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Appraising PPP Projects

46.4 The Financial Structure of the Project Company

A considerable cost associated with the project is the cost of capital or the costs of obtaining the financial resources to implement the project. To correctly estimate these costs, the financial model must accommodate a fundamental problem in project finance[14]: where the required money for the initial investment will come from.

Depending on the existence and the type of financial support offered by the government, part of the capital needed by the project company might be met by viability gap funding or other forms of upfront payments made by governments (see section 6.6). However, PPPs almost always involve a great deal of private financing. In other words, the SPV is generally required to obtain a significant proportion of the resources needed to implement the asset.

Thus, to achieve a reasonable estimate of cash flow, equally reasonable assumptions about the financial structure are required.

The most usual structure is a mix of equity, or money from the shareholders of the Project Company, and debt in the form of bank loans. The loans are contracted directly by the project company, with or without collateral security offered by the project company’s shareholders[15]. Some of the relevant parameters required to correctly estimate the financial structure are as follows;

  • The level of leverage: This refers to the percentage of the total capital required for the project that will be acquired through debt. Typically, most of the funds to finance the asset are in the form of debt. This is a very common strategy of shareholders because, typically, the project offers higher returns than the interest rates charged by banks[16]. So, all other things being equal, the higher the proportion of debt in the capital structure, the higher the relative return on equity (the positive leverage effect) and the higher the difference between the latter and the return of the project[17] (but the higher the exposure of the equity internal rate of return (IRR) to the volatility of the project returns);
  • The level of leverage has, however, an upper limit imposed by lenders’ requirements and, sometimes, limits imposed by the PPP contract. Similarly, as leverage is increased, there might be a marginal increase in the costs of debt as lenders are subject to more risks in the project. Eventually, increasing the debt proportion becomes impossible (or too expensive) and the interplay between the costs of loans and cost of equity reaches an optimum level;
  • The debt repayment term: This is also a very important market condition that needs to be clearly estimated. All things being equal, the longer the debt term, the higher the overall amount of interest paid through the life of the loan, but the smaller the debt repayment is in each period. This latter effect can have very desirable impacts on the finance of the project (as more cash flow is free for shareholders), including positive effects on some the main covenants used to assess the bankability of the project (which will be explained later in this chapter);
  • The repayment profile: This refers to the differences in proportion of debt paid in each period of time. The common profiles include a flat repayment schedule and a constant amortization repayment (with decreasing total debt service). The repayment profile can also be designed to meet the financer’s covenants as explained in box 4.7; and
  • The cost of debt: The interest rates charged by the lender, consisting of an interest base rate and a margin typically determined from market benchmarks or recent projects, are a necessary assumption to be input into the financial model, together with other financing costs such as structuring, arranging and structuring fees, availability fees (during the drawdown period), and interest rate hedging costs (which usually are embedded in the interest rate through an interest rate swap mechanism[18]).

The parameters mentioned above are determined, to a significant extent, by requirements imposed by the lenders, particularly the debt service cover ratio (see the discussion of commercial feasibility in section 8 below for more information on the debt service coverage ratio [DSCR] and other lenders’ ratios).

In practice there are alternatives to commercial banks such as[19]:

  • Obtaining loans provided by the government (or a State-Owned Enterprise);
  • Issuing of project bonds;
  • Obtaining finance from institutional debt providers like pension funds[20];
  • Multilateral development bank financing;
  • Export credit agency financing; and
  • Others less frequent in PPPs such as supplier credits, lease finance, or Islamic finance.

Effort needs to be employed to approximate as accurately as possible the likely financial or capital structure of the Project Company with its specific parameters, such as repayment schedules and interest rates. This involves understanding the specific requirements of each of the capital providers, which varies significantly in different countries, and verifying if the project in hand meets those requirements. A cautious approach should be taken when considering unusual capital structures that may reduce the cost of capital. The assumptions should reflect realistic forecasts.

The capital structure of PPP projects might also incorporate other forms of governmental support to PPPs. As described in chapter 1, some governments provide specific support to the SPV in terms of public soft loans, or public equity contributions. If such support is prescribed, it should be considered in the financial model, subject to possible further detailing of the appropriate mechanism of support during the Structuring Phase.

[14] Project finance is the most usual financing technique in PPP financing. It has been introduced in chapter 0, appendix A.

[15] When more than one type of debt or debt provider is contracted, there is generally an order of priority or seniority of each debt type/provider, defining the sequence in which they will receive the repayments. The higher the debt is on this list, the less it is exposed to risk.

[16] A more detailed explanation of the typical financial structure and the role and benefits of debt (particularly under project finance schemes) can be found in chapter 0.7.1.

[17] From a theoretical mathematical point of view, the return of a project asset (rA) is the sum of the return (or price) of the equity (rE)and the return (or price) of the debt (rD), duly weighted by the percentage that debt and equity represents in the financial structure (rA is also the same as the wacc). Equity IRR (rE) may be explained as a result of the leverage and the return of the project: rE = rA + D/E (rA-rD), or Equity IRR = Project IRR + Debt/Equity x (Project IRR – Debt IRR). For further reading on leverage and financial strategy (from a general corporate finance standpoint) see, for example, Principles of Corporate Finance (10th edition) by Brealey, Mayers and Allen, published by McGraw-Hill Irvin, 2011.

[18] Commonly, the interest base rate will be fixed by an Interest Rate Swap (IRS) mechanism, with a portion of the interest rate remaining variable. Swaps and interest rate hedging are highly specialized financial matters that are beyond the scope of this PPP Guide. Additional reading may be found in Project Financing: 7th Edition, Peter K Nevitt  and Frank J Fabozzi.

[19] See chapter 0 and appendix 5A for more information on sources of funds to finance the projects.

[20]  The involvement of institutional investors in projects generally occurs through project bonds, but can take the form of other financial arrangement.

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