A project finance model is a specialized

financial model Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio o ...

, the purpose of which is to assess the economic feasibility of the project in question. The model's output can also be used in structuring, or "sculpting", the project finance deal. The context:

project finance Project finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a project financing structure involves a number of eq ...

is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project - rather than the balance sheets of its sponsors. The project is therefore only feasible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt. Most importantly, therefore, the model is used to determine the maximum amount of debt the project company ( Special-purpose entity) can maintain - and the corresponding debt repayment profile; there are several related metrics here, the most important of which is arguably the Debt Service Coverage Ratio (DSCR).

Model structure

The general structure of any financial model is standard: (i) input (ii) calculation algorithm (iii) output; see

Financial forecast A financial forecast is an estimate of future financial outcomes for a company or project, usually applied in budgeting, capital budgeting and / or valuation; see . Depending on context the term may also refer to listed company (quarterly) e ...

. 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, the model can be subdivided into the following categories: * Variables needed for forecasting revenues * Variables needed for forecasting expenses * Capital expenditures * Financing A model is usually built for a most probable (or base) case. Then, a model

sensitivity analysis Sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be divided and allocated to different sources of uncertainty in its inputs. A related practice is uncertainty ana ...

is conducted to determine effects of changes in input variables on key outputs, such as

internal rate of return Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term ''internal'' refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or f ...

(IRR),

net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...

(NPV) and payback period. For discussion (i) re cash-flow modelling, see Valuation using discounted cash flows #Determine cash flow for each forecast period; and (ii) re model "calibration", and sensitivity- and

scenario analysis Scenario planning, scenario thinking, scenario analysis, scenario prediction and the scenario method all describe a strategic planning method that some organizations use to make flexible long-term plans. It is in large part an adaptation and gener ...

, see #Determine equity value. Practically, these are usually built as Excel spreadsheets and then consist of the following interlinked sheets (see under the list for "Equity valuation" @ Outline of finance #Discounted cash flow valuation for further model-build items), with broad groupings: *Project build and operation (Data input): operating assumptions; Capital costs (construction); Insurance; Taxes; Depreciation;

Financing Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm uses ...

*Corresponding financial statements:

Income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...

;

Balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a busine ...

;

Cash flow statement In financial accounting, a cash flow statement, also known as ''statement of cash flows'', is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to oper ...

*Resultant project metrics: Retained earnings; Coverage ratios; Present values

Metrics in assessing a project

As stated above, the model is used to determine the most appropriate amount of debt the project company should take: in any year the debt service coverage ratio (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. Related to this is the Project life cover ratio (PLCR), the ratio of the

of the cash flow over the remaining full life of the project to the outstanding debt balance in the period. It is a measure of the number of times the cash flow over the life of the project can repay the outstanding debt balance. The Loan life cover ratio (LLCR), similarly is the ratio of the net present value of the cash flow over the scheduled life of the loan to the outstanding debt balance in the period. Other ratios of this sort include the Cash flow available for debt service (CFADS), Drawdown cover ratio (DCR), Historic debt service cover ratio (HDSCR), Projected debt service cover ratio (PDSCR), and the Repayment cover ratio (RCR). Standard profitability metrics are also considered - most commonly,

Internal rate of return Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term ''internal'' refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or f ...

(IRR),

Return on assets The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue. ROA can be computed as below: :\mathrm = \frac This number tells you what the company can do with what it has, ''i.e.'' how many dolla ...

(ROA), and

Return on equity The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on '' ...

(ROE)

Debt sculpting

Debt sculpting is common in the financial modelling of a project. It means that the principal repayment obligations have been calculated to ensure that the principal and interest obligations are appropriately matched to the strength and pattern of the cashflows in each period. The most common ways to do so are to manually adjust the principal repayment in each period, or to algebraically solve the principal repayment to achieve a desired DSCR. See

Cashflow matching Cash flow matching is a process of hedging in which a company or other entity matches its cash outflows (i.e., financial obligations) with its cash inflows over a given time horizon. It is a subset of immunization strategies in finance. Cash flow m ...

Immunization (finance) In finance, interest rate immunization is a portfolio management strategy designed to take advantage of the offsetting effects of interest rate risk and reinvestment risk. In theory, immunization can be used to ensure that the value of a portf ...

, Asset–liability mismatch.

References

* Penelope Lynch, ''Financial Modelling for Project Finance'', 1997, . * Peter K Nevitt and

Frank J. Fabozzi Frank J. Fabozzi is an American economist, educator, writer, and investor, currently Professor of Practice at The Johns Hopkins University Carey Business School and a Member of Edhec Risk Institute. He was previously a Professor of Finance at ED ...

, ''Project Financing'', 2000, * John Tjia, ''Building Financial Models'', 2009, {{ISBN, 978-0-07-160889-3 Corporate finance Infrastructure investment Valuation (finance) Financial models

Model structure

Metrics in assessing a project

Debt sculpting

See also

References