The modelling of debt facilities is at the heart of every project finance transaction. The term sheet sets out the basic terms and conditions, but senior bankers expect the industry’s accepted practices to be built into the model as a matter of course. Two of those practices, debt sizing and debt sculpting, are often confused.
Debt sizing in a project finance model
Sizing the debt means finding the largest amount of project finance debt the model shows the project can carry. That amount becomes the debt limit, and the amount the bank reserves capital for.
How the limit is calculated is a topic of its own. To keep it simple, assume it is the amount of debt that can be repaid while the debt service cover ratio (DSCR) stays above a set threshold, both the minimum and the average DSCR. Debt can also be sized to ratios other than the DSCR. Other things being equal, the stricter the covenants, such as the minimum DSCR or loan life cover ratio (LLCR) the lender requires, the riskier the project is considered to be.
How the DSCR is calculated
The DSCR compares the cash flow available for debt service (CFADS) in a period with the debt service due in that period.
DSCR=CFADSdebt service
The lender sets a minimum DSCR so the project can make its debt repayments in each period. The higher the minimum DSCR, the less the project can borrow.
Debt sculpting in a project finance model
In many project finance transactions the project’s cash flow varies from period to period. An oil and gas project, for example, has a very different cash flow profile over time from a toll road.
To increase the project’s debt capacity, the total debt service in each period is matched to the CFADS available to pay it. This matching is called sculpting. When we sculpt debt, we set the principal repayments so that total debt service follows CFADS and the DSCR follows a target profile. Sculpting goes hand in hand with sizing, but it is a different exercise.
Principal can be entered by hand for each period, but the most flexible approach calculates it:
principal repayment=CFADStarget DSCR− interest
A higher target DSCR reduces the repayments in every period except the last. That pushes the repayment profile later, which sponsors usually prefer. There is a limit to how high the target can go, because the debt still has to be repaid within the tenor. A lower target DSCR increases the repayments, so the debt is repaid sooner.
Tutorials on this topic
- Using a goal seek macro to solve for the maximum debt limit, an example of debt sizing
- Debt sculpting to target DSCR without VBA, an example of sculpting to a target DSCR
- CFADS: cash flow available for debt service, for a definition of CFADS