engineering

Project finance model

Project finance model is a engineering topic covered in the lgStudy science library. This page brings together a partial reference excerpt, illustrations, worked examples, real-world applications and a short study plan, so you can understand Project finance model rather than just read about it. In short: 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.

Key takeaways

Project finance model belongs to engineering; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Project finance model to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Project finance model from memory before moving on to harder problems.

Reference excerpt

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.

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 (Special-purpose entity) 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 (DSCR) - the financial metric that measures the ability of a project to generate enough cash flow to cover principal and interest payments.

Model structure The general structure of any financial model is standard: (i) input (ii) calculation algorithm (iii) output; see Financial forecast. While the output for a project finance model is more or less uniform, and the calculation is predetermined by accounting rules, the input is highly project-specific. Generally, the model can be subdivided into the following categories:

Variables needed for forecasting revenues Variables needed for forecasting expenses Capital expenditures Financing A model is usually built for a most probable (or base) case. Then, a model sensitivity analysis is conducted to determine effects of changes in input variables on key outputs, such as internal rate of return (IRR), net present value (NPV) and payback period. For discussion (a) re cash-flow modelling, see Valuation using discounted cash flows § Determine cash flow for each forecast period; and (b) re model "calibration", and sensitivity- and scenario analysis, see § Determine equity value there. Practically, these are usually built as Excel spreadsheets and then consist of the following interlinked sheets (see Outline of finance § Financial modeling for further model-build items), with broad groupings:

Project build and operation (Data input): operating assumptions; Capital costs (construction); Insurance; Taxes; Depreciation; Financing Corresponding financial statements: Income statement; Balance sheet; Cash flow statement Resultant project metrics: Retained earnings; Coverage ratios; Present values

Metrics in assessing a project As stated above, the model is used to determine the most appropriate amount of debt the project company should take: in any year the debt service coverage ratio (DSCR) 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 (PLCR), the ratio of the net present value of the cash flow 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 (LLCR), similarly is the ratio of the net present value of the cash flow over the scheduled life of the loan to the outstanding debt balance in the period. Other ratios of this sort include:

Cash flow available for debt service Drawdown cover ratio Historic debt service cover ratio Projected debt service cover ratio Repayment cover ratio Standard profitability metrics are also considered - most commonly, Internal rate of return (IRR), Return on assets (ROA), and Return on equity (ROE)

Debt sculpting

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 also Project finance project risk management power purchase agreement

References

Penelope Lynch, Financial Modelling for Project Finance, 1997, ISBN 978-1-85564-544-8. Renewables Valuation Institute, Debt Sizing with Target DSCR - Project Finance Peter K Nevitt and Frank J. Fabozzi, Project Financing, 2000, ISBN 978-1-85564-791-6 John Tjia, Building Financial Models, 2009, ISBN 978-0-07-160889-3

Worked examples

Example 1 — a first encounter with Project finance model

Start with the simplest possible case. Write down what Project finance model claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In engineering, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Project finance model before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Project finance model ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Project finance model

In research: Project finance model appears in engineering research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Project finance model in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Project finance model is common in secondary-school and first-year university syllabi. It links to neighbouring topics Corporate finance, Financial models, Infrastructure investment, so understanding it makes those chapters shorter.
In everyday life: Look for Project finance model outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

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How to study Project finance model in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Project finance model means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Project finance model out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Project finance model in simple terms?

Why does Project finance model matter?

Because it connects several engineering ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Project finance model?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Project finance model.