Financial modelling of debt facilities has been, is, and always will be, at the heart of a project finance transaction. While the basic terms and conditions are incorporated in the term sheet, the industry nuances and accepted practices are generally expected by senior bankers to simply be embedded into the model. Two of these concepts are often confused when discussing and modelling project finance debt so let us take a look at this issue.
Debt sizing in a project finance model
In a project finance model, the sizing of debt means determining the maximum amount of project finance debt that the financial model indicates can be sustained. This then becomes the debt limit and the amount the project finance bank will reserve capital for.
The calculation of this limit is another topic altogether, but to keep it simple, let us assume that it is the amount of project finance debt that can be repaid assuming the debt service cover ratio (DSCR) stays above a set threshold (the minimum as well as the average DSCR). Project finance debt can; however, also be sized to other ratios than the DSCR.
Everything else being equal, the stricter the covenants, such as minimum DSCR or loan life cover ratio (LLCR) required by the lender, the more risky the project is considered to be.
How is the DSCR calculated?
The two main components are:
Essentially, the lender sets a minimum DSCR to ensure that the project will be able to make debt repayments in each period. As mentioned, the higher the minimum DSCR required, the less debt we can borrow from the lender.
Debt sculpting in a project finance model
In many project finance transactions, the project cash flows are variable from period to period. For instance, an oil and gas project produces a very different cash flow profile over time than a toll road project. To put it simply, to improve the debt carrying capacity of the project, the total debt service in each period is matched to the CFADS available to make that payment. This matching is termed sculpting.
When we sculpt debt, we are manipulating the principal repayments so that total debt service matches CFADS and in turn, the DSCR will follow a target profile. This exercise goes hand in hand, but is different, from sizing debt. Debt can be sculpted by manually entering the principal to be repaid in each period, but most flexible it is calculated as:
P = CFADS / DSCR – I
By increasing the target DSCR, we are reducing the debt repayments in each but the last period. This effectively delays the repayment profile, which is normally desirable for the sponsor. There will be a limit to the size of the DSCR that the project can carry though, since the debt still needs to be repaid within the set tenor. Conversely, a lower DSCR target increases the repayments, which leads to the debt being repaid earlier.
Project finance modelling resources
For more information that relates to this topic, download the following tutorials:
- Using goal seek to solve for maximum debt limit – for an example of debt sizing
- Debt sculpting to achieve target DSCR – for an example of debt sculpting to achieve a target DSCR
- Definition of CFADS – for a definition of CFADS