Policy Analysis

Policy Analysis

Pricing Support

• Various mechanisms can be used to support wind power:– a simple fixed tariff (usually set somewhere between retail and

wholesale prices for electricity and paid for by the local electricity company to the wind farm) for a number of years;

– "green certificates" provided to renewable energy producers and which can be traded - and which have value because producers of "dirty" electricity are forced by law to purchase growing amounts of such certificates each year to compensate for the polluting nature of their production;

– investment subsidies (a one off amount paid at the onset of the project, or over a number of years) to compensate for higher initial investment costs.

Tax Depreciation Analysis

• Review of Tax Depreciation Allowances– 5 Year MACRS– Incentive with Straight Line– Technical Issues

• ½ Year Convention• Applicable Assets• Transfer of Tax Credits

• Effects of Tax Depreciation on the Economics of Wind Projects– Best Case Effects– Worst Case Effects

Effect of Production Tax Credit and Accelerated Tax Depreciation

• A principal reason for the use of private investors rather than municipal ownership is the possibility to use production tax credits and accelerated tax depreciation to offset taxes that would otherwise be paid.

• Without the PTC and accelerated depreciation, private investors would require higher electricity rates to meet the rate of return requirements.

• The tables on the next page use a rate of return of 9% and a debt service coverage of 40% to illustrate the effect of the tax benefits. The first case assumes the PTC and a five year depreciation is available, while the second assumes that the tax benefits are not available.

Value of Tax Benefits in Alternative Cases

• Consider Extreme Cases:– If there is no energy production, there is no PTC.

This implies that higher capacity factor projects have greater tax benefits.

– If a project earns no income above the interest cost, there is not tax to pay and the advantage towns have in terms of tax payments do not exist.

– If a project has a very low cost, there is a low base for tax depreciation and the accelerated tax depreciation benefits are not as important.

Summary of Tax Benefits and Costs

• The graph below summarizes the components of costs and benefits of taxes in a private investor scenario. The benefits include the PTC and accelerated tax depreciation. The costs are that taxes must be paid on profits. This has a large negative effect in the later years of the project life.

$1,264,761 $952,427

$1,829,825

($3,000,000)

($2,500,000)

($2,000,000)

($1,500,000)

($1,000,000)

($500,000)

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

Free Cash Flow Without

Taxes

Value of Production Tax Credits

Value of Depreciation

Total Taxes Paid without PTC and Dep

Benefits

Purely Private Model

Taxes Potentially Avoiadable Post PTC

Total Potential Value with

Mixed Private/Public

Components of Value With No Financing

This chart shows the effects of taxes on the value of the project. The first bar has no taxes in the town case. The second and third bars show the effects of PTC and tax depreciation benefits. The

Alternative Tax Cases

• The analysis in the adjacent chart shows tax benefits in three alternative cases.

• Case 1: – Base Case

• Case 2: – Higher Capacity Factor, Lower

Electricity Rate and Higher Cost

• Case 3:– Lower Capacity Factor, Higher

Electricity Rate and Lower Cost

• Note the Significant swing in value

$1,066,660 $886,806

$1,737,960

($2,500,000)

($2,000,000)

($1,500,000)

($1,000,000)

($500,000)

$0

$500,000

$1,000,000

$1,500,000

$2,000,000


Taxes




Benefits





Components of Value -- Total Potential Value $671,300

($390,016)

$211,022

$1,044,920

($2,500,000)

($2,000,000)

($1,500,000)

($1,000,000)

($500,000)

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000


Taxes




Benefits





Components of Value -- Total Potential Value $1,434,936

$2,756,798

$1,823,109

$2,681,624

($3,000,000)

($2,000,000)

($1,000,000)

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000


Taxes




Benefits





Components of Value -- Total Potential Value ($75,174)

Components of Cash Flow for U.S. Project

Wholesale Power Rates and Net Metering Rates

• Energy legislation known as the Green Communities Act was recently signed into law allows the energy produced at customer-sited generation facilities of up to 2 MW to be sold to the grid as if it were offsetting the energy used at the customer’s meter.

• Previous Massachusetts law only allowed facilities of up to 60 kW to benefit from net metering while for larger facilities only the portion of the production that coincided with load could be credited at the retail rate.

• Each municipality can net meter up to 10 MW of generating capacity, provided that no individual unit exceeds 2 MW.

• According to the legislation, the net metering credit for generation used to offset load at a customer’s meter is credited at a rate equal to the “default service kilowatt-hour charge in the ISO-NE load zone where the customer is located.

National Grid Rate TariffCreditable Under

Net MeteringCustomer Charge 72.06 $Generation/Supply 0.15802 $/kWh xDistribution Demand 3.87 $/kWDistribution Energy

Peak 0.01363 $/kWh xOff-peak 0.00108 $/kWh x

Transmission 0.00749 $/kWh xTransition Demand 0.52 $/kWTransition Energy 0.00142 $/kWh xDSM 0.00250 $/kWhRE 0.00050 $/kWh

Total Net Metering Credit: 0.17481 $/kWh

G-3

Net Metering (Quincy)

• Energy legislation known as the Green Communities Act was recently signed into law in Massachusetts that has made this on-site usage requirement moot. This legislation allows the energy produced at customer-sited generation facilities of up to 2 MW to be sold to the grid as if it were offsetting the energy used at the customer’s meter. Previous Massachusetts law only allowed facilities of up to 60 kW to benefit from net metering while for larger facilities only the portion of the production that coincided with load could be credited at the retail rate. Each municipality can net meter up to 10 MW of generating capacity, provided that no individual unit exceeds 2 MW.

• According to the legislation, the net metering credit for generation used to offset load at a customer’s meter is credited at a rate equal to the “default service kilowatt-hour charge in the ISO-NE load zone where the customer is located.

•

National Grid Rate TariffCreditable Under

Net MeteringCustomer Charge 72.06 $Generation/Supply 0.15802 $/kWh xDistribution Demand 3.87 $/kWDistribution Energy

Peak 0.01363 $/kWh xOff-peak 0.00108 $/kWh x

Transmission 0.00749 $/kWh xTransition Demand 0.52 $/kWTransition Energy 0.00142 $/kWh xDSM 0.00250 $/kWhRE 0.00050 $/kWh

Total Net Metering Credit: 0.17481 $/kWh

G-3

Benefits of Private Ownership with and without Tax Incentives

• The two adjacent graphs show the effects of tax incentives on the cash flow and rate of return earned in a private investor scenario. The rate of return declines from 9.15% to 3.07%

• In the example, the price in the PPA contract would have to increase from $141/MWH to $191/MWH

-

100,000.00

200,000.00

300,000.00

400,000.00

500,000.00

600,000.00

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Cash Flow Components Equity IRR 9.15% DSCR 1.40

Cash Flow without PTC and Tax DepreciationTax Depreciation

PTC Benefits

-

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

140,000.00

160,000.00

180,000.00

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Cash Flow Components Equity IRR 3.07% DSCR 1.22

Cash Flow without PTC and Tax DepreciationTax Depreciation

PTC Benefits

Structuring

Flip Structure

Details of Tax Flip

• This flow will only arise IF EPIC applies/receives approval to receive credit under Section 48B.• As proposed by CSI, the $$ flow of ITC (to Master Tenant) and corresponding investment (from Master Tenant to

Landlord) would occur annually;• the $11MM investment would not be paid as a lump sum before the ITCs are created. There are other ‘flip’

structures (equity investors) that make the investment on the front-side of project.• For FY2008, $337MM was available for Section 48B projects.• The submission date for 2007-2008 funding closed 10.31.07, with notification of awards targeted for mid-2008.• In June 2007, the Treasury Department and DOE released revised guidance on the procedures for awarding the

tax credits authorized under EPAct 2005 for qualifying advanced coal projects and qualifying gasification projects. Under the revised guidance, applications for

• DOE certification received before October 31, 2007, will be acted on in 2008.• DOE received five applications for projects in five different states before the October 31 deadline. Two

applications, requesting $258 million in tax credits, were received for qualifying advanced coal projects costing $4.1 billion, while three applications, requesting $390 million in tax credits, were received for qualifying gasification projects costing $5.0 billion Due to some (potentially conflicting) language regarding the application deadline in IRS 2007-53, I am investigating if there is still a window of opportunity to submit an application for FY2008 funds.

• Otherwise, an application could be submitted for FY2009 funds (by 10,31,08), if deemed worthy to do so for either the EPIC-HES Ethanol Project (HGL) or other EPIC client projects. To ensure qualification for a future Section 48B award, EPIC would need to both be carbon capture ready and capture/dispose of its carbon emissions as part of the project.

• Consortium Investments is interested in making an EPIC investment if/when tax credits can be exchanged for an equity investment.

Different Structures for Renewable Projects

Reasons for Hybrid Analysis

• General Structure– Partnership between private investors and town– Not typical partnership with percent of contributions

and percent of dividends– Different contributions and dividends paid at different

time periods

• Tax Benefits and Tax Costs• Tax Investors in Wind Farms

– Flip structure– Returns to tax investors– Alternative Structures

Modeling of Hybrid Structure

Partnership

Dividends and FinancingRequirements of Partnership

Private Entity

Debt ServiceDividends Debt ServiceDividends

Town

PTCTax Dep

Contributions

Example of Hybrid Structure

• Contributions to Partnership– Private 80%– Town 20%

• Dividends from Partnership before year 11– Private 99%– Town 1%

• Dividends from Partnership after year 10– Private 1%– Town 99%

• Derive the town partnership contributions through working with the contract level and with private IRR similar to private investor case

Length of Pre-Flip Period

• An issue arises in structuring a hybrid analysis as to whether the first pre-flip period should be 10 years to cover the PTC payments or should it be 5 years to cover the accelerated depreciation (in which case some of the PTC benefits are given up).

• The adjacent charts demonstrate that a five year flip structure has more value than a ten year flip structure.

Five Year Flip

Ten Year Flip

Considerations in Developing Hybrid Structure

• Building from principles in earlier discussion, the amount of contributions to the partnership should consider:– The project IRR for the town portion must be greater

than the municipal interest rate, otherwise it is not possible to repay loans

– The equity IRR should be just sufficient to induce investment and the debt coverage should be aggressive. This can be accomplished by adjusting the contract price

– After making the structuring adjustments, evaluate the savings relative to town savings on a standalone basis.

Example of Hybrid Structure

• Contributions to Partnership– Private 80%– Town 20%

• Dividends from Partnership before year 11– Private 99%– Town 1%

• Dividends from Partnership after year 10– Private 1%– Town 99%

• Derive the town partnership contributions through working with the contract level and with private IRR similar to private investor case

Considerations in Developing Hybrid Structure

• Building from principles in earlier discussion, the amount of contributions to the partnership should consider:– The project IRR for the town portion must be greater

than the municipal interest rate, otherwise it is not possible to repay loans

– The equity IRR should be just sufficient to induce investment and the debt coverage should be aggressive. This can be accomplished by adjusting the contract price

– After making the structuring adjustments, evaluate the savings relative to town savings on a standalone basis.

Length of Pre-Flip Period

• Issue: Should the repayment period be 10 years to cover the PTC payments or should it be 5 years to cover the accelerated depreciation

Complexities

Periodic Cash Flow Modeling

• Monthly versus Annual Periodic Modeling–Need to model with years on a vertical rather

than a horizontal basis because you run out of room.

–Use look-up tables to find inputs from annual workings analysis and monthly construction etc.

–Adds accuracy where• Debt service is quarterly etc.

• Scrapping occurs at specific points

Dates and Length of Period

• Standard IRR and NPV calculations in Excel assume that the cash flows occur at the end of the period

• To be consistent with this, one would make the formulas for interest, depreciation and other items use the opening balance rather than the average or the ending balance

• To be careful, explicitly show the beginning day of the period and the ending day of the period and use XIRR and XNPV

• It is helpful to explicitly show how many months are in each period so the EDATE function can be used

Step by Step Process for Setting up Dates

• Step 1: Input months per period for various phases of the project – typically one month for construction period and six months for operating period.

• Step 2: Develop period code – this is an essential part of the process, the last date before operation is period zero and the project begins its life in period one.

• It does not matter at all that the length of some periods is different than other periods. The start period of construction is the negative of the number of construction months minus one. For example if the start date of construction versus the completion date yields 40 months, the first period is negative 39. Then, the first period of construction will be zero as desired. (Note: it is a good idea to hide remaining columns)

• Step 3: Develop switches (TRUE/FALSE) for different phases and important dates – construction period, operation period and terminal period.

• Step 4: Correspond the months per period from the switches. For example, for the construction period, the months per period is one.

• Step 5: Enter the dates using the EDATE function. Show both the beginning date and the ending date. The first beginning date is the established date and the ending date is the EDATE function with using the months per period. The beginning period in the second period is the ending period plus one day.

• Step 6: Compute the number of days per period and the days in 360 day year (first period next year)

Tip for Computing Months of Construction

• To set-up a model that accounts for different project phases, a few excel techniques are helpful. First, the total construction period should be defined by subtracting the completion date from the date at which construction begins (the construction start date and the completion date should be defined in the model along with the number of periods per year for construction and the number of periods per year for operation.) Through defining dates in this manner, the model can be flexible enough to account for delays in construction of the project.

• To compute the start date in this manner on a monthly basis, use the DAYS360 function in excel and enter the start date of construction and the completion date (DAYS360(start date, completion date), then divide this number by 30. To illustrate this process consider the following example:

• Start date of construction: 1-March-2010• End date of construction: 1-December-2015• DAYS360(begin,end) : 270• Divide by 30 : 69

Modeling the Financial Structure

• Model Structure– Sources and uses– Debt financing– Depreciation Schedule– Financial statements

• Time Periods– Construction– Debt module– Operating– Financial statements– Returns

Annualizing with Fiscal Year

It is simple to annualize periodic cash flows once the fiscal year has been established. This can be accomplished by listing the year below the date and then using the SUMIF function to sum the periodic cash flows within the year. To demonstrate the process, the establishing the fiscal year is discussed and then the process of using the conditional sum is described. Establishing the fiscal year can be demonstrated by considering the example of Microsoft Corporation. For this company, the fiscal year 2007 ends at June 30, 2007 and covers the period July 2006 through June 2007. Here, one would define the fiscal year as June. For programming purposes, January through June correspond to the current calendar year (2007) and the later months, July through December, correspond to the prior fiscal year. In project finance models, for convenience, the fiscal year should in the month just before commercial operation. For example, if construction ends in May and the project begins in June, the fiscal year should end in May. Once the month of the fiscal year is established, use the YEAR function along with the MONTH function and an if statement to determine the fiscal year. For the case where the fiscal year is ending in May, if the month is less than to June, the fiscal year equals the calendar year. On the other hand, when the month is greater than June, the fiscal year is the calendar year plus one.•Step 1: Compute Fiscal year•If the month of the opening date is less than the fiscal month, (e.g. June) then the fiscal year is the same of the calendar year (e.g. 2007). (For example, for months of January through May, the year is 2007.)•If the year of the opening date is greater than or equal to the fiscal month (e.g. July), the year is the calendar year plus one (e.g. 2007+1). (In the example above, June through December are set to 2008.)•Step 2: Copy titles to a separate section: Once the fiscal year is established, copy the cash flow titles to a separate section, or a separate sheet.•Step 3: Apply the SUMIF function, where the initial range is the fiscal year definition, the criteria is the year and the sum range is the cash flow item. To make this work shade the entire row and use fixed references for the fiscal year, and relative references for the criteria.

Cash Sweep

• Cash sweeps mean that if the project is successful, we get repaid faster, by taking ("sweeping") a portion of the surplus to reimburse the loans.

• Banks always use more conservative revenue estimates than investors to have a higher certainty that such revenue levels will always be reached - and make it possible for the debt to be paid.

• If thing go well, of even just as expected, there will be more revenue than the banks plan, and the investors will make a lot more money.

• So in this case, we have a right to a portion of these extra revenues in the "better-than-the-pessimistic-scenario" cases. That means that it is actually quite likely that we be repaid faster than we expect.

• We don't earn more, but we take risk over a shorter period, and it does lower the rate of return of the investors (as their own income is delayed by these payments).

Debt Schedule

Debt Schedule Discussion

• Basics– Debt Draws come from sources and uses; debt repayments

come from inputs– Debt Corkscrew with Opening and Closing Balance– Use of Minimum Function (rather than if statement) to assure

that repayments do not exceed the opening balance• Other Issues with Debt

– Grace period– Level payment– Customized repayment using solver

• Include Debt Service Reserves in this Section

Setting-up the Debt Schedule

• The fundamental part of a debt schedule is defining the balance of debt outstanding and computing the interest rate from the balance of the debt. The debt outstanding should be computed from explicitly showing the opening balance, the new debt issues, the debt repayments and the closing balance on distinct rows of the model. These debt balance schedules should be listed for every single existing and prospective debt facility that will be present during the forecast period. In the case of project finance models, the debt issues include all of the different tranches of debt that are issued to finance construction. In addition, project finance models should be set up to include debt issues that will in a re-financing.

• New debt draws are computed from the source and use statement and from some criteria that defines how re-financing will occur.

• The manner of repaying debt depends on the type of debt issue. In general, the repayment calculation uses the opening balance of the debt. For example, in a subordinated debt issue with repayment at a single date – bullet repayments – a TRUE/FALSE test can be created from the repayment year and this is used to assure that repayment only occurs on the repayment date. (The programming involves (year = repayment year) x opening balance.)

• It is generally a good idea to show the total accumulated amount of the debt on a separate line item above the debt balance. This accumulated balance can then be multiplied by the repayment percent or a tailored repayment schedule to establish the periodic repayments. In this case, the MIN function should be used to assure that the amount being repaid does not exceed the opening balance of the debt.

Example of Debt Module in Actual Models• The debt schedule can be much more complicated than an opening

balance, with drawls and closing balance as illustrated below

Note the items for cash sweep, interest capitalization, scheduled amortisation, refinancing

Debt Repayment Structure and Risk

• A project's debt amortization schedule often influences the rating, more so than the degree of leverage.

• Front-loaded principal amortization schedules that capitalize on the more predictable project cash flows in the near term may be less risky that those with whose delayed amortizations seek to take advantage of long-term inflation effects.

• Flexible re-payment structures can be developed where the project has irregular cash flows.

Debt Repayment - Sculpting

• When working on a project finance model, you sometimes would like to compute the debt capacity through “sculpting” the debt repayments such that the debt service coverage ratio achieves a targeted ratio. This is accomplished using the solver and the following steps:

• - Setting the both debt leverage and the repayment for each period.• - Add a constraint that the computed debt service ratio equals the target debt

service coverage ratio• - Add a constraint that the final debt balance must be zero.• It is helpful to set-up a macro to re-do the solver with a macro. Unfortunately, this is a

bit complex because the visual basic must be adjusted to allow the solver to work. This process involves:

– Step 1: Press the Alt-F11 key to get the visual basic menu– Step 2:Go to the tools and references option and then click on the solver option.– Step 3:After beginning to record a macro, re-set the solver– Step 4: Make sure the first part of the solver is not blank– Step 5: Re-do the solver– Step 6:Add a TRUE statement after solver solve to automate

Modelling Defaults on Debt• In order to evaluate the credit spread, it is useful to determine at what point an investment

experiences a loss on a loan. When a loss occurs, the interest rate realized by lenders is less than promised interest rate and attempts to restructure the debt have not allowed temporary defaults to be repaid. Modeling defaults on debt is important in credit analysis because the ultimate task in credit analysis is to measure the probability of default as well as the loss given default. The following process can be used to compute defaults on debt and shows how to model defaults:

• Step1: Set up the debt balance with line items to incorporate defaults and re-payment of defaults.

• Step 2: Fill in the default row from a sub-total line in the cash flow waterfall that computes the default on debt from the inability to meet debt service (this should be computed using the formula MAX(-cash flow,0).

• Step 3: Set the re-payment of default to be the previous year’s default amount implying that all defaults are paid of in the subsequent year. This means the model attempts to fully repay the default in the year immediately following the default. If there is no cash flow to repay the default, the default increases by the amount of the default.

• Step 4: Enter the repayment of default as a cash outflow item in the cash flow waterfall.• Step 5: Assure that the repayment of default is less than the opening balance of the

debtless the scheduled repayment so that too much debt is not repaid in the final year of the model.

• Step 6: Compute the cash flow realized by lenders through deducting defaults and adding re-payment of defaults to the scheduled debt service.

Relationship Between Debt Schedule and Cash Flow Schedule in Structured Finance

• This shows the linking of the debt schedule and the cash flow statement

Debt Schedule

Opening Balance

New Issues

Repayments

Default

Repayment of DefaultRepay after default

Cash Flow Statement

Operating Cash Flow

Plus Interest

Cash Before Financing

If negative during construction , feeds into financing needs

If positive, used for repayment of debt

If insufficient cash after construction, default

Default Mechanics

• Steps in computing default and repayment of default– Compute default in cash flow statement by structuring a cash flow waterfall– Assume all defaulted debt is paid in subsequent period, before any other debt

service– If cash is insufficient to pay debt service and re-payment of default, default will be

larger and will attempt to repay larger default– Example

• Default Year 1 100• Cash Flow Year 2 -50• Year 2

– Cash flow (50)– Repayment of Default from year 1 (100)– Total Cash Flow (150)– Default in year 2 150

Modelling Defaults on Debt - Procedure

• The following illustrates the modelling process for defaults. – Note how the default comes from the cash flow statement– The if statement in the cash flow statement– The repayment of default from the prior default

DSCR Covenants and Risk Mitigation

• Covenants will not come into play if everything is working in a base case scenario.

• Covenants cannot change an un-economic project into an economic project – they cannot prevent the inevitable

• Effective covenants can allocate more of the free cash flow to debt holders and less to equity holders in a project that is marginally economic.

• A project model should be able to:

– Measure which covenant is most effective in reducing risk

– Measure the level of the covenant that will materially reduce risk

– Evaluate whether a covenant does not do much in assisting in risk reduction for the economics of a project

Investors Need Some Dividends Before All Debt is Paid Off

• The timing of debt service (i.e. loan interest payments and principal repayments) is one of the biggest factors that drives the rate of return for equity holders in a project. If the debt service is structured to allow no dividends until all debt is paid, return will be lower. This will generally be unacceptable to sponsors.– The faster investors in a project are paid dividends, the better

their rate of return.– Investors therefore do not wish cash flow from operations of the

project to be devoted to lenders at the expense of these dividends.

– Lenders, on the other hand, generally wish to be repaid as rapidly as possible. Striking a reasonable balance between these conflicting demands is an important part of loan negotiations.

– ER Yescombe, Principles of Project Finance

Cash Sweeps and Cash Traps

• Cash sweep mechanisms. That simply means that if the project is successful, we get repaid faster, by taking ("sweeping") a portion of the surplus to reimbursethe loans. Banks always use more conservative revenue estimates than investors to have a higher certainty that such revenue levels will always be reached - and make it possible for the debt to be paid. If thing go well, of even just as expected, there will be more revenue than the banks plan, and the investors will make a lot more money. So in this case, we have a right to a portion of these extra revenues in the "better-than-the-pessimistic-scenario" cases. That means that it is actually quite likely that we be repaid faster than we expect. We don't earn more, but we take risk over a shorter period, and it does lower the rate of return of the investors (as their own income is delayed by these payments).

Example of Financial Covenants

• SECTION 6.15 Financial Covenants.

• (a) The Borrower shall not, as of the end of each fiscal quarter, permit the Ratio of Cash Flow to Fixed Charges to be less than 1.5:1.0.

• (b) The Borrower shall not, as of the end of each fiscal quarter, permit the Ratio of Debt to Capitalization to be greater than 0.6:1.0.

• (c) The Borrower shall not, at the end of each fiscal quarter, permit (i) Consolidated Net Worth to be less than the Minimum Consolidated Net Worth and (ii) Non-Trading Consolidated Net Worth to be less than the Minimum Non-Trading Consolidated Net Worth.

Cash Flow Restrictions (Reference)• Covenants can restrict the amount of dividends paid to sponsors during good

time and bad time periods. Covenants that restrict cash flow in bad time periods are known as cash traps. Covenants that limit cash payments when cash flow is high are known as cash flow sweeps. These covenants are explained as follows by Standard and Poor’s:

• A project’s credit is generally strengthened by covenants that limit, or even preclude, distributions to sponsors unless both robust historic and projected DSCRs are met, and reserve funds are fully funded.

• The reason for dividend restrictions in time periods when cash flow is low is because when financial results are worse than expected, it is essential to assure that cash flow is kept for the debt holders and not “leaked” out of the project as dividends. A cash flow trap operates by limiting any dividend payments if the debt service coverage is below a debt service ratio criteria. If the dividend restriction is tied to a relatively high level of the debt service coverage such as 2.5x, the dividend restriction will occur more often than if the dividend restriction is set to a relatively low level such as 1.2x – the “bad” time periods occur more often with the higher covenant. Since the covenant limits dividends, cash flow traps mean that something must be done with the cash flow that is not distributed to sponsors. Cash either can be used to payoff debt early or be put into a debt service reserve to protect debt holders.

Cash Flow Sweeps and Cash Flow

• A cash sweep covenant applies in periods when cash flow is high rather than when cash flow is low. The reason for restrictions on dividends in good time periods is because when prices higher than normal, cash flow can be kept for the debt holders to protect against default in later periods when cash flow and prices may be below normal.

• Cash flow sweeps operate by computing the amount of dividends that will just limit the debt service coverage to the covenant – for example, dividends cannot be paid above a level that implies a DSCR of 2.0x.

• Unlike the cash traps, if the cash sweep covenant is set to a low level it is more restrictive (the cash flow trap covenant described above was more restrictive with a higher level). If the cash sweep is tied to a relatively low level of the debt service coverage such as 1.5x, the dividend restriction will occur more often than if the dividend restriction is set to a relatively low level such as 3.5x.

Cash Trap Mechanics

• Set up Cash Reserve Account and Relate to the Cash Flow Statement

Cash Reserve

Opening Balance

Cash Inflows

Cash Outflows

Ending Withdrawls

Interest Income

Cash Flow Statement

Operating Cash Flow

Add: Cash Balance

Add: Interest Income

If positive cash and debt outstanding, trap cash

If negative cash and positive cash balance, use cash

If paid off debt and positive cash flow, withdraw all cash

Subtract: Cash Balance

Fixed Assets and Depreciation

Items Included in Fixed Asset and Other

• Plant Balance• Book Depreciation Expense• Accumulated Depreciation• Tax Depreciation Expense• Accumulated Unamortized Debt Financing Fees• Amortization of Debt Financing Fees• Operating Reserves

Computing Vintage Amounts

• Step by Step Process– Transpose years to create an index with year born on the

vertical column– Compute the age of the plant –

• year of model minus year born + 1• Use relative references• Allow negative numbers before born

– Use HLOOKUP to compute the rate (better than match and index)

– Use SUMIF with test on “<>#N/A” to add all of the amounts

Step by Step Process for Depreciation

• Computation of depreciation can be complex when the depreciation rate is not constant for each year. In this situation, the age of the asset must retained to compute depreciation. This can make be one of the most difficult parts of the process. To do this, the following process can be used:

• Step 1: Enter the depreciation rate by year for category.• Step 2: Use the TRANSOPSE function (not the copy and paste special) to set up a

matrix that has the year the asset was created on the column and the year of the model on the row

• Step 3: Compute the age of the plant and allow the age to be negative in years before the asset was created (use relative references)

• Step 4: Use the HLOOKUP function to relate the depreciation rate to the vintage of the plant

• Step 5: Multiply the depreciation rate by the cost of the asset being depreciated from the cost of the asset that was created from the TRANSPOSE function.

• Step 6: Repeat the process for assets with different vintages and with book and tax depreciation.

Depreciation Expense and Vintage• Compute straight line depreciation expense• Multiply the accumulated plant balance from the balance sheet by the

depreciation rate• More complex depreciation modeling – vintage, accelerated, deferred taxes,

multiple categories will be covered later

Operating Reserves

• Deposits into Reserve– Estimate of future nominal amounts

• Accounting and Cash Flow– Record actual cost as income– Do not accrue expenses– Deposit is cash outflow– When remove deposit and pay expense, record

income and cash flow account.• Checks on the balance of funds being positive

Modelling Amortisation of Debt Financing Fees

• Commitment Fees:– Computed on the uncommitted balance of the loan during the

construction period (banks must hold reserves even if the loan has not been drawn – e.g. 1.5%)

• Accumulate fees including fees on committed but unused balance and up-front fees and fees at closing. This requires inputting the commitment as well as the outstanding amount of the loan

• Use switch for debt outstanding to compute amortisation of fees• Compute accumulated amortisation of fees so as to show the un-

amortised balance on the balance sheet

Income Statement and Income Taxes

Net Operating Loss

• Net operating loss should be part of a reasonable model.• If earnings before tax is less than zero and a simple if statement is used,

future years do not get credit for the earlier negative taxable income. Therefore, not including NOL will tend to understate value.

• To model the Net Operating Loss:– First compute taxable income without the NOL which allows negative taxes– Create a cork-screw that keeps track of the beginning balance and the additions

and subtractions to the NOL– The additions occur when there are negative taxes– The subtractions occur when there is positive tax and a balance in the beginning

NOL– The taxes paid are the taxes without NOL plus the inputs to the NOL minus the

withdrawls from the NOL.

NOL Example

• The following example illustrates modelling of an NOL

– To model the NOL use the following:

• An if statement the adds to the NOL when the taxes before NOL are positive

• An if statement together with a minimum statement to withdraw from the NOL balance.

Cash Flow Waterfall

Elements of the Cash Flow Waterfall

• Project finance model must measure risks of different tranches of debt rather than a single senior debt issue. Examples of issues that involve modeling include:

– What should be the credit spread on senior and junior debt

– How do the covenants and debt service reserves affect the risk of junior debt

– What should be the repayment structure of junior debt – after the senior debt is fully repaid or before

– What covenants and debt service reserves should be in place for junior debt

– What restrictions should be placed on junior debt service to protect senior debt

Cash Flow Waterfall

• Waterfall Issues– Defaults and subsequent repayments of defaults before

dividend distributions– Model different priorities of debt– Model cash flow trap mechanisms– Evaluate Pre-payments from covenant violations– Compute Debt service reserve injections and withdrawls– Accumulation of debt service reserve after construction period

• It sounds obvious, but the order of the model should be the same as the order of the waterfall

• Compute subtotals at many different places to evaluate defaults, balances for sweeps, covenants

Cash Flow Waterfall in Project Finance Model

Cash Flow Priorities

• Once the cash flow for the waterfall is computed, you can compute the defaults on senior and junior debt.

• Subtract scheduled interest payments and maturities from the cash flow for waterfall• Also subtract attempts to re-pay earlier defaults• The difference is cash flow after senior debt that determines default – defaults are the

driven by an if statement driven by whether there is negative cash flow.• Any defaults are added to cash flow to determine the cash flow to junior debt

– This step of the waterfall is illustrated below:• Cash Flow for Waterfall

– Less: Scheduled Repayment– Less: Interest on Senior– Less: Repayment of earlier defaults

• Cash Flow after Senior Debt– Add: Default on Senior Debt

• Cash Flow to Junior Debt– Less: Scheduled Repayment– Less: Interest on Junior– Less: Repayment of earlier default

Cash Flow Traps and Dividends

• After junior debt is evaluated, traps on cash and distributions can be evaluated.

• Cash Traps can be evaluated at this point that prevent excess cash going dividends before debt is paid– This step of the waterfall is illustrated below:

• Cash Flow after Junior Debt– Add: Default on Junior Debt– Less: Cash Balance Added Above

• Net Cash Flow– Switch for Trapping Cash– Less: Cash Trapped– Add: Cash Withdrawn from Account

• Dividend Distributions

Computing Cash Flow for the Waterfall

• To model priorities in a cash flow waterfall the first step is setting up a the cash flow statement in a model that reflects the actual ordering of cash flow:

– Begin with the cash flow after capital expenditures and after all new financing and acquisitions

– Add back interest expense that was deducted because the interest will be accounted for on an issue by issue basis

– Add the beginning balance of cash. Even though it seems odd to add the cash balances, these cash balances are available to pay off debt.

– The sum of these items gives the cash flow for the waterfall as illustrated below.

• Cash Flow After Capital Expenditures– Add: New Debt Issues– Add: New Equity Issues

• Cash Flow before waterfall adjustments– Add: Total Interest Expense– Add: Beginning Cash Balance

• Cash Flow for Waterfall

Examples of Cash Flow Cascades

Example of Cash Flow Cascade - 2

Distributions to Equity Holders and Flip Structures

• Generally, the distributions to equity holders are straightforward to compute – the distributions are whatever is left over after all other cash distributions.

• Flip structures can be more complex:– After a certain rate of return is achieved, the cash flow is distributed differently

between the two investors:• Example: Criteria is 10%• Before 10%, 99% to one investor and 1% to second investor• After 10%, 30% to one investor and 70% to second investor

– Could compute the IRR on a cumulative basis and then change the payouts• Problem is in the year of the change in payout• Better solution is to compute the future value of payouts• Simple with two payouts, but trick with dividends imbetween

Debt Structure Case Studies

• In analyzing the transaction, Standard & Poor's performed many sensitivities on plant availability and merchant prices to determine a range of potential outstanding debt amounts at maturity.

• The default scenario assumes that the merchant market deteriorates such that the plant cannot carry its debt burden. In each of the recovery scenarios analyzed, payments on the contracts are used to amortize debt according to the 75% cash sweep requirement during the contract period.

• At the termination of the contracts, the net present value of the cash flow available for debt service under various discount factors was compared with the outstanding debt amount.

• The first-lien loans enjoy 100% recovery even under Standard & Poor's low price scenario. However, since the lending documents allow payment of any principal on the second-lien term loan only after completely paying down the first-lien term loan, remaining cash is only expected to provide recovery on the second lien term of 50% to 80%.

Equity Returns and Re-Financing

7.8%

29.2%

37.3%

44.6%

7.7%

16.0%

18.9%

21.7%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

Low Base High Very High

Equity

IRR

Traffic Scenario

Equity IRR with and without Re-financing

Re-Finance

No Re-Finance

Re-financing Analysis

• Re-financing of Debt– Include a source and use analysis– Include a criteria or input for new financing

and the DSCR on the new financing– Include fees and pre-payment penalties in

sources and use analysis– Include new debt issues in debt schedule and

line for re-payment of existing debt issues

Documents

Policy Analysis