A project finance model is a specialized financial model, the purpose of which is to assess the economic feasibility of the project in question. The model's output can also be used in structuring, or "sculpting", the project finance deal. The context: project finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project - rather than the balance sheets of its sponsors. The project is therefore only feasible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt. Most importantly, therefore, the model is used to determine the maximum amount of debt the project company can maintain - and the corresponding debt repayment profile; there are several related metrics here, the most important of which is arguably the Debt Service Coverage Ratio.
Model structure
The general structure of any financial model is standard: input – calculation algorithm – output; see Financial forecast. While the output for a project finance model is more or less uniform, and the calculation algorithm is predetermined by accounting rules, the input is highly project-specific. Generally, the model can be subdivided into the following categories:
As above the model is used to determine the maximum amount of debt the project company can maintain: in any year the debt service coverage ratio should not exceed a predetermined level. DSCR is also used as a measure of riskiness of the project and, therefore, as a determinant of interest rate on debt. Minimal DSCR set for a project depends on riskiness of the project, i.e. on predictability and stability of cash flow generated by it. Related to this is the Project life cover ratio, the ratio of the net present value of the cashflow over the remaining full life of the project to the outstanding debt balance in the period. It is a measure of the number of times the cash flow over the life of the project can repay the outstanding debt balance. The Loan life cover ratio, similarly is the ratio of the net present value of the cashflow over the scheduled life of the loan to the outstanding debt balance in the period. Other ratios of this sort include the Cash flow available for debt service, Drawdown cover ratio, Historic debt service cover ratio, Projected debt service cover ratio, and the Repayment cover ratio. Standard profitability metrics are also considered - most commonly, Internal rate of return, Return on assets, and Return on equity
Debt sculpting
is common in the financial modelling of a project. It means that the principal repayment obligations have been calculated to ensure that the principal and interest obligations are appropriately matched to the strength and pattern of the cashflows in each period. The most common ways to do so are to manually adjust the principal repayment in each period, or to algebraically solve the principal repayment to achieve a desired DSCR. See Cashflow matching, Immunization, Asset–liability mismatch.
