Lesson sets on this page include videos and files associated with selected project finance issues including debt sizing, covenant structuring, debt drawdowns and sculpting that I think are fairly advanced and require you to think carefully about the underlying finance theory. In demonstrating nuances associated with how project finance features can affect price bidding for a project, I discuss a variety of more subtle project finance issues on this page ranging from liquidated damages, availability penalties, performance ratio incentives, debt sizing, sculpting, development fees, pre-operational cash flow, DSRA, credit spreads, risk premiums, letter of credit fees, re-financing, mini-perms, Yieldco's and other items. The spreadsheet files that you can download on this page are intended to demonstrate these and other issues including synthetic sculpting through maintenance contracts, measurement of political risk and risk for lenders relative to return for investors of cash sweeps and other credit enhancements. With respect to the various advanced issues, I don’t think you can make a simple checklist evaluating particular features project finance that are seemingly optimal. Instead, you need to think about the interrelationships that can affect the issue. For example, development fees and other items that can increase the project cost without increasing equity investment can be instrumental in pushing up the equity IRR when the debt to capital drives the debt size of a project. However, when the prospective DSCR determines the debt constraint, these items have no effect on the profitability of a project from an equity perspective. The lesson sets on this page involve building models that isolate on a particular project finance issue.


The video and the associated course outline are intended to describe some of the theory associated with the lesson sets included on this page.





Any project financed loan facility can be divided into five elements that include; (1) the size of the loan; (2) the method for borrowing money once the loan size is defined; (3) the length of time and method for repaying the loan; (4) the interest rate and fees charged for the loan; and (5) various items that further protect the loan. In my humble opinion, term sheets, loan contracts, assumptions in financial models and calculations in financial models should be arranged according to these five fundamental parts. However when you look at actual term sheets the specific terms that define debt size, debt funding, debt repayment, interest rates and credit enhancements are not organised nicely, but instead all over the place. For example, the loan size according to debt to capital may be defined at the beginning of the document whilst the loan size defined by prospective debt service coverage may be specified many pages later.


I am in the process of arranging seven lesson sets on this page. The first five lessons are deal with the five elements that define any project finance debt facility that I mentioned in the above paragraph -- debt size, debt funding, debt repayment, interest and fees and credit enhancements. The lessons are designed to focus on nuances associated with the debt element where the implications of various strategies are not immediately obvious and are interrelated with different provisions in the debt contract. To address issues that I think are complex, I have attempted to create models that concentrate only on the particular issue and present a graph that displays the issue. I have created some videos that are long and difficult to listen to associated with building these simple models.


The last two lessons deal with contract structuring issues and tax issues in project finance. I believe that the contract structure can distort efficient investment decisions when you take a step back and evaluate incentives to build a plant too quickly, pay an EPC contractor too much margin, gold-plate operation and maintenance and many other things. Exercises and videos associated with contract structuring are included in lesson set six. In the last lesson set I discuss the remarkable U.S. tax code that gives away money to large companies with a big tax bill in the name of providing incentives for renewable energy.


I am in the process of updating the videos and the associated files with shorter videos and conceptual discussion so that you can clearly see the interesting theoretical nuances associated with project finance. Please bear with me as I take my time to complete the structure of this page.

Advanced Project Finance Lesson Set 1: Debt Sizing


Cost of capital is one of the central reasons for use of project finance (another may be a signal that lenders are giving the project a stamp of approval). Advantages of project finance depend on the level of debt, the length of the debt and the interest rate. This section deals with subtle issues relating to the size of debt and in particular the level of debt that arises from two constraints that are implicitly or explicitly used by lenders. These two constraints are assuring that the debt size does not exceed a given debt to capital ratio and that the DSCR does not fall below a given DSCR. Both of these constraints are often given by relatively arbitrary benchmarks used by financial institutions. The videos and files in this lesson set demonstrate differences in strategy that are applicable when the debt service constraint applies relative to when a debt to capital constraint drives the debt size.

The subject of debt sizing is introduced in the context of fundamentally different banking philosophies of “skin in the game” and “believing a forecast”. The debt to capital constraint is founded on a banking philosophy that equity providers will be careful with their own money and if they have put money into the investment they will care about the downside risk. With no money invested, the investors do not give a hoot about the downside – they will of course stick with the investment in the upside case. The debt service coverage ratio constraint is derived from the notion that the debt service coverage buffer is one of the best possible measures of risk. Other measures of risk like beta and VAR are statistics that measure almost nothing. But a DSCR ratio measures the percent reduction in cash flow that occur before debt service cannot be met – a much more reasonable way to look at risk. For example, if the DSCR is 1.5, then the cash flow can decline by (DSCR-1)/DSCR or 33%. Alternatively, the formula can be expressed in terms of the percent reduction in cash flow relative to a reference or base case. Re-writing the formula results in DSCR = 1/(1-% Reduction in Cash Flow). For example, if the percent reduction in cash flow is 50%, 1-50% = .5 and 1/.5 = a required DSCR of 2.0x.

Videos Associated with Lesson Set 1


The videos associated with debt sizing demonstrate how to create models that assess strategy differences when the debt to capital constraint applies and when the DSCR constraint applies. The conclusions are that the debt to capital constraint tends to occur with (1) higher project IRR, (2) longer debt tenor, (3) lower interest rates, (4) lower DSCR, and (5) lower taxes. For each of the subjects there is a rather long and boring video describing how the focused model can be developed. I am also in the process of making shorter videos that discuss the strategic issues associated with debt sizing.



Files Associated with Lesson Set 1



Unlike other lessons, I have set the files up with open-ended conceptual questions in the first page of the file. You should be able to answer the questions with the model that is developed in subsequent pages by messing around with the spinner boxes. Questions involve when you should worry about P90, P50 or development fees and what strategies could you apply to do something about these things. Alternatively, questions delve into whether the debt to capital constraint or the DSCR constraint will apply in Ghana or Holland. I do not provide answers in the excel files and I will comment on some of the real-world answers that I have received from people that have participated in my class and who have responded to the exercises. To make you feel good (according to modern marketing theory), I will charge a fee of 40 Euros for the course (if you have ever taken any of my classes, you do not have to pay the fee).



Advanced Project Finance Lesson Set 2: Borrowing Money During the Construction Period (Funding)


The videos and files in this lesson set address alternative methods of borrowing money that has been committed by lenders. Pure project finance would involve putting all of the equity money in before debt is drawn. But now with some kind of direct or indirect support from either sponsors or EPC contractors, the debt can be borrowed on a pro-rata basis with equity. Further with a guarantee from the parent, equity bridge loans have been used. These bridge loans involve borrowing money for the equity and then paying back the loan at commercial operation. As equity bridge loans would not be made without a parent guarantee, interesting conceptual issues arise as to whether the benefits of the bridge loan should be attributed to the project or whether the project return should be computed without the equity bridge loan.
Other issues associated with borrowing money during the construction involve capitalisation of interest rather than payment of interest, the accounting treatment of cash flow and profits generated during construction, treatement of interest during construction on a shareholder loan, evaluation of the risks and costs for a construction over-run facility, liquidated damages for delay and other issues. Capitalisation of interest makes hardly difference at all either where a debt to capital constraint is applied or whether a DSCR constraint is used. In fact, if equity is contributed before debt it makes no difference at all. If profits during construction are measured as income rather than cash flow, the amount of cash equity input into the project can be dramatically reduced. This has an effect if the debt to capital constraint is applicable. The lesson set also deals with liquidated damages for delay in construction associated with the cost of money that occurs while a project is delayed. This requires alternative assumptions with respect to how the delay in construction occurs. Finally, the lesson includes working capital that may be funded during construction and the alternative ways working capital can be financed.


Videos Associated with Lesson Set 2 – Borrowing Money During the Construction Period


Videos associated with this lesson set describe how to program alternative drawdown techniques in the construction phase of a project. Circular issues arise with interest during construction and fees during construction. Further, the models use monthly periods and demonstrate the effect of alternative construction periods. As with other lessons, I am in the process of making shorter introductory videos that focus on the economics and finance issues.

Files Associated with Lesson Set 2 – Funding During Construction


As with lesson set 1 of this page, I have set the exercise files up with open-ended conceptual questions in the first page of the file. The idea is to answer the questions with the model that is developed in subsequent pages by messing around with different construction periods and different funding or construction strategies. I have not provided answers in the excel files and I will comment on some of the real-world answers that I have received from people that have participated in my class and who have responded to the exercises. As with the first lesson set, to make you feel good (according to modern marketing theory), I will charge a fee of 40 Euros for the course. Again, if you have ever taken any of my classes, you are lucky and you do not have to pay the fee.



Advanced Project Finance Lesson Set 3: Repaying Money After the Construction Period



The third lesson set deals with a host of issues involving the tenure of debt and pattern of debt repayment. The length of debt repayment can be one of the most important issues in debt analysis as there are both first and second order effects. First order effects involve increased equity IRR from a longer period of high debt to capital ratios. Second order effects involve a lower DSCR which can (but does not always) increases the amount of debt. Therefore, the second order effects can either overwhelm the first order effects or the second order effects may not be very important. Similar issues are associated with sculpting or alternative repayment patterns for debt. In some cases sculpting can influence the size of debt while if the debt to capital constraint is operative, the pattern of repayment is much less of an issue. Sculpting issues can get tricky when the DSRA is used as the final repayment, when debt service includes letter of credit fees for the DSRA, when interest income is included in CFADS, when a balloon payment is a percent of the sculpted payments, and because of taxes with net operating losses and the effects of depreciation on interest during construction. These issues are addressed in the scuplting course (see the A-Z course). Repayment patterns can also involve something I have named synthetic sculpting. This is where debt repayment pattern cannot be changed, but cash flows can be adjusted. Examples of synthetic sculpting include adjusting the timing of outflows for a maintenance contract and PPA contracts that have step-down capacity charges that correspond to the debt tenure. Further hard mini-perms, soft-mini perms or other hair style names can be used with balloon payments and structured repayments that is derived from longer tenures. These issues bring up a fundamental issue of whether re-financing should be an integral part of financing analysis as mini-perm structures require some kind of re-financing assumption.

Videos Associated with Lesson Set 3 – Debt Repayment Analysis


The videos associated with debt repayment and debt tenure include instructions on how to create project finance models that measure the effects of sculpting, length of debt, mini-perm and re-financing as well as adjustment of cash flow to meet a target DSCR. In addition to the long videos that describe how to make the models, a set of shorter videos discuss the nuances of repayment along with when the repayment structure and the repayment tenure really matters and when it does not matter very much. The shorter videos also describe when re-financing dramatically changes the analysis. I am in the process of finishing the shorter videos.

Files associated with Lesson Set 3 – Required Return to Compensate Lenders and Equity Providers for Taking Risk


Files used to make you a thoughtful finance professional are I designed the files for lesson set 3 with exercises that force you to compute the implied probability of default for loans with a high credit spread and/or equity investments with a country risk premium. I desperately want you to see how unfair the high credit spreads and equity risk premiums are to developing countries. When the credit spread and required return on a solar project is high, then prices are high and GDP growth is spent on giving money to foreign investors (including the World Bank). Because this is such an emotional issue for me I have decided to drop any fee for this lesson set. This means that if you go to the files and complete the yellow blanks and see for yourself how much money a 5% credit spread or an 15% equity IRR really mean, you can get your name on the list of completed files and also receive a nice badge and a diploma.





Advanced Project Finance Lesson Set 4: Interest and Fees Over Time Period from Borrowing to Repaying Money


The fourth lesson set deals with a subject that I sometimes become emotional about, the rate of return that is required to compensate a financial institution or another investor for taking risk. It may seem that as long as the all-in interest rate (that I define as the debt IRR), then you should not care too much about the credit spread. But high credit spreads earned over long-term debt tenures can result in a lot of money for lenders simply because of compounding of the return. These high spreads lead to very high implied probability of default even if the loss given default is high as explained in a couple of the videos. Further, in project finance since the equity risks and returns have a lot of debt characteristics, similar analysis of the probability of contract abrogation and the loss associated with contract abrogation can be applied to equity. Therefore, there are a couple of videos and associated files that address the implied probability of default associated with equity investors. I go a bit crazy when I compute the implied probability of default in IFC or other multi-lateral institutions’ credit spreads for countries in Africa and South Asia, and/or the risk premiums computed by Damarodan for developing countries.

Lesson set 4 also includes some more boring issues associated with whether it is better to ask for fees paid up-front or for credit spreads over the life of the debt. The general answer to this question depends on whether a debt constraint or a DSCR constraint applies. If a debt to capital constraint applies, it seems that the debt increases when fees are paid up front and this is beneficial from an equity IRR perspective. However, as fees are paid in cash, they require more cash equity contribution (even if the fees are capitalized). This hurts the IRR and leads to a simple rule that anytime something increases cash equity requirements, it hurts. The situation is aggravated when debt is defined by the DSCR. In this case even if the debt IRR is the same, the Equity IRR is reduced from paying fees up-front.


Videos Associated with Lesson Set 4


Technical aspects of videos associated with lesson set 3 involve a lot of goal seeks with macros to derive the implied probability of default in different circumstances. In most of the videos cash flows from increased risk are compared to cash flows that supposedly have lower risk. Then the cash flows with higher risk are divided into a default case and a non-default case. The default case is attributed an arbitrary probability that is fixed and then a goal seek is used to derive what default probability makes the risky flows (e.g. from Nigeria) become equivalent to the lower risk cash flows (e.g. Germany). Macros are attached to the goal seeks and spinner buttons are used to test alternative loss given default and default timing.

Files associated with Lesson Set 4 – Required Return to Compensate Lenders and Equity Providers for Taking Risk


I designed the files for lesson set 3 with exercises that force you to compute the implied probability of default for loans with a high credit spread and/or equity investments with a country risk premium. I desperately want you to see how unfair the high credit spreads and equity risk premiums are to developing countries. When the credit spread and required return on a solar project is high, then prices are high and GDP growth is spent on giving money to foreign investors (including the World Bank). Because this is such an emotional issue for me I have decided to drop any fee for this lesson set. This means that if you go to the files and complete the yellow blanks and see for yourself how much money a 5% credit spread or an 15% equity IRR really mean, you can get your name on the list of completed files and also receive a nice badge and a diploma.



Advanced Project Finance Lesson Set 5: Credit Enhancements to Debt -- DSRA, Cash Sweep and DSRA


The two files below address deals with complex issues associated with computing the LLCR with changing interest rates and multiple debt issues with different interest rates. If there are multiple issues, the LLCR can be accumulated for the shortest tenor of the debt. For longer tenor issues, the LLCR can be evaluated by computing forward debt IRR with a user defined function.


The files below address issues assocated with reserve accounts, The DSRA account includes detail of how to compute debt service accounts and the DSRA account. Exercise 7 covers a number of issues assoicated with modelling DSRA's ranging from structuring the DSRA requirements to dealing with cash sweeps, sculpting and cash flow waterfalls. The exercise demonstrates that there should be no circular references associated with the DSRA. Exercise five deals with the issue of computing contributions to a maintenance reserve for extraodinary expenditures. The calculations are a little complicated where the amount of expenditures is not constant and the time between periods of expenditures chages over time. This exercise walks through how to program switch variables for the expenditures and how to compute the prospective expenditure so that the amount of contribution to the MRA can be established.

















Advanced Project Finance Lesson Set 6: Structuring Project Finance Contracts -- PPA Contract, EPC Contract and O&M Contract



Advanced Project Finance Lesson Set 7: Tax Equity Structures in the U.S. and the Amazing way that Incentives for Renewable Energy Accrue to Large and Rich Companies with a Big Tax Bill



I am in the process of adding a lesson set for U.S. renewable investments that have a specialised tax treatment that includes very rapid depreciation, production tax credits and investment tax credits. Because the tax benefits generally exceed the level of EBITDA by a wide margin, the tax benefits cannot be used by a standalone corporation. The financial structures that have been developed can involve a few issues that are difficult from a modelling and/or finance theory perspective. The first of these issues involves how to develop a model of flip structure where a partner that can use the tax benefits receives much of the tax benefits and cash flow. After a target yield is met, the cash flow accrues to the second investor. This structure can be modelled using a little trick with MAX and MIN where you set-up the tax equity investment in two pieces. The first piece is represented a lot like subordinated debt. The second issues involves esoteric issues associated with the tax code. If a partnership is established, then taxes can be allocated in alternative ways to the partners where the amount of the income attributed to the partners must be tabulated along with the dividends that are not related to the tax benefits themselves. If capital that is computed using the pre-tax income (less depreciation deductions) and the non-tax related dividends falls to zero, a partner is not allowed to continue receiving tax benefits. It is not surprising that the partner that is exposed to limits on tax is the tax equity investor. To compute the potential exposure, a capital account must be set-up and something called deficit reduction obligations may be used. The complex finance structures and complex tax rules mask what I think is the most important and third issue. The tax equity investment has two characteristics that are particularly favourable. First, the repayment structure is often like a cash flow sweep or a senior debt with very low risk. Second, as much of the cash flow to the tax equity investor is after-tax the required returns should be less than the pre-tax returns. These two points suggest the return to the tax investors should be very low. But the returns to the tax equity investors have been surprisingly high, suggesting that the whole idea of the tax benefits to renewable energy which was supposed to reduce costs for consumers in fact primarily benefits a small group of very rich large companies.

Files associated with Lesson Set 7 – Analysis of Tax Equity Investments


The basic point is that capital for the Tax Equity goes to zero using the first capital calculation (not the outside capital calculation)
Capital is computed with 50% of ITC
Capital is computed with only dividends from operations (it does not include tax distributions)
Net Income for capital computation is allocated using tax allocation factors
Compute a subtotal so you can see how much DRO is needed
DRO is capped at the level of dividends and does not help that much
Compute another sub-total after interim calculation
Stop loss is computed after DRO and constrains the use of tax benefits for tax equity partner
Final closing balance is after the stop loss and should be zero







Subject

Excel File

Video Link

Chapter Reference

Page Reference











Demonstrates how to make model with DSCR or debt to capital and resolution of circularity

1. Minimum DSCR Constraint and Maximum Gearing.xlsm

https://www.youtube.com/watch?v=zyoInPvi55c





Shows how to include income taxes and resolution of circular reference in DSRC and Max Gearing

1. Minimum DSCR Constraint and Maximum Gearing.xlsm

https://www.youtube.com/watch?v=KQrj-pnhjPM





Shows how to create a model with sculpting or equal installment using dynamic goal seek

2. Sculpting vs Equal Installments.xlsm

https://www.youtube.com/watch?v=VUMAcIzqK8Y





How to make a model with installment payments

2. Sculpting vs Equal Installments.xlsm

https://www.youtube.com/watch?v=ce1K2rCB8LU





How Development Fees affect the equity IRR with DSCR or debt to capital constraint

3. Development Fees.xlsm

https://www.youtube.com/watch?v=YuO3twz5i7k





How Development Fees can be used to provide different IRR to different investors

3. Development Fees.xlsm

https://www.youtube.com/watch?v=95zhYGWDa5I





Shows how O&M structuring can be used to mimic sculpting with different O&M contracts

4. O&M Analysis and Synthetic Sculpting

https://www.youtube.com/watch?v=Ig7auAymivc





Demonstrates how cash sweep lowers equity IRR by limiting dividends in early periods

5. Cash Sweep and Covenant Analysis

https://www.youtube.com/watch?v=u5vwsy04hF4





How cash sweeps affect the cash flow break-even points by limiting dividends

6. Cash Sweep and Covent Analysis Break Even

https://www.youtube.com/watch?v=H6UhWCIiA8U





Probability of default with different cash sweep and DSCR lock-up covenants

7. Cash Sweep and Covenant Analysis Monte Carlo

https://www.youtube.com/watch?v=oxl4OJMB4iY





How Negative effects of cash sweeps are offset with re-financing

8. Cash Sweep and Re-financing







Demonstrates how to create a model with multiple re-financing in prospective periods

9. Multiple Re-financing and Sweep







Shows how to create alternative re-financing scenarios in mini-perm re-financing

10. Mini Perm Analysis and Re-financing

https://www.youtube.com/watch?v=A86GYdaYvtg





Demonstrates how to compute equity IRR with different refinancing assumptions

10. Mini Perm Analysis and Re-financing

https://www.youtube.com/watch?v=9hDZRQZ1n88





Shows how to change re-financing assumptions in mini-perm analysis

10. Mini Perm Analysis and Re-financing

https://www.youtube.com/watch?v=ir3nfxbP70g





Shows the effects on equity IRR of re-financing near end of debt tenor from bullet repayment

11. Bullet Repayment







How to structure a model with different contributions from investors and dividend payments

12. IRR Flip with Multiple Investors







Calculation of LLCR when loans have different tenors and interest rates change over time

13. LLCR Analysis - Multiple Debt Issues and Changing Rates

https://www.youtube.com/watch?v=3E1szhP2KH0





Shows how to compute forward effective debt IRR in order to compute NPV of future cash flow

13. LLCR Analysis - Multiple Debt Issues and Changing Rates

https://www.youtube.com/watch?v=O4vWbxm1WX0





Use of stock price data on yieldco's with P/E ratio, Dividend Yield and P/B ratio to derive cost of cap

14. Yieldco Download and Cost of Capital

https://www.youtube.com/watch?v=hGMFl6czx6A





Problems with IRR from long-term projects, changing risks, and country risk premiums

15. IRR Issues

https://www.youtube.com/watch?v=K28BMxz9mVM





Demonstrates how to incorporate development probability and compute implied required IRR

15. IRR Issues

https://www.youtube.com/watch?v=xRtiDPMhHJc





Illustrates how operating cash flow during construction can affect IRR from accounting

16. Operating Cash During Construction

https://www.youtube.com/watch?v=HbKu8ditmKY





Shows the effects of accounting for pre-operational cash flow as asset reduction or equity

16. Operating Cash During Construction

https://www.youtube.com/watch?v=jUa8Z6eaDEY





Shows how the equity bridge loans affect equity IRR using different operating cash flow assumptions

17. Operating Cash During Construction and Equity Bridge Loan

https://www.youtube.com/watch?v=U2EWJGHY9tI





Illustrates how back-to-back contracts are used with PPA contracts and includes examples

18. Contract Matrix







Demonstrates how to measure LD's, penalties, and incentives with cost benefit analysis

19. PPA Cost and Benefit

https://www.youtube.com/watch?v=v02s7FI5pOE





Shows how long-run and short-run marginal costs can be used for cost and benefit analysis

20. Short-run and Long-run Marginal Cost

https://www.youtube.com/watch?v=wUxan9jZULU





Shows how to compute availability payments and target heat rates

21. O&M Availability and Heat Rate

https://www.youtube.com/watch?v=wUxan9jZULU





Computation of LCOE using NPV(Revenues)/NPV(Generation) and importance of real LCOE

22. LCOE Analysis (Real and Nominal)







Effects of IRR, debt terms and taxes on the LCOE of renewable and conventional energy

23. Carrying Charge Analysis of Renewable







How to compute the implied PD and LGD from credit spreads with different tenors

24. Credit Spreads, PD and LGD

https://www.youtube.com/watch?v=MFXiAWzUxb4





How to incorporate DSRA in model and the effects of DSRA with gearing and DSCR constraint

25. DSRA Analysis with Gearing Constraint

https://www.youtube.com/watch?v=xRtiDPMhHJc





Use of the Merton model to derive the PD and LGD of project finance loands

26. IRR on Debt and Merton Model







Alternative methods of computing implied probability of nationalisation and loss from risk premiums

27. IRRs and Country Risk Premiums

https://www.youtube.com/watch?v=cbFwhudakv8





Implied probability of default from nationalisation with leverage

27. IRRs and Country Risk Premiums

https://www.youtube.com/watch?v=VnbW0wbIy4I





How maintenance contracts can be structured and the costs of MRA accounts

28. Maintenance Reserve Account







Costs of using up-front fees rather than credit spreads in funding of projects

29. Debt Fees







How to set-up loans and reserve accounts for working capital in project finance

30. Working Capital Analysis
















..
…………………………………………………………………………………………………………………………………………………………………………..
..
…………………………………………………………………………………………………………….

……………………………………………………………………………………………..