Corporate and Project Finance Modeling

Chapter 43Modeling Debt Service Reserve Accounts

Project finance loans and some leveraged acquisition loans include requirements to put cash aside in a restricted bank account. The idea is to ensure that a liquidity buffer is available to meet prospective debt service requirements. A typical requirement in project finance is that six months of prospective debt service must be held in a cash account. Such an account ensures that temporary declines in cash flow will not cause a default because of insufficient liquidity. It also ensures that if something bad happens and the debt needs to be restructured, there will be sufficient time to make alternative arrangements. For owners of the project, the problem with locking up cash in this manner is that holding cash on the balance sheet and earning a return much lower than the overall equity return can be very expensive in terms of internal rate of return (IRR) on equity. The reason that a funded debt service reserve account (DSRA) has such negative effects on returns is that the interest income rate is generally much lower than the overall return on the project. If a project borrows money at a rate of 7 percent to fund the debt service reserve account (DSRA) and then puts the borrowed money right back into the same bank, it may receive interest income at a much lower rate, say 1.5 percent. This interest rate differential can have a significant negative effect on the equity IRR in the case of projects with tight coverage where the equity ...