project finance modeling

project finance modeling

The Comprehensive Guide to Project Finance Modeling

1. Introduction to Project Finance

For the newcomer, this outline is presented to familiarize the reader with the rudiments of the project finance model, how it is built, and what inputs and outputs are normally involved in this modeling exercise. The intent is to provide the first-time practitioner with a useful guide or basic walk-through on the main elements of project finance modeling. Although it might be both more descriptive and accurate to refer to this outline as a “build” or “construction” of a project finance model, project transactions are most often complex and subject to numerous complexities and contingencies. Thus, an understanding and use of the project finance model requires a detailed appreciation of the operational building blocks that support and structure the purpose of the model. This section is designed to give these practical insights to the model user.

Project finance continues to be the optimal structure of choice for many infrastructure and other large capital projects, both domestically and internationally. This form of financing remains a complex and often esoteric subject, as optimization of the project’s finance involves numerous and varied protagonists, stringent financing, technical engineering and legal structuring, as well as use of a broad array of financing sources and hedge products. ESL employs state-of-the-art technology to provide modeling support on these transactions, be they in power, water, telecommunications, toll-roads, or air transport, among other infrastructure sectors.

2. Key Concepts and Principles in Project Finance Modeling

Across various key concepts we will go over the terms, concepts of project finance, project finance structures, flexibility in waterfall mechanics, term sheet, equity and debt IRR sensitivities, financial model flexibility, model layout and insight into financial modeling, capital expenditure (CAPEX) coverage ratio, and cash flow mechanics involving interest during construction (IDC) and debt service coverage ratio (DSCR). In the subsection involving modeling costs, we delve into generic costs for terminal development (project commissions, guarantees, etc.), building the interest during construction (IDC) mechanics and modeling fees. On the more advanced side, we discuss debt sculpting, covenants, debt sizing – debt service reserve, and service coverage ratios (SCR, DSCR). We then conclude with a recap of the suggested modeling approach.

In this chapter, the objective is to go through a comprehensive list of key concepts in the context of project finance modeling, which we feel are a prerequisite for a project finance modeler to deeply understand. We have divided the chapter into categories, and inside each category, provided relevant key concepts in project finance model that modeler should be clear on. We have provided base-level primer information, as well as more advanced and technical issues, processing from base to intermediate to advanced in terms of difficulty. Since various principles are interlinked, we suggest that readers study the section comprehensively, even if they are already assessed to be at an advanced skill level.

3. Building a Project Finance Model: Step-by-Step Guide

Step 3: Develop the structure: Plan the model before touching the keypad An important initial step is to plan the structure of the model before touching the keypad. That means defining the main input, calculation, and output components, as well as the frequency of construction which will subsequently be used. When planning the structure, it is also important to continually refer to the objectives set in Step 1. While this step may look time-consuming in the initial stages, it can help save time in the long run. For most transactions, the basic elements of the model and the procedures for constructing them will be similar. Once you have developed and gone through some project models, it usually becomes automatic. Therefore, a short amount of time spent initially developing the structure of the model will improve the efficiency of model completion and enable you to better tailor the model to satisfy your objectives.

Step 2: Get a deeper understanding of the transaction It is important to gain a clear understanding of the transaction – its structuring, inputs, outputs, key risks, and main financials. This may involve reading through key transaction documents such as PPA, construction EPC contract, or offtake agreement. A clear understanding should help in determining and identifying all possible components within the model (including key risk areas) which, in turn, will help in setting more detailed objectives.

Step 1: Setting clear objectives Project finance models are used for many different purposes, which include project finance structuring, financial analysis, and investment decision making. The first step in creating a model is to define what you want the model to do and use this definition to drive the subsequent steps. The components of each model should be designed with this in mind. Different objectives will necessitate different outputs; all of the components, assumptions, etc., of the model should be designed around these outputs.

4. Advanced Techniques and Best Practices in Project Finance Modeling

Some might argue that the “best” model has the most complicated, intricate circuitry, while others say the best model tells the well-meaning, focused, and balanced story on how a project will generate cash — for staff, investors, and customers — based on a deep understanding of the project. Don’t clutter your model with stuff that doesn’t count, is the devil incumbent, or both. Validator applauded. It’s not easy, indeed; it is often difficult identifying and making principal judgments. Both your selection and your judgments ought to reflect the key risk profiles. They should be substantiated but marinated. Validator can ask whether the validation process passed mustard. If not, recycle the process. It is good governance. If they did, you reduce unnecessary moments of silent treatment. Sometimes it is best just to say it aloud.

Some projects last decades, but in the end, stopping and reviewing the modeling choices can yield significant dividends. Unfortunately, few projects are subject to such a review – and those that are projects, not project finance models. As a very first step, you should comment on the logic so that some future Picasso can fully recreate the model. Are the custom-defined labels clearly describing the assumptions? Are the terms and covenants defined in the model? This will help if this model is audited. What is your sound? Do your internal checks make efficient use of your time in preventing financial duress, as numerous items can be reviewed quickly and provide captivating insights into project health? It is inevitable that Excel has issues, but try and make these inputs uniform – it is comforting to see inputs consistent so quickly. Are your debt-off and cobweb plots there and explaining the model? Have you mapped out the risk-return trade-off with sensitivity analysis?

5. Case Studies and Real-World Applications

This case study examines an off-balance-sheet, project-finance model for parking spaces. We develop a valuation model for these basic items. Then it is possible to see the profitability characteristics, given a set of operational characteristics, changes in assumptions about these relationships, and lastly the values of these items under a set of operational characteristics. You will find that risk-adjusted, off-balance-sheet derivatives command high premiums when automobile parking spaces are really worth an extremely large amount. Then why are “shuttle” airplanes still a common sight at busy airports? The second case study examines the effect that prospect theory has on the distortion of corporate decisions in the case of the uneconomic ladder and the cost of capital used to value the static arbitrage associated with rational planning atmosphere.

Some of the exercises you solve in this book may have seemed as artificial exercises. However, the insights you gain are critical to analyzing real-world problems. The first case study introduces you to a mode of reasoning in modeling and financial analysis that you are already familiar with – quick estimates, Fermi estimates or “back of the envelope” calculations. For example, how much money can you make parking cars near the airport? Most airlines, which shuttle customers around, do not earn the revenues they could by expanding shuttle revenues by large amounts. Very few businesses make a large amount of money. Then, where are parking spaces available?