– Internal rate of return (IRR)
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Project Investing
Cost-benefit analysis– Compare total costs to total benefits– If competing projects, choose:
Most profitable “Best”
– Not always financial
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Project Investing
Payback period– Period of time it takes to recover the initial
investment– Does not properly account for:
Time value of money Inflation Risk Financing costs
– Managers like it because it is easy
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Project Investing
Internal Rate of Return– Potential problems:
Understates reinvestment value of future positive cash flows Cannot deal with negative cash flows near end of a project
(e.g., environmental cleanup costs) Cannot deal with changing degrees of risk over life of a
project– Managers like it because it can be used to compare
projects of different size
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Project Investing
Mutual exclusivity– Assume a limit on availability of capital at
an acceptable cost– Corresponding limit on the number of investments
that can be made
If projects are mutually exclusive, academics argue that NPV is a better analytical measure than IRR
Ex: High initial cost versus high future cash flows
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Project Investing
Complex measures of return– Modified internal rate of return (MIRR)
Positive cash flows discounted at weighted average cost of capital (WACC) instead of discount rate making positive cash flows more valuable
Future negative cash flows discounted separately and added to initial cost of project
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Project Investing
Complex measures of return– Real options analysis
Each separate cash flow assumed to have unique uncertainty or risk
Uncertainty of each separate cash flow accounted for using “risk-adjusting probabilities”
Risk-adjusted cash flows then discounted at risk-free rate