Policy Analysis
Pricing Support
• Various mechanisms can be used to support wind
power:
– a simple fixed tariff (usually set somewhere between retail and
wholesale prices for electricity and paid for by the local electricity
company to the wind farm) for a number of years;
– "green certificates" provided to renewable energy producers and
which can be traded - and which have value because producers
of "dirty" electricity are forced by law to purchase growing
amounts of such certificates each year to compensate for the
polluting nature of their production;
– investment subsidies (a one off amount paid at the onset of the
project, or over a number of years) to compensate for higher
initial investment costs.
Tax Depreciation Analysis
• Review of Tax Depreciation Allowances
– 5 Year MACRS
– Incentive with Straight Line
– Technical Issues
• ½ Year Convention
• Applicable Assets
• Transfer of Tax Credits
• Effects of Tax Depreciation on the Economics of
Wind Projects
– Best Case Effects
– Worst Case Effects
Effect of Production Tax Credit and
Accelerated Tax Depreciation
• A principal reason for the use of private investors rather
than municipal ownership is the possibility to use
production tax credits and accelerated tax depreciation
to offset taxes that would otherwise be paid.
• Without the PTC and accelerated depreciation, private
investors would require higher electricity rates to meet
the rate of return requirements.
• The tables on the next page use a rate of return of 9%
and a debt service coverage of 40% to illustrate the
effect of the tax benefits. The first case assumes the
PTC and a five year depreciation is available, while the
second assumes that the tax benefits are not available.
Value of Tax Benefits in Alternative Cases
• Consider Extreme Cases:
– If there is no energy production, there is no PTC.
This implies that higher capacity factor projects have
greater tax benefits.
– If a project earns no income above the interest cost,
there is not tax to pay and the advantage towns have
in terms of tax payments do not exist.
– If a project has a very low cost, there is a low base for
tax depreciation and the accelerated tax depreciation
benefits are not as important.
Summary of Tax Benefits and Costs
• The graph below
summarizes the
components of costs
and benefits of taxes in
a private investor
scenario. The benefits
include the PTC and
accelerated tax
depreciation. The costs
are that taxes must be
paid on profits. This
has a large negative
effect in the later years
of the project life.
Components of Value With No Financing
$2,500,000
$1,829,825
$2,000,000
$1,500,000
$1,000,000
$1,264,761
$952,427
$500,000
$0
($500,000)
($1,000,000)
($1,500,000)
($2,000,000)
($2,500,000)
($3,000,000)
Free Cash
Value of
Value of
Total Taxes Purely Private
Taxes
Flow Without Production Depreciation Paid without
Model
Potentially
Taxes
Tax Credits
PTC and Dep
Avoiadable
Benefits
Post PTC
Total
Potential
Value with
Mixed
Private/Public
This chart shows the effects of
taxes on the value of the project.
The first bar has no taxes in the
town case. The second and third
bars show the effects of PTC and
tax depreciation benefits. The
Alternative Tax Cases
Components of Value -- Total Potential Value $671,300
$2,000,000
• The analysis in the adjacent
chart shows tax benefits in
three alternative cases.
• Case 1:
$1,737,960
$1,500,000
$1,066,660
$1,000,000
$886,806
$500,000
$0
($500,000)
($1,000,000)
Free Cash
Value of
Value of
Total Taxes Purely Private
Taxes
Flow Without Production Depreciation Paid without
Model
Potentially
Taxes
Tax Credits
PTC and Dep
Avoiadable
Benefits
Post PTC
Total
Potential
Value with
Mixed
Private/Public
($1,500,000)
($2,000,000)
($2,500,000)
– Base Case
• Case 2:
– Higher Capacity Factor, Lower
Electricity Rate and Higher
Cost
• Case 3:
– Lower Capacity Factor, Higher
Electricity Rate and Lower
Cost
• Note the Significant swing in
value
Components of Value -- Total Potential Value $1,434,936
$2,500,000
$2,000,000
$1,500,000
$1,044,920
$1,000,000
$500,000
$211,022
$0
($500,000)
($1,000,000)
Free Cash
Value of
Value of
Total Taxes Purely Private
Taxes
Flow
Without Production Depreciation Paid without
Model
Potentially
($390,016)
Taxes
Tax Credits
PTC and Dep
Avoiadable
Benefits
Post PTC
($1,500,000)
Total
Potential
Value with
Mixed
Private/Public
($2,000,000)
($2,500,000)
Components of Value -- Total Potential Value ($75,174)
$4,000,000
$3,000,000
$2,000,000
$2,756,798
$2,681,624
$1,823,109
$1,000,000
$0
($1,000,000)
($2,000,000)
($3,000,000)
Free Cash
Value of
Value of
Total Taxes Purely Private
Taxes
Flow Without Production Depreciation Paid without
Model
Potentially
Taxes
Tax Credits
PTC and Dep
Avoiadable
Benefits
Post PTC
Total
Potential
Value with
Mixed
Private/Public
Components of Cash Flow for U.S. Project
Wholesale Power Rates and Net Metering
Rates
•
•
•
•
Energy legislation known as the Green
Communities Act was recently signed into
law allows the energy produced at
customer-sited generation facilities of up to
2 MW to be sold to the grid as if it were
offsetting the energy used at the customer’s
meter.
Previous Massachusetts law only allowed
facilities of up to 60 kW to benefit from net
metering while for larger facilities only the
portion of the production that coincided with
load could be credited at the retail rate.
Each municipality can net meter up to 10
MW of generating capacity, provided that no
individual unit exceeds 2 MW.
According to the legislation, the net metering
credit for generation used to offset load at a
customer’s meter is credited at a rate equal
to the “default service kilowatt-hour charge
in the ISO-NE load zone where the
customer is located.
National Grid Rate Tariff
Customer Charge
Generation/Supply
Distribution Demand
Distribution Energy
Peak
Off-peak
Transmission
Transition Demand
Transition Energy
DSM
RE
G-3
72.06 $
0.15802 $/kWh
3.87 $/kW
Total Net Metering Credit:
0.17481 $/kWh
0.01363
0.00108
0.00749
0.52
0.00142
0.00250
0.00050
$/kWh
$/kWh
$/kWh
$/kW
$/kWh
$/kWh
$/kWh
Creditable Under
Net Metering
x
x
x
x
x
Net Metering (Quincy)
•
•
•
Energy legislation known as the Green
Communities Act was recently signed into
law in Massachusetts that has made this onsite usage requirement moot. This
legislation allows the energy produced at
customer-sited generation facilities of up to
2 MW to be sold to the grid as if it were
offsetting the energy used at the customer’s
meter. Previous Massachusetts law only
allowed facilities of up to 60 kW to benefit
from net metering while for larger facilities
only the portion of the production that
coincided with load could be credited at the
retail rate. Each municipality can net meter
up to 10 MW of generating capacity,
provided that no individual unit exceeds 2
MW.
According to the legislation, the net metering
credit for generation used to offset load at a
customer’s meter is credited at a rate equal
to the “default service kilowatt-hour charge
in the ISO-NE load zone where the
customer is located.
National Grid Rate Tariff
Customer Charge
Generation/Supply
Distribution Demand
Distribution Energy
Peak
Off-peak
Transmission
Transition Demand
Transition Energy
DSM
RE
G-3
72.06 $
0.15802 $/kWh
3.87 $/kW
Total Net Metering Credit:
0.17481 $/kWh
0.01363
0.00108
0.00749
0.52
0.00142
0.00250
0.00050
$/kWh
$/kWh
$/kWh
$/kW
$/kWh
$/kWh
$/kWh
Creditable Under
Net Metering
x
x
x
x
x
Benefits of Private Ownership with and
without Tax Incentives
Cash Flow Components
Equity IRR 9.15% DSCR 1.40
600,000.00
Cash Flow without PTC and
Tax Depreciation
Tax Depreciation
500,000.00
400,000.00
PTC Benefits
300,000.00
200,000.00
100,000.00
-
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
• The two adjacent graphs
show the effects of tax
incentives on the cash
flow and rate of return
earned in a private
investor scenario. The
rate of return declines
from 9.15% to 3.07%
• In the example, the price
in the PPA contract would
have to increase from
$141/MWH to $191/MWH
Cash Flow Components
Equity IRR 3.07% DSCR 1.22
180,000.00
160,000.00
Cash Flow without PTC and
Tax Depreciation
Tax Depreciation
140,000.00
120,000.00
100,000.00
PTC Benefits
80,000.00
60,000.00
40,000.00
20,000.00
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
Structuring
Flip Structure
Details of Tax Flip
•
•
•
•
•
•
•
•
•
•
This flow will only arise IF EPIC applies/receives approval to receive credit under Section 48B.
As proposed by CSI, the $$ flow of ITC (to Master Tenant) and corresponding investment (from Master Tenant to
Landlord) would occur annually;
the $11MM investment would not be paid as a lump sum before the ITCs are created. There are other ‘flip’
structures (equity investors) that make the investment on the front-side of project.
For FY2008, $337MM was available for Section 48B projects.
The submission date for 2007-2008 funding closed 10.31.07, with notification of awards targeted for mid-2008.
In June 2007, the Treasury Department and DOE released revised guidance on the procedures for awarding the
tax credits authorized under EPAct 2005 for qualifying advanced coal projects and qualifying gasification projects.
Under the revised guidance, applications for
DOE certification received before October 31, 2007, will be acted on in 2008.
DOE received five applications for projects in five different states before the October 31 deadline. Two
applications, requesting $258 million in tax credits, were received for qualifying advanced coal projects costing
$4.1 billion, while three applications, requesting $390 million in tax credits, were received for qualifying gasification
projects costing $5.0 billion Due to some (potentially conflicting) language regarding the application deadline in
IRS 2007-53, I am investigating if there is still a window of opportunity to submit an application for FY2008 funds.
Otherwise, an application could be submitted for FY2009 funds (by 10,31,08), if deemed worthy to do so for either
the EPIC-HES Ethanol Project (HGL) or other EPIC client projects. To ensure qualification for a future Section
48B award, EPIC would need to both be carbon capture ready and capture/dispose of its carbon emissions as part
of the project.
Consortium Investments is interested in making an EPIC investment if/when tax credits can be exchanged for an
equity investment.
Different Structures for Renewable Projects
Reasons for Hybrid Analysis
• General Structure
– Partnership between private investors and town
– Not typical partnership with percent of contributions
and percent of dividends
– Different contributions and dividends paid at different
time periods
• Tax Benefits and Tax Costs
• Tax Investors in Wind Farms
– Flip structure
– Returns to tax investors
– Alternative Structures
Modeling of Hybrid Structure
PTC
Tax Dep
Partnership
Contributions
Dividends and Financing
Requirements of Partnership
Private Entity
Dividends
Debt Service
Town
Dividends
Debt Service
Example of Hybrid Structure
• Contributions to Partnership
– Private
– Town
80%
20%
• Dividends from Partnership before year 11
– Private
– Town
99%
1%
• Dividends from Partnership after year 10
– Private
– Town
1%
99%
• Derive the town partnership contributions through
working with the contract level and with private IRR
similar to private investor case
Length of Pre-Flip Period
• An issue arises in structuring a
hybrid analysis as to whether
the first pre-flip period should
be 10 years to cover the PTC
payments or should it be 5
years to cover the accelerated
depreciation (in which case
some of the PTC benefits are
given up).
• The adjacent charts
demonstrate that a five year
flip structure has more value
than a ten year flip structure.
Ten Year Flip
Five Year Flip
Considerations in Developing Hybrid
Structure
• Building from principles in earlier discussion, the
amount of contributions to the partnership
should consider:
– The project IRR for the town portion must be greater
than the municipal interest rate, otherwise it is not
possible to repay loans
– The equity IRR should be just sufficient to induce
investment and the debt coverage should be
aggressive. This can be accomplished by adjusting
the contract price
– After making the structuring adjustments, evaluate the
savings relative to town savings on a standalone
basis.
Example of Hybrid Structure
• Contributions to Partnership
– Private
– Town
80%
20%
• Dividends from Partnership before year 11
– Private
– Town
99%
1%
• Dividends from Partnership after year 10
– Private
– Town
1%
99%
• Derive the town partnership contributions through
working with the contract level and with private IRR
similar to private investor case
Considerations in Developing Hybrid
Structure
• Building from principles in earlier discussion, the
amount of contributions to the partnership
should consider:
– The project IRR for the town portion must be greater
than the municipal interest rate, otherwise it is not
possible to repay loans
– The equity IRR should be just sufficient to induce
investment and the debt coverage should be
aggressive. This can be accomplished by adjusting
the contract price
– After making the structuring adjustments, evaluate the
savings relative to town savings on a standalone
basis.
Length of Pre-Flip Period
• Issue: Should the repayment period be 10
years to cover the PTC payments or
should it be 5 years to cover the
accelerated depreciation
Complexities
Periodic Cash Flow Modeling
• Monthly versus Annual Periodic Modeling
–Need to model with years on a vertical rather
than a horizontal basis because you run out
of room.
–Use look-up tables to find inputs from annual
workings analysis and monthly construction
etc.
–Adds accuracy where
• Debt service is quarterly etc.
• Scrapping occurs at specific points
Dates and Length of Period
• Standard IRR and NPV calculations in Excel assume
that the cash flows occur at the end of the period
• To be consistent with this, one would make the formulas
for interest, depreciation and other items use the
opening balance rather than the average or the ending
balance
• To be careful, explicitly show the beginning day of the
period and the ending day of the period and use XIRR
and XNPV
• It is helpful to explicitly show how many months are in
each period so the EDATE function can be used
Step by Step Process for Setting up Dates
•
•
Step 1: Input months per period for various phases of the project – typically one
month for construction period and six months for operating period.
Step 2: Develop period code – this is an essential part of the process, the last date
before operation is period zero and the project begins its life in period one.
•
•
•
•
•
It does not matter at all that the length of some periods is different than other periods. The start period
of construction is the negative of the number of construction months minus one. For example if the
start date of construction versus the completion date yields 40 months, the first period is negative 39.
Then, the first period of construction will be zero as desired. (Note: it is a good idea to hide remaining
columns)
Step 3: Develop switches (TRUE/FALSE) for different phases and important dates –
construction period, operation period and terminal period.
Step 4: Correspond the months per period from the switches. For example, for the
construction period, the months per period is one.
Step 5: Enter the dates using the EDATE function. Show both the beginning date
and the ending date. The first beginning date is the established date and the ending
date is the EDATE function with using the months per period. The beginning period
in the second period is the ending period plus one day.
Step 6: Compute the number of days per period and the days in 360 day year (first
period next year)
Tip for Computing Months of Construction
•
•
•
•
•
•
To set-up a model that accounts for different project phases, a few excel techniques
are helpful. First, the total construction period should be defined by subtracting the
completion date from the date at which construction begins (the construction start
date and the completion date should be defined in the model along with the number
of periods per year for construction and the number of periods per year for operation.)
Through defining dates in this manner, the model can be flexible enough to account
for delays in construction of the project.
To compute the start date in this manner on a monthly basis, use the DAYS360
function in excel and enter the start date of construction and the completion date
(DAYS360(start date, completion date), then divide this number by 30. To illustrate
this process consider the following example:
Start date of construction: 1-March-2010
End date of construction: 1-December-2015
DAYS360(begin,end)
: 270
Divide by 30
: 69
Modeling the Financial Structure
• Model Structure
–
–
–
–
Sources and uses
Debt financing
Depreciation Schedule
Financial statements
• Time Periods
–
–
–
–
–
Construction
Debt module
Operating
Financial statements
Returns
Annualizing with Fiscal Year
It is simple to annualize periodic cash flows once the fiscal year has been established. This can be accomplished by
listing the year below the date and then using the SUMIF function to sum the periodic cash flows within the year. To
demonstrate the process, the establishing the fiscal year is discussed and then the process of using the conditional
sum is described.
Establishing the fiscal year can be demonstrated by considering the example of Microsoft Corporation. For this
company, the fiscal year 2007 ends at June 30, 2007 and covers the period July 2006 through June 2007. Here, one
would define the fiscal year as June.
For programming purposes, January through June correspond to the current calendar year (2007) and the later months,
July through December, correspond to the prior fiscal year. In project finance models, for convenience, the fiscal year
should in the month just before commercial operation. For example, if construction ends in May and the project begins
in June, the fiscal year should end in May. Once the month of the fiscal year is established, use the YEAR function
along with the MONTH function and an if statement to determine the fiscal year. For the case where the fiscal year is
ending in May, if the month is less than to June, the fiscal year equals the calendar year. On the other hand, when the
month is greater than June, the fiscal year is the calendar year plus one.
•Step 1: Compute Fiscal year
•If the month of the opening date is less than the fiscal month, (e.g. June) then the fiscal year is the same of the
calendar year (e.g. 2007). (For example, for months of January through May, the year is 2007.)
•If the year of the opening date is greater than or equal to the fiscal month (e.g. July), the year is the calendar year
plus one (e.g. 2007+1). (In the example above, June through December are set to 2008.)
•Step 2: Copy titles to a separate section: Once the fiscal year is established, copy the cash flow titles to a separate
section, or a separate sheet.
•Step 3:
Apply the SUMIF function, where the initial range is the fiscal year definition, the criteria is the year and
the sum range is the cash flow item. To make this work shade the entire row and use fixed references for the fiscal
year, and relative references for the criteria.
Cash Sweep
• Cash sweeps mean that if the project is successful, we get repaid
faster, by taking ("sweeping") a portion of the surplus to reimburse
the loans.
• Banks always use more conservative revenue estimates than
investors to have a higher certainty that such revenue levels will
always be reached - and make it possible for the debt to be paid.
• If thing go well, of even just as expected, there will be more revenue
than the banks plan, and the investors will make a lot more money.
• So in this case, we have a right to a portion of these extra revenues
in the "better-than-the-pessimistic-scenario" cases. That means that
it is actually quite likely that we be repaid faster than we expect.
• We don't earn more, but we take risk over a shorter period, and it
does lower the rate of return of the investors (as their own income is
delayed by these payments).
Debt Schedule
Debt Schedule Discussion
• Basics
– Debt Draws come from sources and uses; debt repayments
come from inputs
– Debt Corkscrew with Opening and Closing Balance
– Use of Minimum Function (rather than if statement) to assure
that repayments do not exceed the opening balance
• Other Issues with Debt
– Grace period
– Level payment
– Customized repayment using solver
• Include Debt Service Reserves in this Section
Setting-up the Debt Schedule
•
•
•
•
The fundamental part of a debt schedule is defining the balance of debt outstanding and
computing the interest rate from the balance of the debt. The debt outstanding should be
computed from explicitly showing the opening balance, the new debt issues, the debt repayments
and the closing balance on distinct rows of the model. These debt balance schedules should be
listed for every single existing and prospective debt facility that will be present during the forecast
period. In the case of project finance models, the debt issues include all of the different tranches
of debt that are issued to finance construction. In addition, project finance models should be set
up to include debt issues that will in a re-financing.
New debt draws are computed from the source and use statement and from some criteria that
defines how re-financing will occur.
The manner of repaying debt depends on the type of debt issue. In general, the repayment
calculation uses the opening balance of the debt. For example, in a subordinated debt issue with
repayment at a single date – bullet repayments – a TRUE/FALSE test can be created from the
repayment year and this is used to assure that repayment only occurs on the repayment date.
(The programming involves (year = repayment year) x opening balance.)
It is generally a good idea to show the total accumulated amount of the debt on a separate line
item above the debt balance. This accumulated balance can then be multiplied by the repayment
percent or a tailored repayment schedule to establish the periodic repayments. In this case, the
MIN function should be used to assure that the amount being repaid does not exceed the opening
balance of the debt.
Example of Debt Module in Actual Models
•
The debt schedule can be much more complicated than an opening
balance, with drawls and closing balance as illustrated below
Note the items for
cash sweep,
interest
capitalization,
scheduled
amortisation,
refinancing
Debt Repayment Structure and Risk
• A project's debt amortization schedule often influences
the rating, more so than the degree of leverage.
• Front-loaded principal amortization schedules that
capitalize on the more predictable project cash flows in
the near term may be less risky that those with whose
delayed amortizations seek to take advantage of longterm inflation effects.
• Flexible re-payment structures can be developed where
the project has irregular cash flows.
Debt Repayment - Sculpting
•
•
•
•
•
When working on a project finance model, you sometimes would like to compute the
debt capacity through “sculpting” the debt repayments such that the debt service
coverage ratio achieves a targeted ratio. This is accomplished using the solver and
the following steps:
Setting the both debt leverage and the repayment for each period.
Add a constraint that the computed debt service ratio equals the target debt
service coverage ratio
Add a constraint that the final debt balance must be zero.
It is helpful to set-up a macro to re-do the solver with a macro. Unfortunately, this is a
bit complex because the visual basic must be adjusted to allow the solver to work.
This process involves:
–
–
–
–
–
–
Step 1: Press the Alt-F11 key to get the visual basic menu
Step 2:Go to the tools and references option and then click on the solver option.
Step 3:After beginning to record a macro, re-set the solver
Step 4: Make sure the first part of the solver is not blank
Step 5: Re-do the solver
Step 6:Add a TRUE statement after solver solve to automate
Modelling Defaults on Debt
•
•
•
•
•
•
•
In order to evaluate the credit spread, it is useful to determine at what point an investment
experiences a loss on a loan. When a loss occurs, the interest rate realized by lenders is
less than promised interest rate and attempts to restructure the debt have not allowed
temporary defaults to be repaid. Modeling defaults on debt is important in credit analysis
because the ultimate task in credit analysis is to measure the probability of default as well
as the loss given default. The following process can be used to compute defaults on debt
and shows how to model defaults:
Step1: Set up the debt balance with line items to incorporate defaults and re-payment of
defaults.
Step 2: Fill in the default row from a sub-total line in the cash flow waterfall that computes
the default on debt from the inability to meet debt service (this should be computed using
the formula MAX(-cash flow,0).
Step 3: Set the re-payment of default to be the previous year’s default amount implying
that all defaults are paid of in the subsequent year. This means the model attempts to
fully repay the default in the year immediately following the default. If there is no cash flow
to repay the default, the default increases by the amount of the default.
Step 4: Enter the repayment of default as a cash outflow item in the cash flow waterfall.
Step 5: Assure that the repayment of default is less than the opening balance of the
debtless the scheduled repayment so that too much debt is not repaid in the final year of
the model.
Step 6: Compute the cash flow realized by lenders through deducting defaults and adding
re-payment of defaults to the scheduled debt service.
Relationship Between Debt Schedule and Cash Flow Schedule in Structured Finance
•
This shows the linking of the debt schedule and the cash flow statement
Debt Schedule
Opening Balance
New Issues
Repayments
Default
Repayment of Default
Repay after default
Cash Flow Statement
Operating Cash Flow
Plus Interest
Cash Before Financing
If negative during construction , feeds into financing needs
If positive, used for repayment of debt
If insufficient cash after construction, default
Default Mechanics
•
Steps in computing default and repayment of default
– Compute default in cash flow statement by structuring a cash flow waterfall
– Assume all defaulted debt is paid in subsequent period, before any other debt
service
– If cash is insufficient to pay debt service and re-payment of default, default will be
larger and will attempt to repay larger default
– Example
• Default Year 1
• Cash Flow
• Year 2
–
–
–
–
100
Year 2
-50
Cash flow
Repayment of Default from year 1
Total Cash Flow
Default in year 2
(50)
(100)
(150)
150
Modelling Defaults on Debt - Procedure
•
The following illustrates the modelling process for defaults.
– Note how the default comes from the cash flow statement
– The if statement in the cash flow statement
– The repayment of default from the prior default
DSCR Covenants and Risk Mitigation
•
•
•
•
Covenants will not come into play if everything is working in a base case
scenario.
Covenants cannot change an un-economic project into an economic project
– they cannot prevent the inevitable
Effective covenants can allocate more of the free cash flow to debt holders
and less to equity holders in a project that is marginally economic.
A project model should be able to:
– Measure which covenant is most effective in reducing risk
– Measure the level of the covenant that will materially reduce risk
– Evaluate whether a covenant does not do much in assisting in risk
reduction for the economics of a project
Investors Need Some Dividends Before All
Debt is Paid Off
• The timing of debt service (i.e. loan interest payments and principal
repayments) is one of the biggest factors that drives the rate of
return for equity holders in a project. If the debt service is structured
to allow no dividends until all debt is paid, return will be lower. This
will generally be unacceptable to sponsors.
– The faster investors in a project are paid dividends, the better
their rate of return.
– Investors therefore do not wish cash flow from operations of the
project to be devoted to lenders at the expense of these
dividends.
– Lenders, on the other hand, generally wish to be repaid as
rapidly as possible. Striking a reasonable balance between
these conflicting demands is an important part of loan
negotiations.
– ER Yescombe, Principles of Project Finance
Cash Sweeps and Cash Traps
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Cash sweep mechanisms. That simply means that if the project is
successful, we get repaid faster, by taking ("sweeping") a portion of the
surplus to reimbursethe loans. Banks always use more conservative
revenue estimates than investors to have a higher certainty that such
revenue levels will always be reached - and make it possible for the debt to
be paid. If thing go well, of even just as expected, there will be more
revenue than the banks plan, and the investors will make a lot more money.
So in this case, we have a right to a portion of these extra revenues in the
"better-than-the-pessimistic-scenario" cases. That means that it is actually
quite likely that we be repaid faster than we expect. We don't earn more, but
we take risk over a shorter period, and it does lower the rate of return of the
investors (as their own income is delayed by these payments).
Example of Financial Covenants
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SECTION 6.15 Financial Covenants.
(a) The Borrower shall not, as of the end of each
fiscal quarter, permit the Ratio of Cash Flow to Fixed
Charges to be less than 1.5:1.0.
•
(b) The Borrower shall not, as of the end of each
fiscal quarter, permit the Ratio of Debt to Capitalization
to be greater than 0.6:1.0.
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(c) The Borrower shall not, at the end of each fiscal
quarter, permit (i) Consolidated Net Worth to be less
than the Minimum Consolidated Net Worth and (ii) NonTrading Consolidated Net Worth to be less than the
Minimum Non-Trading Consolidated Net Worth.
Cash Flow Restrictions (Reference)
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Covenants can restrict the amount of dividends paid to sponsors during good
time and bad time periods. Covenants that restrict cash flow in bad time
periods are known as cash traps. Covenants that limit cash payments when
cash flow is high are known as cash flow sweeps. These covenants are
explained as follows by Standard and Poor’s:
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.
The reason for dividend restrictions in time periods when cash flow is low is
because when financial results are worse than expected, it is essential to
assure that cash flow is kept for the debt holders and not “leaked” out of the
project as dividends. A cash flow trap operates by limiting any dividend
payments if the debt service coverage is below a debt service ratio criteria. If
the dividend restriction is tied to a relatively high level of the debt service
coverage such as 2.5x, the dividend restriction will occur more often than if the
dividend restriction is set to a relatively low level such as 1.2x – the “bad” time
periods occur more often with the higher covenant. Since the covenant limits
dividends, cash flow traps mean that something must be done with the cash
flow that is not distributed to sponsors. Cash either can be used to payoff debt
early or be put into a debt service reserve to protect debt holders.
Cash Flow Sweeps and Cash Flow
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A cash sweep covenant applies in periods when cash flow is high rather
than when cash flow is low. The reason for restrictions on dividends in good
time periods is because when prices higher than normal, cash flow can be
kept for the debt holders to protect against default in later periods when
cash flow and prices may be below normal.
Cash flow sweeps operate by computing the amount of dividends that will
just limit the debt service coverage to the covenant – for example, dividends
cannot be paid above a level that implies a DSCR of 2.0x.
Unlike the cash traps, if the cash sweep covenant is set to a low level it is
more restrictive (the cash flow trap covenant described above was more
restrictive with a higher level). If the cash sweep is tied to a relatively low
level of the debt service coverage such as 1.5x, the dividend restriction will
occur more often than if the dividend restriction is set to a relatively low level
such as 3.5x.
Cash Trap Mechanics
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Set up Cash Reserve Account and Relate to the Cash Flow Statement
Cash Reserve
Opening Balance
Cash Inflows
Cash Outflows
Ending Withdrawls
Cash Flow Statement
Interest Income
Operating Cash Flow
Add: Cash Balance
Add: Interest Income
If positive cash and debt outstanding, trap cash
If negative cash and positive cash balance, use
cash
If paid off debt and positive cash flow, withdraw
all cash
Subtract: Cash Balance
Fixed Assets and Depreciation
Items Included in Fixed Asset and Other
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Plant Balance
Book Depreciation Expense
Accumulated Depreciation
Tax Depreciation Expense
Accumulated Unamortized Debt Financing Fees
Amortization of Debt Financing Fees
Operating Reserves
Computing Vintage Amounts
• Step by Step Process
– Transpose years to create an index with year born on the vertical
column
– Compute the age of the plant –
• year of model minus year born + 1
• Use relative references
• Allow negative numbers before born
– Use HLOOKUP to compute the rate (better than match and
index)
– Use SUMIF with test on “<>#N/A” to add all of the amounts
Step by Step Process for Depreciation
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Computation of depreciation can be complex when the depreciation rate is not
constant for each year. In this situation, the age of the asset must retained to
compute depreciation. This can make be one of the most difficult parts of the
process. To do this, the following process can be used:
Step 1: Enter the depreciation rate by year for category.
Step 2: Use the TRANSOPSE function (not the copy and paste special) to set up a
matrix that has the year the asset was created on the column and the year of the
model on the row
Step 3: Compute the age of the plant and allow the age to be negative in years
before the asset was created (use relative references)
Step 4: Use the HLOOKUP function to relate the depreciation rate to the vintage of
the plant
Step 5: Multiply the depreciation rate by the cost of the asset being depreciated from
the cost of the asset that was created from the TRANSPOSE function.
Step 6: Repeat the process for assets with different vintages and with book and tax
depreciation.
Depreciation Expense and Vintage
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Compute straight line depreciation expense
Multiply the accumulated plant balance from the balance sheet by the
depreciation rate
More complex depreciation modeling – vintage, accelerated, deferred taxes,
multiple categories will be covered later
Operating Reserves
• Deposits into Reserve
– Estimate of future nominal amounts
• Accounting and Cash Flow
– Record actual cost as income
– Do not accrue expenses
– Deposit is cash outflow
– When remove deposit and pay expense, record
income and cash flow account.
• Checks on the balance of funds being positive
Modelling Amortisation of Debt Financing
Fees
• Commitment Fees:
– Computed on the uncommitted balance of the loan during the
construction period (banks must hold reserves even if the loan
has not been drawn – e.g. 1.5%)
• Accumulate fees including fees on committed but unused balance
and up-front fees and fees at closing. This requires inputting the
commitment as well as the outstanding amount of the loan
• Use switch for debt outstanding to compute amortisation of fees
• Compute accumulated amortisation of fees so as to show the unamortised balance on the balance sheet
Income Statement and Income Taxes
Net Operating Loss
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Net operating loss should be part of a reasonable model.
If earnings before tax is less than zero and a simple if statement is used,
future years do not get credit for the earlier negative taxable income.
Therefore, not including NOL will tend to understate value.
To model the Net Operating Loss:
– First compute taxable income without the NOL which allows negative taxes
– Create a cork-screw that keeps track of the beginning balance and the additions
and subtractions to the NOL
– The additions occur when there are negative taxes
– The subtractions occur when there is positive tax and a balance in the beginning
NOL
– The taxes paid are the taxes without NOL plus the inputs to the NOL minus the
withdrawls from the NOL.
NOL Example
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The following example illustrates modelling of an NOL
– To model the NOL use the following:
• An if statement the adds to the NOL when the taxes before NOL are
positive
• An if statement together with a minimum statement to withdraw from
the NOL balance.
Cash Flow Waterfall
Elements of the Cash Flow Waterfall
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Project finance model must measure risks of different tranches of debt
rather than a single senior debt issue. Examples of issues that involve
modeling include:
– What should be the credit spread on senior and junior debt
– How do the covenants and debt service reserves affect the risk of junior
debt
– What should be the repayment structure of junior debt – after the senior
debt is fully repaid or before
– What covenants and debt service reserves should be in place for junior
debt
– What restrictions should be placed on junior debt service to protect
senior debt
Cash Flow Waterfall
• Waterfall Issues
– Defaults and subsequent repayments of defaults before
dividend distributions
– Model different priorities of debt
– Model cash flow trap mechanisms
– Evaluate Pre-payments from covenant violations
– Compute Debt service reserve injections and withdrawls
– Accumulation of debt service reserve after construction period
• It sounds obvious, but the order of the model should be the same as
the order of the waterfall
• Compute subtotals at many different places to evaluate defaults,
balances for sweeps, covenants
Cash Flow Waterfall in Project Finance
Model
Cash Flow Priorities
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Once the cash flow for the waterfall is computed, you can compute the defaults on
senior and junior debt.
Subtract scheduled interest payments and maturities from the cash flow for waterfall
Also subtract attempts to re-pay earlier defaults
The difference is cash flow after senior debt that determines default – defaults are the
driven by an if statement driven by whether there is negative cash flow.
Any defaults are added to cash flow to determine the cash flow to junior debt
–
This step of the waterfall is illustrated below:
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Cash Flow for Waterfall
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Cash Flow after Senior Debt
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Less: Scheduled Repayment
Less: Interest on Senior
Less: Repayment of earlier defaults
Add: Default on Senior Debt
Cash Flow to Junior Debt
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Less: Scheduled Repayment
Less: Interest on Junior
Less: Repayment of earlier default
Cash Flow Traps and Dividends
• After junior debt is evaluated, traps on cash and distributions can be
evaluated.
• Cash Traps can be evaluated at this point that prevent excess cash
going dividends before debt is paid
– This step of the waterfall is illustrated below:
• Cash Flow after Junior Debt
– Add: Default on Junior Debt
– Less: Cash Balance Added Above
• Net Cash Flow
– Switch for Trapping Cash
– Less: Cash Trapped
– Add: Cash Withdrawn from Account
• Dividend Distributions
Computing Cash Flow for the Waterfall
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To model priorities in a cash flow waterfall the first step is setting up a the
cash flow statement in a model that reflects the actual ordering of cash flow:
– Begin with the cash flow after capital expenditures and after all new financing
and acquisitions
– Add back interest expense that was deducted because the interest will be
accounted for on an issue by issue basis
– Add the beginning balance of cash. Even though it seems odd to add the
cash balances, these cash balances are available to pay off debt.
– The sum of these items gives the cash flow for the waterfall as illustrated
below.
• Cash Flow After Capital Expenditures
– Add: New Debt Issues
– Add: New Equity Issues
• Cash Flow before waterfall adjustments
– Add: Total Interest Expense
– Add: Beginning Cash Balance
• Cash Flow for Waterfall
Examples of Cash Flow Cascades
Example of Cash Flow Cascade - 2
Distributions to Equity Holders and Flip
Structures
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Generally, the distributions to equity holders are straightforward to compute
– the distributions are whatever is left over after all other cash distributions.
Flip structures can be more complex:
– After a certain rate of return is achieved, the cash flow is distributed differently
between the two investors:
• Example: Criteria is 10%
• Before 10%, 99% to one investor and 1% to second investor
• After 10%, 30% to one investor and 70% to second investor
– Could compute the IRR on a cumulative basis and then change the payouts
• Problem is in the year of the change in payout
• Better solution is to compute the future value of payouts
• Simple with two payouts, but trick with dividends imbetween
Debt Structure Case Studies
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In analyzing the transaction, Standard & Poor's performed many
sensitivities on plant availability and merchant prices to determine a range
of potential outstanding debt amounts at maturity.
The default scenario assumes that the merchant market deteriorates such
that the plant cannot carry its debt burden. In each of the recovery
scenarios analyzed, payments on the contracts are used to amortize debt
according to the 75% cash sweep requirement during the contract period.
At the termination of the contracts, the net present value of the cash flow
available for debt service under various discount factors was compared with
the outstanding debt amount.
The first-lien loans enjoy 100% recovery even under Standard & Poor's low
price scenario. However, since the lending documents allow payment of any
principal on the second-lien term loan only after completely paying down the
first-lien term loan, remaining cash is only expected to provide recovery on
the second lien term of 50% to 80%.
Equity Returns and Re-Financing
Equity IRR with and without Re-financing
50.0%
45.0%
40.0%
44.6%
Re-Finance
No Re-Finance
37.3%
E
q 35.0%
u
i 30.0%
t
25.0%
y
29.2%
21.7%
18.9%
20.0%
16.0%
I
R 15.0%
R
10.0%
7.8% 7.7%
5.0%
0.0%
Low
Base
High
Traffic Scenario
Very High
Re-financing Analysis
• Re-financing of Debt
– Include a source and use analysis
– Include a criteria or input for new financing
and the DSCR on the new financing
– Include fees and pre-payment penalties in
sources and use analysis
– Include new debt issues in debt schedule and
line for re-payment of existing debt issues