The crucial role of Cash Flow Projections for Project Evaluation

By Akash Mittal Prateek Vijay Gupta Sandeep Shrivastava Sankalp Raghuvanshi Tobias Kahn

Key terms
Economic viability Depends on cash inflows and outflows Timing of cash flows is important DCF model, NPV Cash inflows are difficult to predict than cash outflows Discount rate should take riskiness into account Projects total cost Direct costs => engineering, labour, materials + Indirect costs - Finance charges => interest, commitment fees - Cost of financial guarantees Preconstruction costs - permits

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Key terms
Constant dollars vs current dollars: Constant dollar refers to the value of currency adjusted for inflation (using the consumer price index) Current dollars refers to the actual amount of currency earned or spent over a period of time, representing the market value

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Financial Modeling and Project Evaluation

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Debt capacity:
Borrowing capacity: Determined by cash flow coverage ratio (CFCR) CFCR=Operating cash flows/total debt Indicate the ability to pay interest and principal amounts Annual coverage tests:

Interest coverage ratio (ICR=EBIT/Interest expense): determine the ability to pay interest on outstanding debt
Fixed charge coverage (FCC=(EBIT+Fixed charge before tax)/(Fixed charge before tax+Interest)): indicates a firm's ability to satisfy fixed financing expenses, such as interest and leases. It is identical to ICR in the case as no plan to rent any equipment

Debt service coverage ratio (DSCR=Net operating income/Total debt service): indicates the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments
Interest rate risk:

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Financing and allocation of income

Private equity investors Engineering firm Local utility Engineering firm Local utility

Each contributes $5.675 million for 22.22% limited partnership interest

Each contributes $1.419 million for 50% equity ownership interest in general partner

Limited partners Contributes $25.539 million for 90% equity interest

General partner

Receive 90% of income, losses, and distributions until reversion

Contribute $85.131 million of nonrecourse loan

Cogeneration company Debt service payments
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Long-term lenders

To be answered
What is the critical part of the case? Given the construction cost $100 million, why is the interest cost an important factor, according to the sponsors? In the case, explain the criterions used or determining the proportions of debt and equity. What are the assumptions of cash flow projection for cogeneration project? Discuss the process of sensitivity analysis in the case with reference to returns on equity, interest coverage and debt service ratio (Refer to tables 8.8 and 8.9) What are the learning from the case?

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The Nature of Cash Flow Projection

The projected Cash Flows of a Project are the difference between the outflows of the project (revenues) and the on going costs according to the financial arrangements of the project
Main components are the calculated debt service and the returns for the investors

Therefore Cash flow analysis is critical in determining the viability of any Project Moreover, the applied discount rate plays also a decisive role in affecting the projects value
The higher the rate, the lower the projects value

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Assumptions
The proportions of equity and debt were set by evaluating the profitability of the project
With a high guaranteed operating income (Cash Flow), the greater amount of debt can be serviced

The Cogeneration Projects revenues were contractually assured by 15-year purchase agreement with Local Utility (electricity) and from sale of steam under the 15-year steam purchase agreement with a Chemical Company
Prediction was made under a high degree of certainty, because the price per unit (MW-hour) was contractually secured and the operating reliability of similar plants was well-documented

The gas supply agreement covered an contained an increasing gas price, founded on specific economic forecasting
Management fees and other operating fees increase also with the PPI
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Project Financing
Limited partners: Not involved in operations General Partners Engineering firm and local utility Long term debt From commercial bank Non recourse financing

Equity 25%

Total capitalization = $113.5 mm

=

Debt 75%

Total expected cost = $113.5 mm Construction Commitment fee and interest Presonstruction cost Cost of arranging financing

Loan - $120 mm Includes safety net for contingencies and interest rate fluctuation

Financial Analysis I
Two owners: Engineering Firm and Local Utility
Agreed to pay preconstruction costs which were necessary to get further loans ($3 million) Debt-Equity-Ratio 0.75/0.25

Funds during the construction period will be given by a commercial bank (100% of the cost during the construction period) Total Construction Loan is about $120 million
$1.2 million (1%) are paid in advance as a facility fee $2 million of fees related to the permanent financing were estimated Constructing-period loans were made on a floating-rate basis
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Financial Analysis II
Cost of capital
Expected construction cost to $100 million Commitment fees add $7.308 million Difference of $12.692 million available to cover cost overruns or higher interest charges (including $3 million preconstruction costs + $3.2 million cost of arranging finance) Total project cost ($113.508 million) is sensitive to the interest rate during the construction period If interest rate increases, project cost increases

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Financial Analysis III

Overview (in $ million)

Amount
Long-term debt Equity 85.131 28.377

Percent
75.0 25.0

General Partner
Limited Partners Total Capitalization

2.838
25.539 113.508

2.5
22.5 100.0

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Critical Points
The total amount of debt is considered to be very high (75%)

The return on capital is split in active & passive investors

The general partners receive 10% and the limited partners 90% of the partnerships income, until the limited partners have received cumulative cash distributions equal to their original investment ($25.539 million), the split will change to 50/50

Limited Investors will only invest in Cogeneration Project if the return rate is higher than the profit of other investments with a similar risk
Indeed, the timing of equity investment affects the investors expected rate of return

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Sensitivity Analysis Results rarely turn out exactly as expected UNCERTAINITY

Residual Value Interest Rate on 10 year debt issued Construction Cost
Construction Contract eliminates uncertainty
No significant design change will follow previous design
Financial Modeling and Project Evaluation

Gas Price Risk

Electric Power purchase agreement

15 year electric power purchase agreement & 15 year steam purchase agreement mitigate output pricing risk

Remains uncertain

Interest rate protection arrangement is required to make 10 year debt issue certain

15 year Gas Price agreement mitigate gas price risk

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Sensitivity Analysis Sensitivity of the projected returns on equity to variation in the residual value
Return on Equity (%) Return on Equity (%)

45 44 43.75 43 42 41 40 39.41 39

Sponsors

45 44 43 42 41 40 39 Residual Value Before Tax After Tax

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Passive Equity Investors

The projected rate of return show very little sensitivity to the residual value

0.00 0.00
Group 2

81.00 48.60

162.00 101.54

243.00 155.81

324.00 210.08

Financial Modeling and Project Evaluation

Learnings
Construction Loan provide funds for contingencies & fluctuations in interest rates Capital Structure depends on assurity of cash flows, interest rate, maturity date, loan amortization requirements, and lenders coverage requirements

Cash Flow Projections

provide all details and assumptions escalating revenues and costs at same rate on the basis of constant dollars (esp. in a high inflation economy)

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Learnings
Interest Rate term loan

structured futures contract

interest rate swaps Sensitivity Analysis

performed for each variable factor

Discounted Cash Flow Analysis financial model demonstrating projects profitability

ability to service debt obligations

accceptable rate of return for equity investors
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