Drivers of growth and development. Financial modeling in investment projects Principles of financial modeling

In fact, there is nothing complicated in financial modeling. At any stage of business development, it will be useful to do such an “exercise”. Let's figure out what a financial model is, why it is needed and what principles should be remembered when compiling it.

What it is?

A financial model is a set (system) of interrelated indicators that characterize your business. The financial model of the project can be called any financial calculations, “estimating the costs”, forecasting revenue or profit, etc. In other words, after you have decided on the format of your business, you will immediately have a desire to take a calculator (and if you are serious, open Excel) and estimate in numbers how your project will develop. Thus, the financial model is a reflection of your business model in quantitative numbers (money, interest, pieces, etc.).

Why is she needed?

Forecasting financial indicators (revenue, profit, cash flow, asset value, etc.);
Project evaluation (for example, according to the DCF model);
Analysis of the company's efficiency and its financial stability (for example, you can calculate the interest coverage ratio and estimate what loan conditions you need in the baseline project development scenario);
The ability to consider distinguishable scenarios for the development of the project (for example, changing the conversion or churn rate i Percentage of customer churn. and see how it affected the annual profit);
And structure your business vision.

Do I need to immediately send out the financial model to all the investors I know?

No need. The financial model, first of all, is useful to you. It is possible that an investor will look at it only if you seem attractive to him - from the point of view of business, the market and your team.

What should a standard financial model look like?

For most Internet projects, at a very early stage of development, it is enough to model operating activities and cash flow (or a profit and loss statement, as it suits you). Modeled most often in Excel, of course. If your business involves tangible cash gaps or investments in tangible assets, then some knowledge is required.

The extended version of the financial model consists of the following blocks: operating model, profit and loss statement, balance sheet, cash flow statement, as well as other separate calculations (fundraising, company valuation, costing of debt obligations and fixed assets, etc. .).

Operating model is a direct reflection (estimating) of your business model. For example, you assume that every month you will attract 100 leads through different channels with a conversion to paying 10%, respectively, paying customers - 10, and with an average check ... And so on, every month - with a certain growth rate. The operating model is a fundamental part in your model; almost all financial indicators will be built from it.

Cash flow statement is the actual cash flow or outflow that occurs when you enter your business. This statement differs from the "profit and loss statement" in that it does not show items that are not reflected in your bank account. For example, depreciation and receivables will not appear on the cash flow statement (at least not in the straight forward presentation).

Report about incomes and material losses- these are the financial results of your activities for a certain period (month, quarter, year). The form includes the numbers you are familiar with: revenue, miscellaneous expenses, gross profit, interest payments on debt, taxes, and net income.

Balance sheet- this is a summary of information about the value of property, liabilities and capital of your company at a specific point in time (end of the month, end of the quarter, end of the year). The balance sheet consists of:

Assets - what you bought;
Liabilities - what you bought.

There are a lot of examples on the Internet of how all three reporting forms should look.

Where to begin?

It is important to structure your view of the business so that it can be clearly displayed in Excel spreadsheets.

Sketch out your business model on a piece of paper - how you are going to make money and what you are going to spend money on;
Structure all your sources of income, channels of attraction, expenses, etc.;
Make a chain between your indicators that lead to revenue, expenses and other financial indicators. For example, you have 3 channels of attraction (SEO, manual, SMM), two types of services - that means two sources of income (for example, website promotion and its development), and, in accordance with the two types of sales, you have different costs. Based on your historical data, you distribute all paying leads by two types of services, multiply by the average check and get revenue.
This brings you to the income statement. Further, everything is very individual.

When will "these tables" be called a financial model?

Here are general rules to keep in mind when doing financial modeling:

The model must be understandable. It should be read and understood by both your internal and external specialists with ease and without unnecessary questions. Therefore, it will not be superfluous to write a brief instruction and a glossary of abbreviations for it.
The model must be structured. Before you start making it, decide on the main blocks that you are going to model.
Before you sit down to write a financial model, ask yourself: “Why am I doing this?”. It is very important to understand your purpose. The final look of your model depends on it. (What are the goals - see the answer to the question "Why do we need a financial model?".)
Write units of measurement for each line.
Highlight the prerequisites: always in color, or better - on a separate sheet. Prerequisites are those indicators from which you will start - and they are the only ones filled with hard (!). For example, conversion to purchase or sales growth rate. This is done so that it is convenient to change one parameter and see how the financial results change.
Do not write large formulas in one cell. It is better to create a separate block with calculations, where all the logic of calculations will be clear. Ideal: one cell - one iteration.
Be able to justify all the premises and find an explanation for the results you get, as the reader will always have questions.
Summarize, analyze the results. Otherwise - why did you build a financial model?

Andrey Polishchuk

Financial modeling is the most important tool that allows you to build a forecast of the company's financial condition under the influence of various factors, both internal and external. A well-prepared financial model allows you to analyze various development scenarios, taking into account all strategic and tactical decisions made by the company's management.

The financial model should be prepared taking into account all the features of the company's business, and it will be unique for each enterprise.

Targets and goals

Financial modeling allows you to solve a fairly wide range of problems. Here is some of them:

Conducting an assessment of the future financial condition of the company, based on the planned cash flows;
Identification of key items of income and expenses, assessment of their acceptability in the current situation;
Evaluation of the optimal sales volume;
Determination of sources and required amounts of financing;
Analysis of the situation and identification of opportunities for more efficient use of resources at the disposal of the company;
Conducting an assessment of possible risks in order to develop and build a risk management system and minimize losses;
Determination of directions for prompt response to changes in both external and internal factors;
Analysis of the effectiveness of the introduction of new areas of activity and the implementation of significant investment programs of the company.

Despite all the differences and multitasking, financial models for any enterprise will have the same principle of formation and, as a rule, the same set of basic forms and indicators.

Composition of the financial model

The financial model must include:

key indicators, input data and results, which in turn should be dynamically interconnected;
as the results of calculations - the main forms of financial reporting (Profit and Loss Statement, Cash Flow Statement, Management Balance of the company);
A set of financial indicators calculated on the basis of the model depending on the specific tasks set (for example, EBITDA, NPV, PBP, IRR, etc.)

Financial model preparation

When creating a financial model, you must perform the following steps:

Collection, generalization and analysis of initial data for the financial model (production and financial indicators of the enterprise, investment programs);
Identification of the main "drivers" (key factors) of the model;
Determination of external factors that affect the operation of the enterprise and can significantly affect the results of the model (market research of the market situation, forecasts of exchange rates and inflation indicators for significant items of expenditure, etc.);
Definition of parameters and creation of alternative development scenarios;

Principles of formation of the financial model:

When creating a financial model, it is necessary to adhere to the following principles:

The financial model must be transparent. The transparency of the model is necessary so that almost any of its consumers (users) can quickly and easily understand the principle of its construction and operation. A financial model that is obviously difficult to calculate and verify (contains a rather complex code, the accepted initial data and assumptions are not justified, primary calculations are closed for reading, etc.);
The financial model must be flexible. The flexibility of the model is characterized by the ability to easily and quickly change key parameters and obtain new calculation results for these changes (changes in interest rates on loans and taxes, sales and production volumes, etc.)
The financial model should be visual. Clarity or, in other words, simplicity of design and the ability to quickly find out “where to see the result”, “where to make changes to the data”, etc. To implement this principle, a clear, but at the same time simple and concise model structure should be built. Initial data, constants and assumptions should be entered in one place, the main results of calculations should be logically collected on the appropriate forms, intermediate calculations should be logically grouped.

By adhering to these principles, you can successfully create financial models for solving both simple and complex problems, while they will be understandable to both beginners and more sophisticated consumers.

Following the success of the previous course in June, the CFA is hosting on June 30 and July 1 the last 2-day intensive course for investment bankers and financial analysts this summer:

Business Valuation Methods
using financial models

Previous course report

You will learn:
AS BASED ON HISTORICAL DATA AND OTHER FACTORS
VALUE YOUR BUSINESS USING VARIOUS VALUATION METHODS

Registration link -- cfavaluation.qrickets.ru
To pay by bank transfer, please contact Kirill Murakhtanov at or by phone +7-495-761-31-07

THE FIRST DAY

Building a financial model based on historical data.
General principles of modeling and financial model blocks
Separate analysis of balance sheet items and PL for the purpose of forecasting. Blocks: Revenue, OPex, Depreciation, Income taxes (deferred taxes), capital investments, working capital, VAT, interest.
Direct and indirect cash flow statement. Main drivers of growth.

SECOND DAY

Company value. Basic assessment methods (based on the built model)
Determining the cost. Factors affecting the cost.
Assessment methods. Flow, terminal value.
Assessment Methods:

DDM (theoretical justification + calculation)
Residual Value + EVA
Relative valuation (financial and operational)

The course will cover the following topics:

MODELING

Purpose and objectives of the financial model. Types of accounting information and types of models
The structure and logic of building a simple financial model in MS Excel.
Basic rules for modeling in MS Excel
Methodology for analysis and forecasting of the financial model
Analysis of historical information and identification of the main drivers of the model
Forecasting PL: Forecasting revenue, cost, SGA. Analysis of conditionally variable and conditionally fixed costs
Forecasting working capital (consideration of the company's cash cycle) through the days of turnover
Forecasting turnover by fixed assets, Capital investments and depreciation
Forecasting income tax, property tax and VAT turnover
Building a Cash Flow Statement by the Indirect Method
Relationship between PL, BS and CF. Model balancing
Main analytical coefficients (Credit, Liquidity, Profitability, Efficiency of Use of Assets, Return on Invested Capital, Growth). Meaning of each coefficient
Case number 1. Foundry. Analysis of historical management financial statements, drivers and operating ratios. Model building by users. Scenarios. Sensitivity tables

GRADE

Main valuation methods (DCF, Comparative, Recovery (cost)
The concept of Enterprise value, components of this concept (Common Equity, Minority Interest, Preferred Equity, Net Debt). Additional adjustments to Enterprise value
Theoretical substantiations of the DDP method
Various methods for assessing DCF (FCFF, FCFE, EVA, Abnormal Earnings)
Analysis of the FCFF method. Deriving FCFF and Enterprise value from predictive financial data in various ways.
Discount rate WACC. Application of CAPM theory to obtain the cost of equity. Algorithm for obtaining the share capital rate for Russian public and private companies.
Analysis of the FCFE method. Obtaining FCFE and Common Equity based on predictive financial data in various ways.
Analysis of the EVA method. Theoretical substantiation of the method. Get Noplat, Invested Capital and EVA value based on predicted financial data.
Analysis of the Abnormal Earnings (Residual Value) method. Theoretical substantiation of the method. Calculation of the Common Equity value based on forecast financial data Application for valuation of financial assets
Comparative evaluation. The main pros and cons of the method. How to choose comparable companies.
Key financial and operating multiples. An example of calculating multipliers for Russian companies. Multiple migration, dependence on growth and profitability.
Case 1. Foundry. Estimation of the value of the company and the cost of equity capital by the studied DCF methods and using multipliers.
Case 2. Modeling based on IFRS reporting of a public Russian company.
Difficulties associated with accounting and forecasting reserves (provisions) and deferred taxes. Evaluation by various methods, comparison and analysis of the discrepancy with the company's public quotes.

TEACHERS

Main teacher: Denis Sitnikov, CFA

Over ten years of investment and corporate finance practice with top multinationals

Executive MBA in Finance and Investments, Duke University (2011)

Don't worry about people stealing your ideas. If your ideas are any good, you'll have to push them down people's throats. Howard Aiken.

1. What is a "financial model"?

financial model- a computer model of the cash flows of a company or an individual project that simulates past, current, future or proposed operating activities in financial estimates. In fact, this is a structured set of calculations that generates options for assessing the financial result by changing the initial parameters.

The model is based on numerical data, which with the required degree of detail characterize the operating, financial and investment activities. For most models, time, quantity and cost data are used.

In other words, the entire activity of the company or the composition of the project is reduced to the form single cash flow, the composition of which increases or decreases, depending on various internal and external factors.

Typically, the model is built according to a three-stage principle:

Characteristics of a good financial model:

Well structured - easy to understand
Transparent calculations - easy to check
Easy to maintain - easy to change
Suitable for the task
Worth the effort
Corresponds to economic logic
The most automated - does not require additional edits
Multi-line formulas are not applied - do intermediate calculations

2. Why is a financial model created?

The financial model is a "mock-up" of a real business. Since one of the key aspects that investors are interested in is return on investment, first of all, they consider the most important indicators of the project to be:

Reliability of the project (risks of non-return of invested money should be minimal)
Deadlines (money must be returned as soon as possible)
Return (the profit of the project should be greater than if the investor put this money in a reliable Swiss bank at 3-5% per annum).

To evaluate these and other parameters, in terms of visibility, flexibility and ease of analysis of various project options, the best solution is a financial model.

3. How is the financial model used?

The financial model, being the "working layout of the business", allows the user to lose several "lives" projects in different economic conditions. This allows you to evaluate various scenarios for the development of events, taking into account a variety of opportunities, risks and the impact of real and potential threats. And, do it without losing real money.

Successfully built, tested and recognized by the investor as acceptable, the financial model can act as basics for writing a business plan and be attached as a justification to the investment application for receiving money from the bank or to the feasibility study of the project.

After receiving the investment, it is correct to create a new empty financial model, in which you should enter data corresponding to real state of affairs.

4. The most frequent tasks when a model is needed.

In most cases, the model is created for investment analysis (assessment of the investment attractiveness of the project) and for a comprehensive and balanced consideration of all possible risks of the future project (factors that can interfere, complicate, increase the cost, slow down or even stop its progress).

Here are options for other tasks when modeling is used:

ROI assessment
Expansion / Launch of new production
Entering a new market / segment / new region
Development of the sales / branch network
Business restructuring
Mergers and acquisitions (M&A)
Sale of business / assets / direction
Justification of the expediency of the project for investors
Advanced risk analysis for the current project, etc.

5. How the financial model works.

The most commonly used and considered most effective today is simulation method, which reproduces all processes and cash settlements with the required accuracy, taking into account available resources and settlements with internal and external counterparties.

The basic idea of IM is scenario approach, which describes and allows you to compare two, three or more identical projects from different angles, each of which is affected by different factors.

By identifying factors that are unstable in most scenarios, one can judge flexibility and vulnerabilities project.

The greatest performance in financial modeling can be achieved using special software(such as Business Plan Expert, Project Expert, Alt Invest, Prime Expert, etc.).

6. Discounting.

Given the fact that money has a well-defined value, which varies depending on the passage of time and the environment in which it rotates, cash flows that appear in different time periods, cannot be directly compared.

To compare multi-temporal cash flows with each other and bring the cost of money to a single value (identifying the cost of capital at a certain point in time), modern models use the method discounting.

Discount method based on economic indicators, the key of which is discount rate(discount rate). The discount rate is set individually for each project and reflects the profitability of various investment options and the rate of change in the value of money over time.

7. The sequence of steps to receive investment.

The emergence of a business idea, a preliminary vision of the future project, time and money framework, key factors that determine its financial attractiveness.
Analysis of available data, collection and structuring of missing information, marketing research, description of the production scheme, sales, identification of available resources, contractors, etc.
Building a financial model, checking the flexibility of the project in the event of various adverse conditions. Adjustment of the project to make it more sustainable and reduce the risk of non-return of investments.
Creation of a business plan, including marketing (descriptive) and economic (estimated) parts.
Protection of the project before the investor, receipt of funds, launch.

8. The uniqueness of each financial model.

Each financial model has its own characteristics and specifics, which arises as a result of features of doing business in different industries(for example, in the hospitality industry, a metric such as “Revenue per room” is used), geographic regions(for example, in Komi - 90% of the cost of products is delivery), in companies of various sizes (for example, Coca-Cola spends up to 45% of profits on advertising) and due to the influence various specific factors.

Such factors may include, for example, political(for example, projects related to the Sochi-2014 Olympics have a higher priority than other projects, with a noticeably lower or even negative profitability), economic(taxes on alcohol are noticeably higher than on bakery products), social, technological and other types of factors.

9. Indicators of the financial model.

The financial model contains many input factors, on the basis of which the analysis and modeling of future cash flows is carried out:

Initial data(goods, contractors, processes, dates, production and distribution methods, supply volumes, taxes, etc.)
Drivers, key calculated indicators of the project(market share, profit share, ratios, occupancy rates, "average bills", etc.)
Financial(capitalization, liquidity, profitability, turnover, capital structure, etc.)
Investment(efficiency, sustainability, earnings per share, dividend coverage ratio, etc.)
Industry or specific(revenue per turnover in sq.m., average cost of a receipt, cost of increment of a unit of stocks of raw materials, kilowatt-hours per unit of production, cost of attracting one client, cost of a cubic meter of construction, costs of transporting one ton of cargo, average revenue per hotel room and etc.)

10. Indicators of the financial model.

12. Products for financial modeling.

Products for financial modeling are divided into:

open(Alt Invest) - all formulas are "open" and editable. Pros: based on Excel, no modeling knowledge required, simple. Minuses: high risk of errors, search for problem areas takes a lot of time, with a large amount of data they start to work slowly, few functions, simple, it is impossible to build volumetric models.
Open with protection(Prime Expert) - all formulas are open, but protected from corrections. Pros: it is impossible to “spoil” the model, it is possible to build a three-dimensional model, a large number of functions, the ability to use connected spreadsheets. Minuses: more expensive, harder to learn.
Closed(Business Plan Expert, Project Expert, Comfar, Inec) - the formulas are "hardwired" into the program, it is impossible to change them to your own. This is a plus and a minus.

13. Typical mistakes in building models.

Non-compliance with the designated structure of the model - sheets with input data contain calculations, sheets with calculations contain constants
Non-observance of the principle of uniformity of formulas on one line - formulas cannot be stretched
Calculations contain references to empty cells
Model contains hidden rows and columns
Calculations contain links to other files
Model contains system error messages
Iteration mode enabled, calculations contain array formulas

An example of requirements for the financial model on the example of the requirements of VneshEkonomBank (excerpts)

1. General requirements.

No part of the financial model should be hidden, protected, blocked or otherwise unavailable for viewing and modification.

The financial model should have a clear and logical structure. Initial data (assumptions), financial forecasts and interim calculations, results of financial forecasts should be presented in sequence; these elements should be visually separated from each other, but interconnected by calculation formulas.

The financial model should allow for changes to the original assumptions and automatically adjust the financial projections if such changes are made. The model should be designed to allow sensitivity analysis of financial forecast results to changes in all model assumptions.

If the financial figures obtained in the financial model are based on one or more base models, dynamic links between these base models must be provided.

The financial model should have a sufficient degree of detail, that is, contain breakdowns by main types of products, regions, production units, periods, income and cost items, etc. At the same time, the financial model should provide information in an integrated form, namely, it should include a forecast income statement, a forecast balance sheet, a forecast cash flow statement that are interconnected with each other.

Pro forma financial statements and interim reports should not contradict each other.

The model must explicitly specify:

Project lifespan
The duration of the forecast period (should not be less than the discounted payback period of the project and the loan repayment period)
The duration of the post-forecast period and the initial moment of the forecast period
Forecast step (for the investment stage - one quarter, in case of monthly seasonality - one month; for the operational stage - one year)
Type of cash flows (nominal, real)
Final currency of cash flows
Type of discount rate and method of its calculation
Methodology for calculating the final cost (indicating the expected growth rate in the post-forecast period)
Macroeconomic data (forecasts of inflation, exchange rates, real wage growth, etc.)
Forecast of capital investments, sales volume and production volume (as well as other quantitative factors), etc.

Mandatory indicators:

Forecast of prices/tariffs for finished products/services
Resource consumption rates per unit of output
Forecast of prices for the main raw materials and materials and other costs that make up an important share in the cost
Personnel Cost Forecast
Forecast of semi-fixed costs
Terms of settlements with counterparties (delays and prepayments for settlements with suppliers and buyers, budget, personnel)
Turnover ratios
Information on taxes and other obligatory payments (duties, compulsory insurance premiums)
Accounting policy assumptions (policy for depreciation, cost capitalization, provisioning, revenue recognition)
Forecast structure of financing, conditions for debt financing (interest rates, schedule for obtaining and servicing debt)
Stock Market Data for Discount Rate Calculation
Other inputs and prerequisites that are important for a given industry and project type, etc.

Forecast income statement must be compiled on an accrual basis and contain, among other things, the following financial indicators: revenue, gross profit, gross margin, EBITDA (operating profit before depreciation, interest and taxes), EBIT (operating profit before interest and taxes), net profit, net profitability. If, due to industry or other specifics of the project, these indicators are not presented, the fact and reasons for their absence in the description of the financial model should be indicated.

Forecast cash flow statement should include cash flows from operating, investing and financing activities. In the case of proposed debt financing, free cash flows before debt servicing (CFADS) should be given as a reference.

Financial and investment indicators which must be mandatory:

Investment attractiveness(NPV, DPBP, IRRequity)
financial stability(Interest coverage ratio, EBIT/interest, Debt Service Coverage Ratio, DSCR, Loan Life Coverage Ratio, LLCR)
Debt load(Debt/Equity, Debt/EBITDA, Debt/CFADS, PLCR (Project Life Coverage Ratio), RLCR (Reserve Life Coverage Ratio)
liquidity(indicator of current liquidity - current ratio and quick liquidity - quick ratio)
Profitability(return on equity (ROE), return on assets (ROA), return on sales (ROS), return on investment (capital) (ROCE)
turnover(receivables, payables, inventories).

For sustainability assessments financial indicators apply sensitivity analysis method– assessing the degree of impact of changes in key sensitivity factors on the results of financial forecasts. If sensitivity analysis does not allow measuring/illustrating individual risks, other methods are used, including, breakeven point calculation, Monte Carlo method, scenario analysis, factor analysis etc.

To key sensitivity factors include the assumptions (initial data) of the financial model, the actual values of which during the implementation of the project (due to the impossibility of their accurate assessment or their inherent volatility) may deviate significantly from the values included in the financial model. In particular, typical sensitivity factors include:

Prices for finished products and tariffs for services;
Sales volume (intensity of operation, number of buyers/users);
The amount of capital costs;
Delays in putting an investment facility into operation and reaching its design capacity;
Prices for basic raw materials and materials, fuel, labor resources;
The amount of fixed operating costs;
discount rate;
Forecast inflation rates;
Exchange rates, etc.

It is mandatory to conduct a sensitivity analysis to changes in the discount rate, product selling price, key resource price and sales volume.

This chapter discusses the main components of information support and assumptions used in forecasting, which together provide the input data for the financial model of the project (see § 11.1; 11.3-11.6), its basic structure and the results derived from it (see § 11.2), as well as the impact of accounting and tax issues on the project and financial model (see § 11.7).

This chapter also discusses the use of the financial model by investors in the process of assessing the rate of return on their investments (see § 11.8), by lenders in the process of calculating coverage levels for their loans (see § 11.9), and for the baseline scenario (see § 11.10), and when performing a sensitivity analysis.

It also discusses the ways in which investors determine their return requirements and how they may change over time or as a result of a subsequent sale of an investment or loan restructuring (see § 11.12).

An adequate financial model is a very important tool in the process of project financial evaluation. It serves several purposes.

Before all financial documentation is properly executed:

initial evaluation and subsequent re-evaluation of the financial aspects of the project and sponsors' income during the construction phase;
formulating financial clauses of project contracts (including use as a bidding model, when calculating the tariff, if sponsors hold an auction for the right to participate in the project, and to control the settlement of liquidated losses, etc.);
structuring finances and considering the benefits received by sponsors under different financial conditions;
verification of the conscientiousness of participants in contractual relations, which is carried out by lenders as part of the due diligence procedure;
in identifying critical issues in the funding negotiation process;
creating a base scenario (see § 11.10).

After the financial documentation is completed:

as a budgeting tool;
as initial assumptions for lenders in the process of considering changes in the long-term prospects of the project and forming their position.

The financial model covers all activities of the project company, not just project-related issues, and therefore takes into account, for example, taxes and accounting issues that may affect the company's bottom line cash flow. Although sponsors and lenders can develop separate financial models in parallel, as shown in § 4.1.6, it is often more efficient to create a single model together. This may mean that the sponsors start to develop the model and then the lenders join this work, depending on the point in time when they join the project. Sponsors can then use it to calculate their revenues, taking into account the ownership structure of the project company; the results of such calculations are not related to the activities of lenders.

§ 11.1. Initial data for the model

The assumptions for the financial model of the project company can be classified into five areas:

1) macroeconomic (see § 11.3);

2) project costs and funding structure (see § 11.4);

3) operating income and expenses (see § 11.5);

4) use of the loan and debt service (see § 11.6);

5) taxation and accounting (see § 11.7).

These inputs should be used in drafting project contract clauses, taking into account expected and stated completion dates, payment or revenue schedules, fines and bonuses.

The grounds for the initial data must be recorded; usually, a “set of assumptions” is used for this, in which each direction of the financial model is considered and the source of the initial data or calculations for it is indicated with the attached documents, which are the basis for such conclusions.

These assumptions are used to calculate project cash flow projections (see § 11.2; 11.10), which in turn form the basis for calculating investor returns (see § 11.8) and debt coverage ratios for lenders (see § 11.9) . This model must necessarily calculate an acceptable number of sensitivity scenarios (see § 11.11).

Inputs are usually entered into separate statements (ie a statement for individual assumptions such as project costs, a statement for long-term macroeconomic and operational assumptions that cover the entire life of the project). The initial data should not be chaotic so that it is always possible to understand on the basis of which the corresponding conclusions are drawn.

The financial model should cover the period as a whole, from the time of the first construction expenditure to the end of the operation of the project, although, from the point of view of lenders, it should cover the period from the date of signing of all financial documents, taking into account past expenditures. The life of the project is determined either by the duration of the project agreement or by the expected economic life of the project if no agreement has been entered into. By the end of the life of the project, the residual value of the entire equity capital of the sponsors is usually assumed to be zero.

As a rule, the model is prepared for 6 months. During the construction period, when there is not enough detailed information (for example, calculation of interest payments, exact payment schedule for the contractor, etc.), individual forecasts can be made for a month and combined into the main model.

§ 11.2. Model Inferences

Model inferences are a series of calculations:

costs during the construction phase;
use of own capital;
use and repayment of the loan;
interest payments;
operating expenses and income;
taxes;
profit and loss account (profit and loss statement);
balance sheet;
cash flow (sources and use of funds);
lender coverage rates (see § 11.9) and investor returns (see § 11.8).

The summary sheet usually presents key results on one page:

a summary of project costs and sources of funding;
total cash flow;
lender coverage ratios;
investor returns.

§ 11.3. Macroeconomic Assumptions

Initial macroeconomic assumptions are assumptions that do not directly affect the project, but do affect its financial results. These should include:

inflation (see § 11.3.1);
product prices (see § 11.3.2);
interest rates (see § 11.3.3);
exchange factors (see § 11.3.4);
economic growth (see § 11.3.5).

Ideally, macroeconomic assumptions for model forecasting should be taken from objective sources not associated with sponsors. For example, the vast majority of large banks conduct general economic research and obtain relevant forecasts that can be used in the process of financial modeling of the project.

§ 11.3.1. Inflation

In the process of financial modeling, inflation must be taken into account, since it can lead to erroneous conclusions in the forecasting process (see § 8.1).

It may be necessary to use different indices as the basis for predicting the inflation rate when calculating different types of expenditures and incomes, for example:

the consumer price index in the country where the project is located, when calculating the total operating costs;
labor cost indices in the country of the service provider for the project when calculating the same costs;
industrial price inflation when calculating the cost of spare parts;
special price indices for goods produced or purchased by the project company (supply and demand for goods in its own market may affect the price to a greater extent than general inflation).

Care should be taken to avoid using a higher inflation rate in the calculation of income than in the calculation of expenditures.

If the project company has signed a project agreement in which revenues are indexed to inflation (see § 5.1.6), then the financial model should also reflect this fact.

§ 11.3.2. Product prices

As a rule, it is impossible to treat prices in the same way as inflation (that is, to assume that they will continue to rise). The dependence of the project on the cyclical nature of commodity prices, which is characteristic of most goods, must be considered in the process of financial modeling.

A key problem with project finance is that very often a project is developed at a time when prices are high and therefore it is assumed that they will continue, while underestimating the impact of the project itself and other similar projects on the product market. (Or vice versa: a project is developed when fuel or raw material prices are low, and it is assumed that such price levels will continue.)

Changes in commodity prices can be very dramatic in the short term, while project finance is inevitably long term; therefore, it is necessary to demonstrate that the project is robust enough to survive a significant price change (see § 7.8.6).

§ 11.3.3. Interest rates

If the interest rate of a loan is fixed for the entire period (see § 8.1), then assumptions for it should be used when calculating forecast values. However, even in such cases, a different “floating” (short-term) interest rate must be taken into account when forecasting the return on excess capital that the project company uses as collateral for lenders or before payments to investors (see § 12.5.2).

There are two approaches to forecasting short-term interest rates: assumptions can be made directly on the rate itself, or "real" interest rates (after adjusting for inflation) can be used, and the actual interest rate is determined based on the consumer price index rate. In the latter case, as shown in Table. 11.1, if a real interest rate is used, say 4%, then the projected nominal interest rate is the real interest rate adjusted for the inflation rate based on the "Fischer formula".

§ 11.3.4. Exchange rate and currency used in the model

If the project company raises financing for loans and equity investments in local currency, receives proceeds and incurs all costs during the construction and operation of the project in the same currency, then the exchange rate is not necessary.

Otherwise, the financial model must also be prepared for calculations in local currency and be able to make assumptions in the long term regarding changes in the exchange rate of the national currency and other types of currencies used to finance the project. Foreign investors and lenders may find it more beneficial to create a model for their national currency, but it is possible that this may give inaccurate or erroneous results (for example, as a result of the effect of the exchange rate on the amount of taxes paid - see § 11.7.7, or because that some costs must be in the national currency of the country in which the project is located). It is easy for the model to issue a report that translates the local currency forecast results into the corresponding foreign currency; in this way, the accuracy of the calculation is preserved and the way the results are presented becomes more readable.

As with interest rate forecasting, there are two approaches to the currency forecasting process: one can make an ad hoc assumption about future rates, or one can use purchasing power parity rates. In the latter case, the calculation takes into account the difference in the predicted inflation rate for the two currencies and adjusts the exchange rate based on the assumption that it will change in accordance with the inflationary difference (Table 11.2). In year 1, with a 6% difference in inflation rates in favor of currency B, currency A will depreciate by 6% against it, and so on.

Table 11.2. Purchasing power parity

	Now	Year 1	Year 2	Year 3
Projected inflation rates,%
Currency A		9	10	9
Currency B		3	4	3
Forecast rates: currency A/currency B	10,00	10,60	11,24	11,80

§ 11.3.5. GDP and volume growth

Infrastructure projects may be affected by the overall growth rate of the economy, which will translate into increased use of the product or service (see § 7.8.7). For example, there has been a strong correlation between the long-term growth rate of air travel and GDP growth, with traffic growth at twice the rate of GDP growth. Thus, GDP growth rate assumptions are key for airport projects. A similar approach is applicable for traffic related projects.

§ 11.4. Project costs and funding

The next step in the detailed modeling process is for the project company to prepare a budget for the costs of the construction phase and identify sources of funding.

§ 11.4.1. Project costs

The project cost budget takes into account the costs from the start of construction until the time it is ready for operation. A typical budget for a manufacturing plant or infrastructure project (see § 7.5.4) is likely to contain the following items:

development costs. These are the costs incurred by the sponsors (and paid to the project company) or by the project company itself during the financial documentation process. Sponsors need to agree on how to allocate their own costs (including staff overheads and travel expenses), which are likely to be significant over a long development period. It is also necessary to take into account the costs associated with the payment of consultants who represent the interests of the sponsors and the project company;
royalties during development. The project structure may allow one or more sponsors to receive an initial fee from the project company for the development of the project; thus they have the opportunity to profit before the agreements go into effect (see § 11.12.2). These figures are subject to change as the financial estimate of the project changes;
project company costs. This item includes expenses incurred after the financial documentation is signed and related to:
price of a "through" contract(see § 6.1.4);
construction insurance(see § 6.6.1);
start-up costs. These are the costs associated with paying for fuel or raw materials that are necessary for the contractor to test and start the project, before the interested parties acknowledge the fact that the work has been completed; in some projects it is also possible to receive revenue from the sale of products produced during this period of time;
initial accumulation of spare parts. These are the costs associated with the organization of the initial accumulation of spare parts (if they are not included in the "through" contract);
working capital. This is the capital needed for the project, the amount of money to cover the difference in time between the project company invoicing for the reimbursement of operating costs and the receipt of cash income. In fact, this is a short-term (usually 30-60 days) cash flow cycle of the project, which cannot be calculated directly based on the financial model planned for a 6-month period during the operation stage. Initially, working capital can be calculated as the costs that the project company must incur until it receives the first payments from the proceeds. They may include:
taxes. The article includes tax payments for various project expenses such as VAT or sales taxes;
financing costs which include:
financing of reserve accounts.§ 12.5.2 discusses which reserve accounts should be funded as part of the project costs;
unseen circumstances. The costs associated with unforeseen circumstances (see § 7.5.4) must be taken into account in the costs of the project.

§ 11.4.2. Project funding sources

A financing plan based on an expenditure plan includes all sources of full financing, broken down into debt and equity (see Chapter 12; this also includes a calculation of the amount of borrowing that can be raised).

If a separate source of funding is for specific purposes only (for example, a loan secured by an export credit agency can only be used to cover the cost of an export contract from the country in which the agency is located), then this should be taken into account when making calculations. Thus, if the project costs are 100 c.u. e. include equipment costs of 70 c.u. e. in accordance with the export contract, then a financial plan that uses financing provided by the export credit agency in the amount of 80 c.u. e., and additional funding of 20 c.u. e. will be ineffective.

The project company should not use a short-term loan as working capital: these are amounts that are needed on an ongoing basis and should be recovered on the basis of long-term project financing. However, it may be useful to obtain part of the project financing in the form of a revolving loan (i.e. the project company has the ability to repay part of the loan when it has excess cash and re-borrow if it is short of cash). This can help to reduce the size of sponsors' equity, and therefore it will also be beneficial.

Separate short-term loans may be required to pay VAT and other taxes during the construction period. They are repaid in the payment of taxes or on account of the proceeds after the operation begins.

§ 11.5. Operating income and expenses

Let's take a manufacturing company as an example. The main elements of operating cash flow may include operating income from the sale of products minus fuel and raw materials costs, the project company’s own operating costs (personnel, office, etc.) (see § 7.7.3), maintenance costs, expenses under an operation and maintenance contract, insurance (see § 6.6.2).

The first step in forecasting operating income and fuel and raw material costs using the model is to identify key operating assumptions—for example, for a manufacturing plant:

what is the initial volume of output;
how it will change over time;
how long the maintenance will take;
what period of time should also be scheduled for unscheduled stops;
what is the rate of consumption of fuel or raw materials;
how consumption will change over time.

Revenues from sales and expenses for fuel or raw materials result from:

those operating assumptions;
terms of project agreements, such as a contract for the supply of raw materials or a contract for the purchase of products;
market price assumptions in the absence of such contracts.

In addition, it is necessary to take into account forecasts regarding changes in all these indicators.

§ 11.6. Loan and Debt Service Scheme

At the construction stage, the model takes into account:

the required ratio between equity and debt (see § 12.1);
any restrictions on the use of the loan (for example, loans issued by an export credit agency are used only for exported equipment, or expenses in a certain currency are financed by loans in the same currency).

After that, the schedule for the use of equity and loan is calculated. The use of a loan allows you to increase the interest payments (during the construction period), which must also be financed. During the operation period, the model takes into account:

prioritization of the distribution of net operating cash flow (see § 12.5.1);
allocation of funds to the relevant payment items to repay the debt (see § 12.2.4);
calculation of interest payments, which allows contracts to be hedged (see § 8.2).

§ 11.7. Problems of accounting and taxation

Although the decision to invest in a project should primarily be based on an estimate of the cash flow (see § 11.8), accounting figures are important for sponsors who do not seek to publicize the accounting losses from investing in the project company they have created. In fact, they may decide to abandon what at first glance seems to be ideal financing and use another (for example, through leasing - see § 2.4) if this provides a higher accounting profit.

Thus, although financial modeling for project finance is considered in terms of cash flow rather than accounting figures, it is usually necessary to attach an accounting statement to the model (i.e. an income statement and balance sheets for each period).

In addition, it is necessary to control the results of accounting for the profits of sponsors. There are many reasons why accounting metrics are important to the financial model of a project company:

tax payments are calculated on the basis of accounting indicators, and not on the amount of cash flow (see § 11.7.1);
accounting ratios determine a company's ability to pay dividends (see § 11.7.2) and may affect its ability to continue trading shares (see § 11.7.3);
having a balance sheet is a good way to control errors in the model: if it doesn’t converge, then an error has crept in somewhere.

§ 11.7.1. Capitalization and amortization of project costs

The most important differences between accounting and project cash flow calculation are determined by the capitalization and subsequent amortization of project costs.

If the project company were to write off the costs of the project at the time of implementation, the result would be huge losses during the construction phase, accompanied by huge profits during the operation phase. Obviously, this does not reflect the real situation.

In most countries, project costs are capitalized (that is, added to balance sheet assets) rather than immediately written off. Costs in this case include not only construction-related costs (i.e. fixed assets), but also variable costs incurred prior to operation (financing and development costs (including interest payments during the construction phase), consultant fees). etc.).

Subsequently, capitalized costs are amortized (written off) and deducted from income. Standard straight line accounting depreciation for a project may allow the project company to write off the project asset over a period of, say, 20 years. Thus, the depreciation of the design cost of 1000 c.u. e. should be 5% of its original value (50 c.u.) annually. If this depreciation is covered by tax income at a rate of 50%, the depreciation compensation will reduce the amount of tax by CU25. e. for 20 years.

The project company can benefit from large initial tax deductions because investments in fixed assets are subject to accelerated tax depreciation. For example, if the tax depreciation rate for project costs is 25% of the current book value (an example of "accelerated depreciation" which is a typical investment incentive), then this means that depreciation on a $1,000 investment e. is:

year 1: 25% of expenses, i.e. 250 c.u. e.;
year 2: 25% of expenses, i.e. 188 c.u. e. (minus depreciation in year 1), or a total of 438 c.u. e.;
year 3: 25% of expenses, i.e. 144 c.u. e. (minus depreciation between years 1 and 2), a total of 578 c.u. e.;
year 4: 25% of expenses, i.e. 105 c.u. e. (minus depreciation between years 1 and 3), in total 684 c.u. e.;
year 5: 25% of expenses, i.e. 79 c.u. e. (minus depreciation between years 1 and 4), in total 763 c.u. e., etc.

Thus, in the first 5 years, more than 75% of the project costs can be taxed, compared to 25% for the 20-year linear depreciation we considered earlier. In the last years of the project's existence, tax payments in the case where accelerated depreciation has been applied increase, since the costs of the project have already been deducted from taxes; therefore, by the end of the 20-year period, the total tax deduction due to the depreciation compensation (at a tax rate of 50%) will be the same (ie CU500).

Another typical case of tax depreciation is "double depreciation" - if the normal depreciation rate of an asset is 10% annually, then double depreciation allows depreciation at a rate of 20% annually for the first 3 years and then at a rate of 10% annually. Thus, by the end of the year 5 80% of the cost of expenses should be written off for taxes.

In some countries (for example, the US and the UK), depreciation is handled differently for tax and accounting purposes: for accounting, a project asset is depreciated over its lifetime, thus relating the costs associated with that asset to the profit it generates. provided, and increases accounting profit in the first years of the project; while tax accounting uses accelerated depreciation.

The difference between these two amounts is credited (or deducted) to the tax reserve in the balance sheet liabilities. In other countries (for example, in Germany and France), accounting and tax depreciation must necessarily be the same.

Different depreciation rates may apply to different parts of a project (for example, buildings and equipment). In such cases, the contractor will be required to allocate lump-sum payments under the "through" contract to these components for the purpose of tax systematization.

§ 11.7.2. Dividend "trap"

"Equity" may not always be provided by sponsors in the form of common stock. For tax and accounting purposes, it is often more beneficial for sponsors to provide a portion of it in the form of a subordinated loan, in part because interest payments on this loan can be tax-deductible, unlike dividends paid on ordinary shares.

In addition, this approach (making investors' rights dependent on lenders' rights - see § 12.13.5) avoids what is known as the dividend trap, in which the project company has cash flow but cannot pay dividends to its investors from -for the negative balance sheet on profit and loss, as shown in Table. 11.3.

The following assumptions were made in the calculation:

project costs are 1500 c.u. e., 1200 c.u. e. financed from a loan and 300 from equity;
income and expenses are constant and amount to 475 and 175 c.u., respectively. e. per year;
the depreciation charged for project costs is 25% of the residual value (see below);
accounting depreciation is equal to tax depreciation;
the tax rate is 30%;
if the project company incurs a tax loss, a tax credit of 30% of its amount is carried forward and applied to future tax payments;
the principal amount of payments on the debt is 200 c.u. e. annually;
indicators are presented for 6 years, although the project life is much longer.

Calculations show that the project company has a positive cash flow that allows payments to investors since year 1, but it will still not be able to pay dividends because its balance sheet shows a negative balance of CU 75. e. in the income statement resulting from accelerated depreciation, which creates an accounting loss in year 1, and only in year 3 it will be eliminated. Thus, the project company cannot pay dividends until this moment. Even by year 6, excess funds cannot be fully paid back to investors and a significant delay in receiving payments significantly reduces their rate of return.

In general terms, the dividend "trap" here is a function of the difference between depreciation and the amount of payments on the principal debt: if the first indicator is significantly higher than the second, then the size of the dividend "trap" increases, otherwise it is eliminated. This problem is less relevant in countries where accounting depreciation is not a mirror image of tax depreciation.

Table 11.3. Dividend "trap"

		Year 1	Year 2	Year Z	Year 4	Year 5	Year 6	Total
(a) Income		475	475	475	475	475	475	2375
(b) Expenses (including interest)			-175	-175	-175	-175	-175	-875
(c) Depreciation			-281	-211	-158	-119	-89	-1144
(d) Taxable income/loss	[(a) + (b) + (c)]	-75	19	89	142	181	211	567
(e) Tax credit payable	[(-g) × 30%]	23	-6	-27	-43	-54	-63
(f) Tax credit used			6	17	0	0	0
Tax credit deferred		23	17	0	0	0	0
(g) Tax payments	[(g) + (e)]			-10	-43	-54	-63	-170
(h) Net income	[(d) - (f)]	-75	19	79	99	127	148	397
(i) Debt payments/		-200	-200	-200	-200	-200	-200	-1200
(j) Dividends paid				-23	-99	-127	-148	-397
(k) Cash flow Cash balance	[(h)-c) + (i) + (k)]	100 100	100 200	67 267	-42 225	-81 144	-111 33	33
(l) Accumulated profit at the beginning of the period Accumulated profit at the end of the period	[(m) + (h) + (k)]	0 -75	-75 -56	-56 0	0 0	0 0	0	0

If the equity of investors is partially paid in the form of a subordinated loan and reflected in equity, then payments to investors in the first years when dividends cannot be paid can be made in the form of payments of a subordinated loan. In this way, the project company will be able to pay all excess amounts.

The next conclusion that can be drawn from these figures is that some of the tax benefits from the rapid depreciation are wasted: the $23 tax credit. e. in year 1 may not be fully taxable until year 3. In such a case, the project company may decide:

do not fully use the fast depreciation compensation (i.e. deduct project costs from taxes at a lower rate), which is allowed in many countries; in this case, there will be no negative balance on the profit and loss account, and therefore it will be possible to pay dividends in the first years;
use the tax base of the lease (see § 2.3) and pass the depreciation on to the leasing company, which can immediately use the funds, and pass the benefits to the project company in the form of low financing costs.

Other benefits of using subordinated debt rather than equity by shareholders to finance a project company's equity include the ease of returning funds to investors in the event of refinancing and an increase in principal or at later stages of the project when investors may want their money back.

§ 11.7.3. Negative equity

The project company must ensure that by avoiding the dividend trap, it does not fall into a situation of completely eliminating shares from the company's equity. If the majority of a project company's financing comes from a subordinated loan and it incurs significant accounting losses in the early years of the project's existence, this can lead to a complete liquidation of equity. In most countries, the shares of a company with negative equity (which has a share capital less than a negative income statement) are required to be withdrawn from trading and subject to liquidation.

For the case presented in Table. 11.3, if the project costs are 1500 c.u. e. financed with 20% equity (i.e. $300), of which 267 is a subordinated loan and the remaining 33 is equity, the loan must be repaid in the first 3 years, after which dividend payments will begin . The project company incurred an accounting loss of CU75 in year 1. e. (even without taking into account interest payments on a subordinated loan), which significantly exceed the share capital; such a gap should not exist (perhaps in this case the project company should consider options for a lower rate for tax depreciation).

Similar results may also emerge with linear depreciation, but with a lower rate of return in the early years (eg due to high taxes on interest payments with a subordinated loan).

Because low equity is a hallmark of project finance, the accounting performance of the project company must be carefully monitored during the financial modeling process. This allows the following condition to be met: even if there is a cash flow, it can be legally paid to investors and the project company's equity capital is positive.

§ 11.7.4. tax payment schedule

Very often, corporate tax payments are transferred at the end of the period, which means that there is a gap between the date of accrual and the actual date of payment. Therefore, the financial model must necessarily show both the tax calculations in the income statement and the amounts of payments in the cash flow calculations for these dates.

§ 11.7.5. Value Added Tax (VAT)

In some countries (for example, countries in the European Union), VAT on costs associated with the construction of the project will be paid by the project company, but these amounts may be refunded if VAT is paid on sales after the start of operation of the project. It is very common for lenders to provide a separate credit for VAT in accordance with short-term financing requirements.

§ 11.7.6. Tax deductions

The project company may be required to deduct local income taxes from interest payments by lenders who do not reside in the country or from dividend payments to foreign investors. However, lenders are able to recover these amounts when paying taxes on other income; they usually require the project company to bear these costs (see § 8.2.4). Therefore, it may be more beneficial for a company to attract domestic lenders, if possible.

Investors may in some cases be able to recover tax withholdings from their dividends when paying taxes on other income, but if they are not able to do so, then the amount of the deduction should be taken into account when calculating the income on investments in the project, even if it is not reflected in the accounting report of the project company or her cash flow.

§ 11.7.7. Exchange rate and tax

If the project company borrows in a foreign currency, then the change in the exchange rate will have an impact on tax payments and, consequently, on the income of investors, even if revenue and operating expenses are indexed to this currency.

This can be seen from the data presented in Table. 11.4. It also clearly shows why it is necessary to calculate the financial model in local currency, and not in the foreign currency used in the country where investors or lenders live.

The investor's income is calculated in US dollars, the project company maintains accounting and calculates taxes in euros. Two calculations are presented: one is based on a financial model calculated in dollars, and the other is based on a calculation in euros. The following assumptions have been made:

all project costs, revenues and costs (including interest and principal payments) are either denominated or indexed to the dollar; thus, theoretically, the project is not related to the exchange rate;
initial exchange rate is EUR 1.10 = USD 1. EUR is depreciated by 5% per annum at the start date of the project;
the project cost is $1,000, which is equivalent to €1,100 at the date of cost incurrence;
tax depreciation in dollar terms is not $150, as it might seem on the basis of the conclusions of the financial model, but $130. Therefore, the model calculated in dollars does not reflect this and exaggerates the value of cash flow.

Table 11.4. Exchange rates and taxes

		Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Calculations, USD
(a) Start-up costs		1000
(b) Depreciation	[(a) × 10%]		100	100	100	100	100	500
(c) Tax deductions	[(b) × 30%]		30	30	30	30	30	150
Settlements, euro
(d) Start-up costs		1100
(e) Depreciation			110	110	110	110	110
(f) Tax deductions	[(d)×30%]		33	33	33	33	33	165
(g) Exchange rate		1,10	1,16	1,21	1,27	1,34	1,40
(h) Depreciation cost, USD	[(e)/(g)]		95	91	86	82	78	433
(i) Cost of tax deductions, USD	[(hedgehog)]		29	27	26	25	24	130

Thus, in a project that uses foreign currency financing, even if it is fully hedged, it is always necessary to track the change in the exchange rate.

§ 11.7.8. inflation and tax

A project that operates under high inflation and revenues, and whose costs are fully indexed to the inflation rate, still will not generate income that increases in parallel with the inflation rate, because the tax depreciation is based on the initial costs; this is largely due to factors that affect the project (these are discussed in § 11.7.7).

In some countries, project costs on the company's balance sheet will also be revalued using the inflation rate before tax depreciation is calculated. Again, this confirms the importance of calculations based on “nominal” rather than “real” cash flow rates for project financing (see § 8.1) (that is, taking into account the impact of various inflationary scenarios).

§ 11.8. Return on equity

The standard calculation of return on equity for project investors is usually based on the calculation of cash flow, taking into account:

the time of depositing funds. As will be shown in § 12.3, it is likely that there may be some time gap between the date of the official transfer of equity and the actual date of the cash deposit. The vast majority of investors evaluate their profitability based on the transferred funds, and not on the planned investments;
dividend schedule. What is important is not when the project company makes a profit, but when it is paid to investors in the form of compensation (dividends or interest payments or payments on a subordinated shareholder loan); there may be a significant time gap between these dates (for example, because lenders may require that funds be accumulated in reserve accounts, and dividends paid 2 times a year, taking into account the company's financial results for half a year - see § 12.5.3).

In order to measure the return of investors from investments in different periods of time, it is necessary to bring it to a common basis by discounting the calculations. Basically, two interrelated quantities are used: the net present value (NPV - see § 11.8.1) of the cash flow and the internal rate of return (IRR - see § 11.8.2), which are measured by the value of future profits, adjusted for the exchange rate for this moment. However, these values must be used with caution (see § 11.8.3), as they can lead to erroneous conclusions if a significant part of the investment is not made in cash (see § 11.8.4).

As shown in § 11.7, companies will also evaluate how their investment in the project is presented in published reports as well as in cash flow calculations.

§ 11.8.1. Net Present Value (NPV)

NPV is the present value of an amount due in the future, adjusted for a discount rate. The formula for calculating NPV is as follows:

where FROM is the amount of future cash flow, i- percentage or discount rate, n- period number. (The discount rate can be annual or, for example, semi-annual.)

Thus, if the discount rate is 10% annually and the amount expected in one year is $1,000. That is, the NPV for this amount is:

or 909.1 c.u. e. Let's do the opposite: if 909.1 y. e. is the amount of investment for the year at a rate of 10%, 1000 c.u. e. (that is, 909.1 × 1.10) will be paid at the end of the year. NPV for the amount of 1000 c.u. e. when calculating for 2 years and a discount rate of 10%, calculated for half a year (5% for half a year), is:

or 822, at. e.

Cash flow NPV determines the present value for future cash flows. It is calculated as follows:

We calculated the amount of net cash flow for each future period (usually for project financing this is half a year); it is discounted to NPV at a rate (it is not necessary to use a formula or spreadsheet to calculate NPV - this can easily be done using a financial calculator or related software).

The application of NPV calculations can be illustrated by comparing the cash flows for two investments, which are presented in Table. 11.5. The initial amounts for each of them are 100 USD. e., the cash flow for 5 years is 1359 c.u. e. and generates income (net initial investment) of 350 c.u. e. Cash flow for each year is discounted to NPV at an annual rate of 10%. “Year 0” is the first day of the project after the investment; the remaining cash flows are shown for subsequent semi-annual intervals.

Table 11.5. Calculation of NPV

		Investment A		Investment B
(a) Year	(b) Discount factor [(1 + 0.1) (a) ]	(c) Cash flow	NPV [(c)/(b)]	(d) Cash flow
0	10 000	–10 000	–10 000	–10 000
1	11 000	340	309	200
2	12 100	305	252	235
3	13 310	270	203	270
4	14 641	235	161	305
5	16 105	200	124	340
Total		350	49	350

As you can see, although the undiscounted cash flows are equal, the NPV for investment A is 49 (that is, the discounted cash flows from 1st to 5th years of 1049 cu less than the amount of the initial investment), while for investment B = - 2.

The discount rate used by investors for the project company's equity is the minimum required rate of return, which is usually derived from the investors' cost of capital (see § 11.12.1). If the NPV using this discount rate is a positive number, then the investment meets the minimum requirement; if not, then it is not worth investing. If investors demand a return of at least 10%, then it is quite clear that investment A meets these minimum requirements, since the result is positive, while investment B does not meet them. The calculation of NPV can also be used when choosing a project (but it is necessary to take into account the conclusions presented in § 11.8.3) - it is clear that for the case presented in Table. 11.5, investment A is a more profitable investment option. Such a difference in the calculation of NPV demonstrates the importance of the distribution of cash flows over time.

As will be noted in § 11.9, NPV is also used by lenders when calculating loan coverage ratios.

§ 11.8.2. Internal rate of return (IRR)

The internal rate of return (IRR) measures the rate of return on an investment over its lifetime. This is the discount rate at which the NPV of the cash flow is 0. Thus, in the example presented in Table. 11.5, the IRR for investment A is 12.08%, and for investment B - 9.94%, which once again proves that investment A is more profitable; the calculation can be verified by discounting two cash flows with the appropriate rate (Table 11.6). In the process of calculating IRR, one must be very careful, such calculations cannot be used if the cash flow in different periods of time can take both positive and negative values, since they can give several answers.

In addition to the IRR for a project company's equity investment, it is also possible to calculate the IRR of the entire project, which is based on the cash flow before debt service payments and equity returns are paid, and which is determined by the return on the required investment (for loan or equity) . Sometimes this operation is carried out at the initial stage of project development in order to test its viability without regard to the specific financial structure. Otherwise, IRR is of limited use in project finance, where the main benefit of using financial leverage on a project with a loan is the ability to improve the return on equity. IRR can still be used by investors in a portfolio of projects on balance sheet and project financing to compare options. It can also be used in the calculation of compensation, as it is equivalent to the mixed debt servicing costs and income of the project's equity (see § 5.8.1).

Table 11.6. IRR Calculation

The end of the year	Investment A		Investment In
The end of the year	Cash flow	NPV at 12.08%	Cash flow	NPV at 9.94%
0	–1000	–1000	–1000
1	340	303	200
2	305	243	235
3	270	192	270
4	235	149	305
5	200	113	340
Total	350	0	350

§ 11.8.3. Using IRR and NPV values in the process of making investment decisions

In the process of making a decision to invest in a project and analyzing the impact of changes in the accepted assumptions on the return on investment, investors consider the values of IRR and NPV. However, when using these quantities, care must be taken to understand how they are calculated. This consideration can be illustrated by the example of two investments, which are presented in Table. 11.7: it is clear that investment D provides the best return and the NPV value confirms this conclusion, but the IRR values for both investments are the same, since the standard IRR calculation process assumes that the funds withdrawn from the project are refinanced at the IRR rate until the end of the calculation period ( thus, as shown in the third column of Table 11.7, if the cash flows for years 1, 2, 3 and 4 are reinvested at 15% annually, then the total amount will reach 2011 c.u. by the end of the 5th year). It should be noted that investments C generate cash flow faster, but the assumption that these funds can be reinvested at 15% is perhaps incorrect or at least implies double counting the return on investment. Thus, IRR initially overestimates cash flows; lengthening the period leads to an increase in IRR when using a high reinvestment ratio.

Table 11.7. IRR and various cash flows

Year	Investment C	Investment D	Investment C
	Cash flow	Cash flow	Reinvested annual cash flow at 15% up to year 5
0	–1000	–1000
1	298	0
2	298	0
3	298	0
4	298	0
5	298	2011
Total	492	1011
NPV at 12%	75	141
IRR,%	15	15

There are two ways to account for this type of distortion:

1) modified IRR (MIRR). The MIRR value implies a lower reinvestment rate (i.e. the cost of capital for investors for NPV instead of the rate for IRR) for the funds withdrawn from the project. In this case, the overall picture becomes more realistic. In the example presented in Table. 11.7, if the investment rate is taken as 12%, then MIRR for investment C will decrease to 13%, while for investment D it will certainly remain unchanged;

2) payback period. The IRR analysis ignores the problem of reinvestment, but requires that the investment also have a maximum payback period (that is, the period of time required to return the original investment amounts). This somewhat counterbalances the effect of the IRR exaggeration for longer-term cash flows, but the calculation remains approximate—in particular, it does not take into account the returns received after the payback period. However, this approach can be a useful control tool. The payback period for investment C is less than 4 years, for investment D - 5 years. At the same time, in the process of making decisions on new investments, investors also require that the maximum payback period does not exceed a certain value.

Again, when comparing two different projects, the indicators should be comparable, as shown in Table. 11.8. Investment F has a higher NPV than investment E, but only because of volume. Obviously, investments E are more profitable; investment F with stable growth of 1000 c.u. e. provide lower returns.

§ 11.8.4. Non-cash transactions when investing

Another factor that also has a significant impact on the NPV and IRR values is the actual time of contributions to the equity of the project company (see § 12.3.3). Moreover, if investors commit to invest in equity only if the project company's cash flow is inadequate, the IRR value is not affected in any way (see § 12.3.3).

The values of NPV and IRR reflect the return on cash investments, and not the return on all investments that the investor has risked. Thus, if the project company has significant amounts of unused equity capital, then the NPV and IRR indicators can mislead investors.

In order to take into account unused equity, it is necessary to assume in the IRR calculation process that this capital is used on Day 1 of the project's existence and generates a return equal to the value of the investors' capital until it is actually used by the project company. This is a more accurate measure of an investor's risk return.

§ 11.9. Debt coverage rates

The level of debt is determined primarily by forecasts of the project's ability to pay interest and guarantee the return of the principal amount in accordance with the agreed schedule. To assess this strength, lenders calculate coverage rates, as follows:

the annual debt service coverage rate (see § 11.9.1);
coverage rates for the lending period (see § 11.9.2);
the average annual debt service coverage rate and the coverage rate for the period of the loan (see § 11.9.3);
the coverage rate for the life of the project (see § 11.9.4) and the reserve coverage rate (see § 11.9.5).

These rates for a typical project are given in § 11.9.6. It should be noted that none of these can be calculated until the project company is operational, as they reflect the relationship between operating cash flow and the level of debt or amounts required to service it.

§ 11.9.1. Annual Debt Service Coverage Rate

The Annual Debt Servicing Coverage Rate (ADSCR) evaluates the project company's debt service capability and is calculated as follows: operating cash flow of the project for the year(that is, operating revenue minus operating expenses, including amounts charged to reserve accounts for maintenance, etc. held for other purposes (see § 12.5.2), and excluding any non-cash positions such as depreciation; this may be similar to EBITDA (earnings before interest, taxes and depreciation) used in corporate finance, but the project's operating cash flow for the year should be based on cash flow, not accounting figures) divided by the amount required to service the debt of the project for the year — that is, payments of interest and principal, excluding amounts from reserve accounts.

Thus, if the operating cash flow for the year is 120. e., interest payments - 55 c.u. e. and payments on the loan - 45 c.u. e., then the rate of coverage of the annual amount of debt service will be: 1.2 / 1 (120 / (55 + 45)) c.u. e.

Typically, the annual debt service coverage rate is calculated in six-month increments as an average annual value. Obviously, it can be calculated only after a year from the start of the operation of the project; however, it may affect the ability to pay dividends (see § 12.5.3), and therefore in the first period it can be calculated for half a year.

In the initial assumptions of the base case (see § 11.10), lenders consider the annual debt service coverage rate for each period and ensure that this rate does not fall below a required minimum. The actual annual debt service coverage rate is reviewed (subject to change in assumptions) after the start of operation of the project (see § 12.5.3).

Different projects determine different minimum annual debt service coverage rates, but the following can be taken as approximations for ordinary projects:

1.2/1 for infrastructure projects where there is no risk of use (such as a public hospital or prison);
1.3/1 for projects related to the operation of power plants or industrial enterprises in which a contract has been concluded for the sale of manufactured products;
1.4/1 for infrastructure projects where there is a risk of use, such as toll roads or public transport projects;
1.5/1 for mining projects;
2.0/1 for projects related to commercial power plants for which there is no contract for the sale of electricity or a price hedging contract.

Higher coverage rates should be used in projects that have unusual risks or are located in countries with a very low credit rating.

It should be noted that, unlike corporate loans, the cash flow coverage rate for annual interest payments is generally not considered as a significant indicator. This is because corporate loans are very often renewed, while project finance loans must be repaid after a certain period of time; therefore, the project company must necessarily be able to reduce its debt in accordance with the schedule and, in general, payment of interest alone is not considered acceptable.

§ 11.9.2. Coverage rates for the loan period

Lending Period Coverage Rates (LLCR) are calculated in a similar way, but for the entire lending period: projected operating cash flow(similarly calculated) from the projected start date of the project to the date when the debt is due, discounted to NPV at the same interest rate assumed for the debt (subject to interest swaps or other hedging options) divided by the outstanding amount of the debt on the date of settlement minus the balance of reserve accounts, which accumulate amounts to service the debt.

The minimum initial coverage rate for the lending period for the base case is projected to be approximately 10% higher for “standard” projects than for the debt servicing case.

In addition, the rate can be recalculated throughout the life of the project by comparing the projected cash flow for the balance of the debt period with the outstanding debt at the settlement date.

The coverage rate for the period of the loan is a useful indicator in the initial assessment process, which helps to determine whether it will be possible to service the debt as a whole. It is also used in the monitoring process during the loan period, but it is clear that its usefulness is reduced in case of significant changes in the size of the cash flow. In this case, the annual debt service coverage rate may be a more significant indicator of the project company's debt service capability.

§ 11.9.3. Average coverage rates for the annual amount of debt service and the coverage rate for the loan period

If the projected values of the annual debt service coverage rate are constantly at the same level, then the average value will be exactly the same as for the coverage rate for the loan period. However, if it is higher at the initial stage, then the average value will exceed the average coverage rate for the loan period, and vice versa. Thus, the average annual debt service coverage rate as a long-term indicator is sometimes more significant for lenders than the coverage rate for the lending period; in this case, it is likely that the minimum requirements will be equivalent to the minimum value for the coverage rate for the period of the loan.

The average value for the coverage rate for the period of the loan (ie the average value for indicators that are recalculated every 6 months) is also used as a criterion by lenders, although the significance of this indicator is debatable.

§ 11.9.4. Coverage rate for the period of project operation

Lenders also review the project to see if it is possible to repay the loan after what was originally assumed to be the final maturity date if there are difficulties in making payments on time. These additional opportunities are known as the "tail" and lenders typically expect cash flow to be generated at least a year or two after the end of the loan term. The tail size calculation can be based on:

on the general ability of the project company to continue operating the project and thus generate cash after the loan expires (in any case, the life of the project should technically exceed the life of the loan);
the existence of a contract for the sale of products, a contract for the supply of fuel or raw materials, or a concession agreement in which there are clauses that determine the functioning of the project company.

The cost of such a tail to lenders can be calculated using the Lifetime Coverage Rate (PLCR); in this case, the net cash flow before debt service payments for that period (and not just for the life of the debt, as in the case of calculating the coverage rate) is discounted to its NPV, and this value is divided by the value of the loan outstanding. Obviously, the coverage rate for the entire life of the project will be higher than the coverage rates for the life of the debt; lenders may want the first rate to be 10-15% higher than the minimum rate for the second.

§ 11.9.5. Reserve coverage rate

In mining projects, the lifetime coverage rate (in this case referred to as the reserve coverage rate) becomes more significant due to special requirements for the residual volume of minerals (i.e. proven reserves that can be produced after the period of debt expires - see § 7.9.4).

For guaranteed success, the reserve coverage rate should be 2:1 based on prudent commodity price forecasts by lenders, and obviously not less than 1:1 for the minimum acceptable forecasts.

§ 11.9.6. Calculation of coverage ratios

Table 11.9 shows the coverage rates for a typical project that has:

annual cash flow before debt service payments is CU220. e.;
the loan is $1,000. e. and paid in equivalent amounts over 10 years;
The interest rate on the loan is 10% annually and is equal to the NPV discount rate.

Table 11.9. Coverage rates

Year

Operating cash flow

NPV of operating cash flow

(in)

Debt payments

(G)

Outstanding loan (end of year)

1000

(e)

Interest payments

(e)

Total debt service (c) + (e)

Annual (a) / (e) debt service coverage rate (X)

Annual (b) / (d) debt service coverage rate

1,35

Average annual debt service coverage rate

1,65

Assuming that the project generates an annual profit of $200. e. for the next 3 years after the repayment of the loan (that is, in the period from 11 to 13), then the NPV of the total cash flow for 12 years is 1499 c.u. e. and thus the coverage rate for the entire life of the project will be 1.50:1 (1499:1000).

It is necessary to decide whether to deduct tax payments from net cash flow before paying debt service amounts, especially when calculating the annual debt service coverage rate, since changes in interest payments also affect tax payments. It may be prudent to proceed in this way if there is a significant change in taxes (for example, as a result of the impact of offsets for accelerated tax depreciation) that needs to be taken into account. An argument against is the fact that taxes are paid only after deducting interest expenses, which are not included in the indicators of operating cash flow; in addition, the problem arising from a significant change in the amount of taxes can be solved by placing funds in reserve accounts intended for paying taxes (see § 12.5.2). However, as long as the decision-making process on the level of the rate takes into account whether the amounts of tax deductions are included in it, the choice of option does not play a serious role.

It should be noted that "booking" rates, such as current or quick ratios, are generally not used in project finance (short-term liquidity is provided by creating reserve accounts). The debt/equity ratio used in calculating the level of investment in the project company's equity (see § 12.1.4) is also based on cash injections and not on accounting figures.

§ 11.10. Base case and changes in assumptions

Once lenders and sponsors agree that the financial model structure and calculation formulas reflect the specifics of the project and contracts, key assumptions are identified, and the financial structure and timing are agreed and put together (see Chapter 12); the final calculation of the model, taking into account these assumptions, is called the "base case" (base case) or "banking scenario" (banking case). This final settlement is usually carried out immediately prior to the signing of the project financial documentation, so that lenders can verify, using revised assumptions and final project contracts, that the project will be able to provide them with adequate coverage for the loan being made.

But subsequently, the project cannot remain unchanged, and lenders will continue to monitor emerging options. As will be shown below, adverse changes in the annual debt service coverage rate and the coverage rate for the period of the loan may affect the project company's ability to pay dividends to investors (see § 12.5.3) or even cause the project company to default on the loan (see § 12.11).

However, if new projections are made during project implementation, someone must decide how to modify the assumptions that have been used up to that point. If the right to make decisions on the admission is given to the project company, then the lenders may disagree with the decision, and vice versa.

There is no standard solution for this problem, but whenever possible one should strive to use objective sources to revise forecasts, for example:

macroeconomic assumptions (including commodity prices) may be based on an economic review published by one of the lenders or another external source, as long as it is carried out for general purposes and not for a specific project;
changes in revenue or other performance assumptions should be based primarily on the actual performance of the project company;
lenders usually have a voting say in the decision to change assumptions, but where possible, investors should ensure that decisions are sound and based on qualified advice from technical advisors who work on behalf of lenders or their market or insurance advisors, not the right to make the final decision.

§ 11.11. Sensitivity analysis

The financial model must also have some flexibility to allow investors or lenders to calculate a series of different scenarios (also known as project development scenarios) that take into account the impact of changes in the key input assumptions for the base case when the project is initially considered. These options may include calculating coverage and yield ratios depending on:

from construction budget overruns (usually based on full use of contingency funding);
payments for liquidated damages in accordance with the "through" contract, allowing you to compensate for costs resulting from downtime or non-compliance of production indicators with the plan;
completion of work late (for example, 6 months) without payment of liquidated damages under a "through" contract;
longer downtime and less workload;
decrease in sales volumes or volumes of use of the project;
reduction in the selling price;
selling prices of goods at the break-even point level;
higher costs of fuel and raw materials;
higher operating costs;
increase in project payments (if they were not fixed);
changes in exchange rates.

Finally, the sensitivity analysis considers the financial implications of alternative financial and commercial risk options for a project that does not deliver the predicted performance.

Lenders also typically conduct a “combined critical point analysis” to determine the impact of multiple adverse factors at the same time (for example, construction completed 3 months behind schedule, 10% reduction in sales prices, and 10% increase in downtime). The calculation of the simultaneous impact of several different factors is also called "scenario analysis".

§ 11.12. Investor Analysis

Investors typically aim for a certain minimum level of equity IRR (see § 11.12.1), which may vary depending on the period they are involved in the project (see § 11.12.2). Resale of shares upon completion of construction and in the event of successful operation can give investors who came to the project at an early stage of its implementation, the opportunity to more quickly earn a return on investment (see § 11.12.3); also, investors' returns can be increased if the loan is refinanced at this stage (see § 11.12.4).

§ 11.12.1. Investor income

Typically, investors have "barrier rates" for IRR on their stocks; investments for which the IRR is higher are considered eligible. As a rule, "barrier rates" are based on:

on investors' capital expenditures (based on a combination of equity and debt), which are commonly used as the discount rate in NPV calculations;
additional returns in excess of the capital costs required to deal with a particular type of risk (e.g. project type, project location, risk hedging under the project agreement, increase or decrease in risk to the investor's portfolio after funds are deposited, etc.).

Establishing a required return according to risk based on the equity IRR of the project company can be a cyclical process because the equity IRR depends on financial leverage, which in turn depends on risk.

Equity IRR in projects with moderate risk, such as energy projects with an agreement to purchase electricity, or infrastructure projects with limited use risk, will typically be 12-20% (pre-tax and in nominal values, that is, adjusted for inflation in the cash flow forecasting process). This is relatively low compared to returns on other types of new equity investments, and it reflects a lower level of risk: in fact, the returns received are similar to returns from a subordinated or mezzanine loan, and not returns on “true” equity.

Market rates for equity IRRs are designed for industries such as power generation and public infrastructure, in which projects are often offered to governments or product buyers (see § 3.6).

Investors may require their investments to have a positive NPV and a minimum payback period (see § 11.8.3) and meet an IRR cap.

§ 11.12.2. Equity investment schedule

Investor requirements for profitability also depend on the moment when they entered the project. They come to projects at different stages of implementation and with different strategies. Any project at different stages of development is characterized by different levels of risk (Table 11.10).

* The level of risk depends on the following factors:

degree of compensation of commercial risks by project agreements;
stability of traffic or demand in projects focused on the use of products.

If the project develops successfully, then the IRR of equity for new investors gradually decreases.

A sponsor who was present in a project at the development stage and brought in another sponsor to invest in the project's equity near the due date of all financial documentation expects to be compensated for taking the highest risk. This condition can be met if the new sponsor pays bonuses on its shares (the price per share is higher than for the original sponsor) or makes a loan to the original sponsor at a theoretically high rate for the amount that has already been spent on the project. This fact is taken into account when calculating the share of organizational expenses of each sponsor and the distribution of shares among them, taking into account the funds spent.

In addition, the initial sponsor may withdraw money from the project as a result of the project company's application fee, which is usually paid at the time the financial documentation is signed. In fact, it will be an early return on investment, which is partly funded by the lenders as part of the development costs of the project. Thus, the registration fee can be used as an alternative option for compensation by one sponsor to another of the risk associated with the development of the project. Organizational fees may be challenged by lenders, but may be acceptable to them, as long as the initial sponsor's cash investment is not substantially below acceptable levels; it is obvious that the increase in the size of the loan should be acceptable to the project.

§ 11.12.3. Share resale effect

Another investor may be unwilling or unable to bear the high costs and risks associated with a project during the design and construction stages, but may buy shares in the project company from the original sponsors after construction has been completed and successful operations have commenced at a higher a price that reflects a lower rate of internal return, now considered acceptable because the risk has decreased.

The sale of some or all of the equity investment after the project has gone live offers sponsors or other initial investors the chance to significantly improve their stock returns from their original projections. Indeed, the achievement of the investment target for some investors, such as project finance funds, will depend on the profitability of selling their shares at this stage.

The benefits derived from such a sale are presented in Table. 11.11 for a project that has:

expenses amount to 570 c.u. e.;
construction period: 2 years, half of the cost is paid on the 1st day, the balance is calculated at the end of each following year;
financing: 85% of debt for 15% of equity used pro rata during the construction period;
net income: 75 c.u. e. per year until the required debt service amounts are paid, the project is designed for 20 years;
debt service: debt is paid on a rent basis (see § 12.2.3) for the first 15 years of operation (that is, by the 17th year of the project life) at an interest rate of 7% annually (note that interest payments during the construction period are added to the debt and financed as part of project costs, tax impact is not taken into account, figures are rounded to the nearest whole number).

The data presented in table. 11.11 indicate that the internal rate of return for investors' initial equity capital was 18%; shows the result of a share sale at the end of the second year of operation to a buyer willing to accept a lower IRR of 15%, reflecting the lower risk inherent in a successful project. Purchase of shares in the project company for 130 USD. e. provides 15% IRR for the buyer; this sale raises the IRR for the original investors to 25% and generates a profit of $43 on an initial equity investment of $87. e. (Although the IRR for the original investors has improved significantly, some of the project's benefit from deferred income has been lost.)

Unplanned profits for this type of investor may create problems with the purchaser of the product or contract partner under the project agreement (see § 5.9.2), and the sale of sponsor shares at this stage should be agreed with the lenders (see § 3.1).

Table 11.11. Equity resale effect

	Construction			Exploitation
Year	0	1	2		...	18	19	...	22
(1) Initial Project Financing
(a) Project costs (including interest payments during the construction phase)	-190	-190	-190
(b) Net income					...	70	70	...
(c) Use of debt/payments	162	162	162		...			...
Net cash flow (a) + (b) + (c)	-29	-29	-29		...	70	70	...	70

(2) Sale at the end of the 2nd year of operation (Year 1 of the Project)
(d) Position of the original investor
Project cash flow	-29	-29	-29
Sale
Net cash flow	-29	-29	-29
Equity IRR = 25%
(e) Position of the new investor
Purchase
Project cash flow					...		70	...	70
Net cash flow					...	70	70	...	70
Equity IRR = 15%

Table 11.12. Refinancing effect

	Construction	Exploitation
Year	0		...		18	19	...	22
(1) Initial Project Financing

(b) Net income			...		70	70	...	70
(c) Use of debt
(d) Debt repayment			-22	...	-50
(e) Outstanding debt at the end of the year [(e) previous year + (c) + (d)]	162		...
			...
(g) Debt service [(e)+(f)]			...
			...				...
			...
Coverage rate for the entire period
project operation at the end of the year 4
Equity IRR = 18%
(2) Refinancing
(a) Project costs including interest during the construction phase
(b) Net income			...		70		...	70
(c) Use of debt	162
(d) Debt repayment			...				...
(e) Outstanding debt at end of debt [(e) previous year + (c) + (d)]	162		...				...
(f) Interest payments [(e) at 7%]			...				...
(g) Debt service [(e) + (f)]			...				...
(h) Net cash flow [(a) + (b) + (c) + (g)]			...				...
Debt Coverage Rate [(b)/(g)]			...				...
Coverage rate for the entire period of operation of the project at the end of the year 4
Equity IRR = 24%

§ 11.12.4. Benefits of refinancing

The data in table 11.12 are presented for the same project as in table. 11.11, but the profit received from debt refinancing in the 2nd year of operation (in the 4th year of existence) is considered. Refinancing extends the maturity of the loan by 2 years and also increases the size of the outstanding loan by the end of the 4th year by 125 c.u. e.

The refinancing is based on the assumption that, at this stage, lenders are satisfied with the conditions for the next 2 years of the project's existence, with a lower annual debt service coverage rate (and lifetime coverage rate) for future periods of 1.25 (and also with a coverage rate of for the entire life of the project, reduced to 1.38 compared to the end of the year 2). As a result, investors will receive 125 USD. i.e. in year 4 and thus recover all of their initial equity investment at that date and increase their total IRR to 24%. (These calculations do not take into account the amount of fees, as well as legal and other costs associated with the refinancing itself, which can be 1-1.5% of the refinancing amount.)

However, refinancing may create prerequisites for problems with the purchaser of the product or the contract partner under the project agreement (see § 5.9.1). In addition, appropriate items must be included in the lending documentation to enable refinancing (see § 12.6.3).

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