Corporate and Project Finance Modeling

Chapter 40Funding Techniques in Project Finance and the Associated Circular Reference Problems

The manner in which a project is funded with senior debt, subordinated debt, and equity during the construction phase can have important effects on the earned rate of return to equity holders. Different techniques to size debt reflect fundamental differences in philosophical approaches to lending. When funding is derived from a debt to capital ratio, the general philosophical notion is that cash flow forecasts are not required and may not even be trustworthy. Instead, the money is lent on the basis that equity holders are sensible and trustworthy people and, as they generally get paid after lenders, that the debt should be safe. In the case of lending on the basis of cash flow, a buffer of debt service relative to projected cash flow drives the process. Here a forecast of cash flow is trusted in one way or another by lenders and the debt size is backed out from analysis of the debt service coverage ratio (DSCR) and a buffer in different scenarios.

This chapter primarily uses the first philosophy of debt sizing where debt is determined from a maximum debt to capital criteria. Given the debt sizing criteria, three modeling options that may need to be addressed for the financing stage of a project finance transaction are:

1. Funding. In some projects with parent support from letters of credit or strong engineering, procurement, and construction contracts, the equity may not be contributed ...