The Business and the Financing Plan for the Project. Financial Modeling and Evaluation

1. ACADEMY OF ECONOMIC STUDIES FACULTY OF INTERNATIONAL BUSINESS AND ECONOMICS The Business and the Financing Plan for the Project. Financial Modeling and Evaluation Lecture 6: Lect. Cristian PĂUN

2. The business and financing plan definition • Business plan is a picture or a model of what a business unit will be. • Business plan contains information on: • product(s) • markets • employees • technology, facilities • capital, revenues and profitability • Financing plan is a distinctive part of the business plan and contain a detailed presentation of: • Borrowing capacity • Sources of financial funds; • Cost analysis for each source; • WACC analysis; • Discounted Cash Flow Analysis; • Presentation of Financial Forecast • Income Statements • Balance Sheets • Statements of Cash Flows

3. Why a business and financing plan ? • To get help from others, especially financial funds providers (banks, equity investors); • To convince the sponsors, banks and other creditworthiness parties that the project will be a successful one. • Provides a guide for running operations once the project is started. • Incidental benefit: Pulls the participants and management team together and forces owners/managers to fully understand the tasks ahead of them

4. Contents Executive Summary Mission Statement Market Background The Customers Product Description Competitive Analysis Pricing Operations Sources of Input/Costs Processes / Equipment Management/Staffing Financial Projections Current Statements Projected Statements Application for Funds Contingency Planning Appendices Business Plan Outline

5. Financing Plan Objectives • Designing the optimal financing plan for a project generally involves the following objectives: • Ensuring the availability of sufficient financial resources to complete the project; • Obtaining the necessary funds at the lowest practicable cost; • Minimizing the project sponsors exposure to the project; • Establishing a dividend policy that maximize the rate of return for the sponsor’s equities; • Maximizing the value of tax benefits for the project ownerships; • Obtaining the most beneficial regulatory treatment.

6. Financing plan components • Borrowing Capacity of the project; • Project ability to service the debt; • Financing Sources Table; • WACC Analysis; • Discounted Cash Flow Analysis; • Income Statement; • Balance sheet; • Cash Flow Statement;

7. Financial Modeling of a Project

8. Financial Modeling Inputs • Macroeconomic assumptions; • Project costs and funding structure • Operating revenues and costs; • Loan drawings and debt service; • Taxation and accounting.

9. Financial Modeling Outputs • Construction phase costs; • Drawdown of equity; • Drawdown and repayment of debt; • Interest calculation; • Operating revenues and costs; • Tax; • Income statement; • Balance Sheet; • Cash Flow Statement; • Lender’s coverage ratio.

10. Main steps for financial modeling • Macroeconomic assumption; • Project costs and funding structure; • Operating revenues and costs; • Borrowing capacity; • Capacity to cover debt service; • Taxation and accounting. • WACC; • IRR and NPV for the project;

11. Step 1: Macroeconomic assumption Targets: • Inflation • Commodity prices • Interest rates; • Exchange rates; • GDP Growth; • Other macroeconomic aspects (ex: traffic)

12. Step1.1. Inflation Analysis • Offer a “real” basis for the project; • In the analysis could be used different indicators: • Consumer price inflation in the Host Country; • Indices of employment costs in the country of suppliers or providers of services; • Industrial price inflation for the cost of spare parts; • Specific price indices for commodities produced or purchased by the project.

13. Step 1.2. Commodity prices • It referrers not to the inflation but to the vulnerability of the project to cyclical movements in commodity prices. • The projects are developed when commodity prices are high, and assume that these prices will continue to remain at least at this level. • Commodity prices may be very violent on a short term basis.

14. Step 1.3. Interest rates • Interest rates factors; • Interest rates components; • Nominal interest rate vs real interest rate. Step 1.4. Exchange rates The approaches: • Traditional theory; • PPP Theory; • Monetary approach; • IPP Theory. + Step 1.5. GDP Growth

15. Step 2: Project Costs and funding • Project costs: • Development costs: stuff and other travel costs to develop the project; • Development fees: taxes paid for the location, concessions; • Project Company costs: • Personnel costs; • Office and equipment; • Costs for permits and licenses; • Construction supervision; • Training and mobilization costs. • Construction price; • Construction insurance; • Star-up costs: • Fuel or raw materials; • Initial spare parts; • Working capital covering: • Initial inventories; • Office and personnel costs; • The first operating insurance premium.

16. Project Costs and funding • Project costs (cont.): • Taxes: VAT or other sales taxes; • Financing costs: • Loan arrangements and underwriting fees; • Loan and security registration costs; • Costs of lender’s advisers; • Interest during construction; • Commitment fees; • Loan agency costs. • Funding of Reserves Accounts; • Contingency (provisions for unexpected events).

17. Operating revenues and costs • Operating revenues from sales of product • Operating costs: • Cost of fuel or raw materials; • Personnel and office costs; • Maintenance costs; • Insurance costs. Accounting and taxation issues • Capitalization and depreciation of the project costs; • The dividends; • Tax payments and accountings

18. Project funding • The required ratio between equity and debt; • The borrowing capacity of the project; • The capacity of the project to service the debt; • For each financial source should be made an amortization table: • Principals; • Interest payments; • Annuities. • The priority of drawing between equity and debt; • Any limitation of the use of debt; • A drawdown schedule for both equity and debt; • WACC Analysis.

19. Project’s borrowing capacity

20. Borrowing Capacity Model for a Project Hypothesis A: Full drawdown of capital in the moment of full completion • The amount the bank will lend to a project entity should equal a fraction of the present value – PV of the available cash flows: α x D = PV Where: α – is the target cash flow coverage ratio D – the maximum loan amount PV – present value of future cash flows • PV is calculated from the cash flow projection for the project; • The projection of cash flows is based on a preliminary estimation of: • R – cash revenues during the first year; • E – cash expenses during the first year; • The rates (gE and gR) at which revenues and expenses are growing during the period of the project debt is contracting.

21. Borrowing Capacity Model for a Local Project The cash flow available for debt service for year t is: (1-T) x [R(1+gR)t-1 – E(1+gE)t-1-C] + C = (1-T) x [R(1+gR)t-1 – E(1+gE)t-1] + TC

22. Borrowing Capacity Model for a Local Project Taking into consideration the initial assumption: α x D = PV We can obtain the value for the revenues that can cover a desired loan amount – D: Where: - “i” is the interest rate of the debt; - “N” is life of the loan measured from the date of completion.

23. Example: Calculation of a Project’s Borrowing capacity

24. Example: Calculation of a Project’s Borrowing capacity Initial Assumption Task: - you should determine what is the total debt that the project is capable to support

25. Borrowing Capacity – Assumption 1 Formula for PV: The answer is: PV = 1.488.691 Euro D* = 992.461 Euro The debt capacity of the project is 992.461 Euro based on an estimated present value of the cash flows in value of 1.488.691 Euro.

26. Example: Calculation of a Project’s Borrowing capacity Assumption 2: a lower debt level for the project Task: - you should determine what is the minimum value for cash revenues in order to cover a debt of 700.000 Euro

27. Borrowing Capacity – Assumption 2 Formula for R: The answer is: Cash Revenues = 2.614.542 Euro The minimum cash revenues that can support a debt of 700.000 Euro is R = 2.614.542 Euro. A lower debt level (700.000 Euro instead 992.461 Euro) involves a lower level of cash revenues for the project.

28. Example: Calculation of a Project’s Borrowing capacity Assumption 3:a lower growth rate for cash revenues Task: - you should determine what is the minimum value for cash revenues in order to cover a debt of 700.000 Euro.

29. Borrowing Capacity – Assumption 3 Formula for R in case of different growth rates for cash revenues and expenses and C=0: The answer is: Cash Revenues = 2.869.381 Euro The minimum cash revenues that can support a debt of 700.000 Euro is R = 2.869.381 Euro. A lower growth rate for the cash revenues (than cash expenses) involves a higher level of cash revenues for the project in order to maintain the same debt level.

30. Borrowing Capacity Model for a Project Hypothesis B: The revenues and operating expenses do not begin for M years • The amount the bank will lend to a project entity should equal a fraction of the present value – PV of the available cash flows beginning with the year M: • The project company will draw a loan in the initial moment but the cash revenues and expenses are generated in a future moment M. • The present value of the project future cash flows should equal present value of the debt D drawn in the initial moment: M Construction phase Operating phase Drawing moment for the debt D α x D x (1+i)M = PV

31. Borrowing capacity for a project – Hypothesis B α x D x (1+i)M = PV

32. Example: Estimation of M Average life = 1.929 years = M This is the estimated period before the project produces any operating cash flows.

33. Example: Calculation of a Project’s Borrowing capacity Assumption 4: the project generates cash flows after 2 years Task: - you should determine what is the total debt that the project is capable to support

34. Example: Calculation of a Project’s Borrowing capacity Assumption 5: the project generates cash flows after 3 years Task: - you should determine what is the total debt that the project is capable to support

35. Project ability to service the debt

36. Project Ability to service the debt • To evaluate the project ability to service its debt usually it is used three main financial ratios: • Interest coverage ratio: ICR=EBIT / Interest • Fixed Charge Coverage ratio: FCCR=(EBIT + 1/3 rentals) / (Interest + 1/3 rentals) • Debt Service Coverage ratio:

37. Cost of capital and WACC

38. Cost of International Financing Step 1: Determine the proportions of each source to be raised as capital. Step 2: Determine the marginal cost of each source. Step 3: Calculate the weighted average cost of capital. Current Yield = Current Yield = 9.04%

39. Present Value, Net Present Value, Internal Rate of Return IRR = k  NPV = 0 • Inflation rate • Interest rate • Estimated profit for an investment project Expectations in terms of Discounted rate

40. Present Value, Net Present Value, Internal Rate of Return Conclusion 1: Internal Rate of Return is the best measure for the marginal cost of international financing (real cost is 17.80 instead 10% or 8.89%)

41. Comparing credits in different currencies using NPV • Method I: • Estimating k(euro) • Estimating k(USD) • NPVeuro x spot0 = NPVeuroUSD

42. Comparing credits in different currencies using NPV • Method II: • Estimating k(euro) • Estimating exchange rate • Transforming An from USD in € • Comparing NPV

43. Comparing credits in different currencies using NPV • Method III (best accuracy): • Estimating k(euro) • Estimating k(USD) • Estimating an average FX rate • Transforming NPV from USD in € • Comparing NPV

44. Comparing credits in different currencies using IRR Method I: Comparing IRR obtained on initial An expressed in different currencies We have the same IRR (= 17.8%) Method II: Transforming An from USD to Euro and calculating IRR We have different IRR:

45. NPV Criteria in International Financing • Easier to be calculated than IRR • It is difficult to estimate different discount rates for different financial markets; • We should take into consideration the exchange rate when we compare different NPVs; • NPV encourage big investment projects and discourage big financing projects. IRR Criteria in International Financing • Independent from FX rate; • It is quite complicated to be estimated; • In some cases we can’t calculate it (symmetric annuities, positive annuities). CONCLUSION 2: When compare different financing alternatives we should use both two criteria: NPV and IRR

46. Cost of Equity • Scenario A: • Buy – back of stocks after 5 years: NPV = 0  Kstocks Scenario B: no buy - back Kstocks = (D0/IP)+g (Gordon – Shapiro Model)

47. International Financing Plan - summary WACC = 13.27%