This chapter provides a practical example of the topics covered in the preceding chapters using a hypothetical project. The chapter provides an overview and background of the project and then discusses its structure, sources of revenue, funding, and financing. The purpose is to illustrate in a very simplified way how the viability of a project with regard to financing through a P3 may be assessed.
The hypothetical Pennorado River Crossings project includes the following components:
The Pennorado DOT is interested in undertaking a P3 with a concessionaire (i.e., project company) to design, build, finance, operate, and maintain the new project assets and to rehabilitate existing project assets. It will also be assigned the right to collect tolls for use of the project assets. The term of the agreement will be 50 years from the start of construction and the agreement will set out arrangements and remedies for delays, compensation events, and relief events in accordance with general norms as discussed in section 2.6, most notably timely completion (see section 2.6.6).
As discussed in section 2.5, the project company would enter into a set of contracts with subcontractors to transfer risks and responsibilities. The design-build contractor would be obligated to fulfill the project company's responsibilities relating to the design and construction of new project assets and the upgrading of existing project assets under the P3 Agreement.
There would be a separate tolling contract that would assign the project company's tolling responsibilities to a tolling system subcontractor. Several other subcontracts would be issued for the O&M of the project including for washing, landscaping, line striping, storm cleanup, street sweeping, and guardrail maintenance. The project company would enter into an Interface Agreement with the design-build contractor and the tolling contractor. As part of this agreement, the two subcontractors would agree to cooperate on fulfilling their individual contractual obligations and achieving overall project milestones.
The project company and Pennorado DOT would enter into an Electronic Toll Collection Agreement whereby Pennorado DOT would provide toll transaction account management services to the project company. An independent investment bank (which has no major sub-contractors) would become a critical means of assuring effective overall project management in the interests of the equity investors.
Tolls were identified as the main source of revenue for the project. Potential equity investors in the project company and Pennorado DOT would rely on the traffic and revenue forecasts prepared by a transportation consulting firm. Another planning and engineering firm would provide an independent report on traffic and revenue forecasts for the bond underwriters. In the simple project financial model developed for the illustrative financial viability assessment presented in this chapter, it is assumed (based on the traffic and revenue forecasts) that toll revenues in Year 6, the first year of operation, will be $140 million and that this will increase by an annual rate of 4.5% in nominal terms.
The transfer of traffic and revenue risk to the private sector is one of the justifications for implementing the project as a P3. The P3 Agreement would establish a "concession fee" to be paid to Pennorado DOT if gross revenues exceed projections. It would establish five bands of potential revenues and assign a percentage-based fee to each band. Total revenues in a band would be multiplied by the appropriate percentage to calculate the fee for the given year. The percentages are:
Operating expenses are estimated at $35 million for the first year and assumed to increase at an annual rate of 3.0% for the life of the project. The annual capital asset replacement rate is set at 0.5%.
The design-build contract is valued at $1.40 billion in real dollars, i.e., not accounting for inflation during the design-build phase. After accounting for inflation during the design-build phase and for capitalized interest on debt, nominal investment cost (i.e., "capex") rises to more than $2.1 billion. This is the amount to be raised for the project. In reality, many other costs are included as capital expenditures, including preparatory work and fees for advisory services and debt issuance. In our simple illustration, we account only for capitalized interest as an additional cost to be added to the design-build contract price. A combination of senior debt, subordinate debt and equity will be used to finance the project. Capital subsidies from the public sector area also likely (see Section 3.3.1 above).
As discussed in section 3.1.1, senior debt providers are generally conservative and risk-averse, at least compared to other sources of financing for P3s. As such, they will assess a project with a critical approach to ensure the risk of default is minimal. The P3 structure described in section 5.2 is designed to minimize the construction and operational risks on the project. Another key project risk is revenue risk. Senior debt providers rely on the expertise of a specialized consulting firm to estimate toll revenues. Then, they determine cash flows available for debt service (CFADS) by deducting projected operating expenses and major maintenance expenses from the toll revenue estimates. 34 (See Appendix A for more information on traffic and revenue forecasting.)
If the risk to project revenues were minimal, such as in the case of an availability payment from an AAA-rated public authority, then the revenue projections would have minimal uncertainty. However, the revenues from the Pennorado Tunnel project feature quite a different risk profile. These are toll revenues to be collected from millions of trips by individual drivers who make their decisions on a daily basis on whether or not to pay to use the project's assets. Ultimately, these decisions rely on a large number of parameters, including individual drivers' valuation of time, the overall state of the economy, their preferences, etc. Each of these parameters carries a significant level of uncertainty, thus making project revenues uncertain. To better protect themselves from the risks inherent in toll revenues, the senior debt providers would select a relatively high required minimum DSCR, meaning that in any given year, CFADS are projected to be larger than debt service by a significant margin. The sample calculations in Table 16 use a DSCR of 2.0. (With a DSCR of 2.0, CFADS must be at least double the annual debt service in any given period). To make optimal use of the project's revenues, a sculpted repayment profile can be used. In that case, CFADS (project revenues minus operating expenses and capital maintenance expenses) are divided by the DSCR in each period to yield the senior debt service for that period.
| Stylized Cash Flow Waterfall Senior Debt | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | |
| Capital Subsidy | 128.6 | ||||||||||||||
| Toll Revenue | - | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 | 199.1 | |
| Total Revenue | 128.6 | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 | 199.1 | |
| Operating Expenses | - | - | - | - | - | 35.0 | 36.1 | 37.1 | 38.2 | 39.4 | 40.6 | 41.8 | 43.0 | 44.3 | |
| Operating Income (EBITDA) | 128.6 | - | - | - | - | 105.0 | 110.3 | 115.8 | 121.5 | 127.6 | 133.9 | 140.5 | 147.5 | 154.8 | |
| Deduct Major Maintenance Expenses | - | - | - | - | - | 11.5 | 11.9 | 12.4 | 12.8 | 13.2 | 13.7 | 14.2 | 14.7 | 15.2 | |
| CFADS (whole project Term): | 15,101.6 | 128.6 | - | - | - | - | 93.5 | 98.3 | 103.4 | 108.7 | 114.3 | 120.2 | 126.3 | 132.8 | 139.6 |
| CFADS at DSCR of: | 2.0 | 64.3 | - | - | - | - | 46.7 | 49.2 | 51.7 | 54.4 | 57.2 | 60.1 | 63.2 | 66.4 | 69.8 |
| Total Debt Service, Sr Debt Tenor: | 4,326.2 | ||||||||||||||
| Interest Rate: | 5.00% | ||||||||||||||
| Tenor: | 40 | ||||||||||||||
| Total Interest: | 2,884.2 | ||||||||||||||
| Total Principal: | 1,442.1 | ||||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 4,326.2 | ||||||||||||||
| Stylized Cash Flow Waterfall Senior Debt | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 15 | 16 | 17 | 18 | 19 | 20 | 21 | 22 | 23 | 24 | 25 | 26 | 27 | |
| Capital Subsidy | ||||||||||||||
| Toll Revenue | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 | 352.8 | |
| Total Revenue | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 | 352.8 | |
| Operating Expenses | 45.7 | 47.0 | 48.4 | 49.9 | 51.4 | 52.9 | 54.5 | 56.2 | 57.8 | 59.6 | 61.4 | 63.2 | 65.1 | |
| Operating Income (EBITDA) | 162.4 | 170.4 | 178.8 | 187.5 | 196.7 | 206.3 | 216.4 | 227.0 | 238.0 | 249.6 | 261.7 | 274.4 | 287.7 | |
| Deduct Major Maintenance Expenses | 15.7 | 16.3 | 16.8 | 17.4 | 18.0 | 18.7 | 19.3 | 20.0 | 20.7 | 21.4 | 22.2 | 23.0 | 23.8 | |
| CFADS (whole project Term): | 15,101.6 | 146.7 | 154.1 | 161.9 | 170.1 | 178.7 | 187.7 | 197.1 | 207.0 | 217.3 | 228.2 | 239.5 | 251.5 | 264.0 |
| CFADS at DSCR of: | 2.0 | 73.3 | 77.0 | 81.0 | 85.0 | 89.3 | 93.8 | 98.5 | 103.5 | 108.7 | 114.1 | 119.8 | 125.7 | 132.0 |
| Total Debt Service, Sr Debt Tenor: | 4,326.2 | |||||||||||||
| Interest Rate: | 5.00% | |||||||||||||
| Tenor: | 40 | |||||||||||||
| Total Interest: | 2,884.2 | |||||||||||||
| Total Principal: | 1,442.1 | |||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 4,326.2 | |||||||||||||
| Stylized Cash Flow Waterfall Senior Debt | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 28 | 29 | 30 | 31 | 32 | 33 | 34 | 35 | 36 | 37 | 38 | 39 | 40 | |
| Capital Subsidy | ||||||||||||||
| Toll Revenue | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 | 625.3 | |
| Total Revenue | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 | 625.3 | |
| Operating Expenses | 67.1 | 69.1 | 71.1 | 73.3 | 75.5 | 77.7 | 80.1 | 82.5 | 85.0 | 87.5 | 90.1 | 92.8 | 95.6 | |
| Operating Income (EBITDA) | 301.6 | 316.2 | 331.5 | 347.5 | 364.2 | 381.7 | 400.1 | 419.3 | 439.4 | 460.4 | 482.5 | 505.5 | 529.7 | |
| Deduct Major Maintenance Expenses | 24.6 | 25.5 | 26.4 | 27.3 | 28.2 | 29.2 | 30.2 | 31.3 | 32.4 | 33.5 | 34.7 | 35.9 | 37.2 | |
| CFADS (whole project Term): | 15,101.6 | 277.0 | 290.8 | 305.1 | 320.2 | 336.0 | 352.5 | 369.8 | 388.0 | 407.0 | 426.9 | 447.8 | 469.6 | 492.5 |
| CFADS at DSCR of: | 2.0 | 138.5 | 145.4 | 152.6 | 160.1 | 168.0 | 176.3 | 184.9 | 194.0 | 203.5 | 213.5 | 223.9 | 234.8 | 246.3 |
| Total Debt Service, Sr Debt Tenor: | 4,326.2 | |||||||||||||
| Interest Rate: | 5.00% | |||||||||||||
| Tenor: | 40 | |||||||||||||
| Total Interest: | 2,884.2 | |||||||||||||
| Total Principal: | 1,442.1 | |||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 4,326.2 | |||||||||||||
Assume a 40-year term for the debt, which is ten years shorter than the 50-year concession period. The extra ten years (also referred to as the "debt tail") provides an additional buffer to debt financiers, should the project not be able to service its entire debt in the 40-year debt term. The sum of the first 40 years of CFADS for senior debt gives the total amount of senior debt service available for the project. This must then be divided into principal and interest payments. For this example, we use 5.0 percent as the assumed interest rate. We can arrive at an initial estimate of principal that can be raised by dividing the total debt service figure by the product of the interest rate and tenor plus 1. This is represented by the equation presented in Figure 18.
Figure 18. Equation. Calculation of Principal Payments
![P=TDS/[(r x t)+1]](/ipd/images/p3/toolkit/guidebooks/financing_of_highway_p3_projects/fig18.png)
Where
P = Principal
TDS = Total Debt Service
r = Interest Rate
t = Tenor (years)
This is a simple model that assumes that the entire principal will be paid at the end of the financing term. It also assumes annual interest payments instead of semi-annual payments that are typical of bond financing. These assumptions keep the formulae and calculations simple for illustrative purposes.
Multiplying the estimated principal by the interest rate and tenor provides an estimate of total interest payments. Total interest and total principal can then be summed to verify that they equal total debt service. As shown in Table 16, total estimated principal is $1,442.1 million. Bringing forward principal payments would reduce the overall interest payments required. Note that the total CFADS ($15,101.6) in Table 16 is the sum for the entire project period of 50 years, while the total debt service calculated for senior debt ($4,326.2) is only for the 40-year financing term, and factoring in the 2.0 DSCR.
As explained in section 3.1.2, subordinate debt providers have a different outlook and a different risk appetite than senior debt providers. They are less risk-averse than senior debt providers but not as "adventurous" as equity investors. They are still lenders in that they enter into a contract to be repaid, unlike equity investors who generally accept the possibility of losing their entire investment (against the expectation of a higher return). However, their repayment terms are typically more flexible than those of senior debt providers. They may allow repayment to be delayed, and by definition they always assume a ranking below senior debt providers in order of priority of payment from annual cash flows. Also, in the case of a default, senior debt will be paid ahead of subordinate debt. To determine the cash flows available for subordinate debt service, the senior debt must be factored out.
In terms of financial indicators, subordinate debt providers generally accept lower coverage ratios than senior debt providers. They typically demand higher interest rates than senior debt providers, though not as high as the expected returns for equity investors. Subordinate debt issuance is typically limited by covenants in senior debt documents, as senior debt will want to avoid the project defaulting on subordinate debt. For example, a bond covenant or loan agreement for senior debt may stipulate that while a senior DSCR of 2.0 must be maintained, the total DSCR (including both senior and any subordinate debt) must be maintained at 1.3. For an initial estimate of hypothetical subordinate debt on Pennorado Tunnel, we assume a target total debt service coverage ratio of 1.3 35, a subordinate debt tenor of 30 years 36, and an interest rate of 10 percent. This yields a principal amount of $312.5 million (see Table 17).
| Stylized Cash Flow Waterfall Senior Debt | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 12 | 14 | |
| Capital Subsidy | 128.6 | - | - | - | - | - | - | - | - | - | - | - | - | - | |
| Toll Revenue | - | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 | 199.1 | |
| Total Revenue | 128.6 | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 | 199.1 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| Operating Expenses | - | - | - | - | - | 35.0 | 36.1 | 37.1 | 38.2 | 39.4 | 40.6 | 41.8 | 43.0 | 44.3 | |
| Operating Income (EBITDA) | 128.6 | - | - | - | - | 105.0 | 110.3 | 115.8 | 121.5 | 127.6 | 133.9 | 140.5 | 147.5 | 154.8 | |
| Deduct Major Maintenance Expenses | - | - | - | - | - | 11.5 | 11.9 | 12.4 | 12.8 | 13.2 | 13.7 | 14.2 | 14.7 | 15.2 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| CFADS (whole project Term): | 128.6 | - | - | - | 93.5 | 98.3 | 103.4 | 108.7 | 114.3 | 120.2 | 126.3 | 132.8 | 139.6 | ||
| CFADS at DSCR of: | 1.3 | 98.9 | - | - | - | - | 71.9 | 75.6 | 79.5 | 83.6 | 87.9 | 92.4 | 97.2 | 102.1 | 107.4 |
| Total Debt Service, Sr Debt Tenor: | 3,570.9 | ||||||||||||||
| Less Sr Debt Service | 2,321.1 | ||||||||||||||
| Subordination Debt Service: | 1,249.8 | ||||||||||||||
| Interest Rate: | 10.00% | ||||||||||||||
| Tenor: | 30 | ||||||||||||||
| Total Interest: | 937.4 | ||||||||||||||
| Total Principal: | 312.5 | ||||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 1,249.8 | ||||||||||||||
| Stylized Cash Flow Waterfall Senior Debt | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 15 | 16 | 17 | 18 | 19 | 20 | 21 | 22 | 23 | 24 | 25 | 26 | 27 | |
| Capital Subsidy | - | - | - | - | - | - | - | - | - | - | - | - | - | |
| Toll Revenue | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 | 352.8 | |
| Total Revenue | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 | 352.8 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| Operating Expenses | 45.7 | 47.0 | 48.4 | 49.9 | 51.4 | 52.9 | 54.5 | 56.2 | 57.8 | 59.6 | 61.4 | 63.2 | 65.1 | |
| Operating Income (EBITDA) | 162.4 | 170.4 | 178.8 | 187.5 | 196.7 | 206.3 | 216.4 | 227.0 | 238.0 | 249.6 | 261.7 | 274.4 | 287.7 | |
| Deduct Major Maintenance Expenses | 15.7 | 16.3 | 16.8 | 17.4 | 18.0 | 18.7 | 19.3 | 20.0 | 20.7 | 21.4 | 22.2 | 23.0 | 23.8 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| CFADS (whole project Term): | 146.7 | 154.1 | 161.9 | 170.1 | 178.7 | 187.7 | 197.1 | 207.0 | 217.3 | 228.2 | 239.5 | 251.5 | 264.0 | |
| CFADS at DSCR of: | 1.3 | 112.8 | 118.5 | 124.5 | 130.8 | 137.4 | 144.3 | 151.6 | 159.2 | 167.2 | 175.5 | 184.3 | 193.4 | 203.0 |
| Total Debt Service, Sr Debt Tenor: | 3,570.9 | |||||||||||||
| Less Sr Debt Service | 2,321.1 | |||||||||||||
| Subordination Debt Service: | 1,249.8 | |||||||||||||
| Interest Rate: | 10.00% | |||||||||||||
| Tenor: | 30 | |||||||||||||
| Total Interest: | 937.4 | |||||||||||||
| Total Principal: | 312.5 | |||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 1,249.8 | |||||||||||||
| Stylized Cash Flow Waterfall Senior Debt | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 28 | 29 | 30 | 31 | 32 | 33 | 34 | 35 | 36 | 37 | 38 | 39 | 40 | |
| Capital Subsidy | - | - | - | - | - | - | - | - | - | - | - | - | - | |
| Toll Revenue | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 | 625.3 | |
| Total Revenue | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 | 625.3 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| Operating Expenses | 67.1 | 69.1 | 71.1 | 73.3 | 75.5 | 77.7 | 80.1 | 82.5 | 85.0 | 87.5 | 90.1 | 92.8 | 95.6 | |
| Operating Income (EBITDA) | 301.6 | 316.2 | 331.5 | 347.5 | 364.2 | 381.7 | 400.1 | 419.3 | 439.4 | 460.4 | 482.5 | 505.5 | 529.7 | |
| Deduct Major Maintenance Expenses | 24.6 | 25.5 | 26.4 | 27.3 | 28.2 | 29.2 | 30.2 | 31.3 | 32.4 | 33.5 | 34.7 | 35.9 | 37.2 | |
| - | - | - | - | - | - | - | - | - | - | - | - | - | ||
| CFADS (whole project Term): | 277.0 | 290.8 | 305.1 | 320.2 | 336.0 | 352.5 | 369.8 | 388.0 | 407.0 | 426.9 | 447.8 | 469.6 | 492.5 | |
| CFADS at DSCR of: | 1.3 | 213.1 | 223.7 | 234.7 | 246.3 | 258.5 | 271.2 | 284.5 | 298.5 | 313.1 | 328.4 | 344.4 | 361.2 | 378.8 |
| Total Debt Service, Sr Debt Tenor: | 3,570.9 | |||||||||||||
| Less Sr Debt Service | 2,321.1 | |||||||||||||
| Subordination Debt Service: | 1,249.8 | |||||||||||||
| Interest Rate: | 10.00% | |||||||||||||
| Tenor: | 30 | |||||||||||||
| Total Interest: | 937.4 | |||||||||||||
| Total Principal: | 312.5 | |||||||||||||
| Check Total Debt Service (sum Total Interest & Total Principal): | 1,249.8 | |||||||||||||
It should be noted that the estimated total combined debt capacity of senior and subordinate debt would be subject to limits based on the debt-to-equity ratio required by debt providers, to ensure that equity investors have sufficient skin in the game. To keep this illustration simple, we will assume that the required debt-to-equity ratio is met.
As discussed in section 3.2, equity investors seek to maximize their returns. One of the core elements of this strategy is to maximize leverage, or debt/equity ratio. We have already pursued this strategy by maximizing senior and subordinate debt for the project at the most beneficial terms and arrangements. Equity investors typically have a higher target return from a project. Using market-based information from projects with a similar risk profile, we estimate that investors in this project would seek a pre-tax target equity return of 11.7 percent.
Now that we have estimates of project costs and revenues and estimates of potential senior debt, subordinate debt and targeted equity returns, we can analyze the project's financial feasibility as a P3 by estimating the equity IRR that can be achieved by the project given different levels of public subsidy, assuming that the required debt-to-equity ratio will be met.
The cash flow available to equity investors may be calculated by subtracting operational and major maintenance expenses, senior debt service and subordinate debt service from revenues. (We ignore reserve requirements to keep the illustration simple). This provides an estimate of the total amount of cash flows available to be paid out as dividends. However, not all of these funds can be paid out as soon as they become available. Minimum reserve requirements need to be satisfied and the project needs to maintain positive cash flows throughout the full term. Therefore, actual dividend payments are limited to ensure these other conditions are met.
Using a simplified financial model (see Table 18), we can first estimate the equity IRR assuming that the entire balance of funding needed for investment, over and above the total of senior and subordinate debt, can be provided by equity investors. (For simplicity, we will ignore other potential criteria such as requirements for reserves).
The table shows the seniority of project cash flows. Since the project has a five-year construction period, revenues do not begin until Year 6. The same is true for operational expenses (Opex) and Major Maintenance expenses. Senior and subordinate debt service are also shown to begin in Year 6. However, interest is in fact due during the first five years. As no revenues are being generated yet that could be used to pay interest, additional sums are borrowed for this purpose and included in the principal amounts for both types of debt. In other words, interest is being "capitalized." The figures in the second column are summations of the amounts for the project term.
Note that for both senior and subordinate debt, the total amount of debt service paid is less than the estimate from our raw calculations in the preceding tables. This is because our raw debt sizing estimates assume interest-only payments until the end of the project term with a bullet (lump sum) principal payment at the end of the debt tenor. In reality, principal on both types of debt is paid down as project cash flows permit so less interest is paid over debt tenors. In the illustration, debt is assumed to be fully "sculpted" to fit CFADS (as discussed in Section 3.6.1). This allows for efficient use of project funds. The debt providers also offer a grace period during which no principal payments are required. In our example, the grace period is 10 years so principal payments begin in Year 11.
The Cash Flow Available to Equity is calculated by subtracting Opex, Major Maintenance, Senior Debt Service and Subordinate Debt Service from Revenues. This provides an estimate of the total amount of cash flows available to be paid out as dividends. Note that the values are negative in the first few years. A negative value indicates that additional funds will need to be injected by equity investors. In order to support the project during these early years, equity investors provide an additional injection of equity in Year 6, 7 and 8 which covers the negative cash flow in Years 6, 7 and 8. Equity IRR can be calculated using the IRR function in Excel, using the cash flows available to equity line item in the table below. As indicated in Table 18, the equity IRR calculated is much lower than the required return of 11.7%, and would not be feasible from the equity investors' point of view.
Table 18. Cash Flow Waterfall (in Millions of Dollars) Assuming Equity Can Provide Funding Balance
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | |
| Revenue | 19,439.0 | - | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 |
| Opex | - | - | - | - | - | 35.0 | 36.1 | 37.1 | 38.2 | 39.4 | 40.6 | 41.8 | 43.0 | |
| Major Maintenance | 1,220.8 | - | - | - | - | - | 11.5 | 11.9 | 12.4 | 12.8 | 13.2 | 13.7 | 14.2 | 14.7 |
| Sr Debt Service | 3,408.4 | - | - | - | - | - | 77.4 | 77.4 | 77.4 | 77.4 | 77.4 | 80.7 | 83.8 | 86.7 |
| Sub Debt Service | 854.6 | - | - | - | - | - | 31.2 | 31.2 | 31.2 | 31.2 | 31.2 | 32.7 | 33.9 | 35.0 |
| Cash Flow Available to Equity | 10,710.0 | - | - | - | - | - | (15.2) | (10.4) | (5.3) | 0.0 | 5.6 | 6.8 | 8.6 | 11.1 |
| Equity Investment | (357.9) | (167.5) | (38.9) | (38.9) | (38.9) | (35.0) | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,736.7 | (167.5) | (38.9) | (38.9) | (38.9) | (35.0) | - | - | - | - | - | - | - | - |
| Equity IRR: | 9.80% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 14 | 15 | 16 | 17 | 18 | 19 | 20 | 21 | 22 | 23 | 24 | 25 | 26 | |
| Revenue | 19,439.0 | 199.1 | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 |
| Opex | 44.3 | 45.7 | 47.0 | 48.4 | 49.9 | 51.4 | 52.9 | 54.5 | 56.2 | 57.8 | 59.6 | 61.4 | 63.2 | |
| Major Maintenance | 1,220.8 | 15.2 | 15.7 | 16.3 | 16.8 | 17.4 | 18.0 | 18.7 | 19.3 | 20.0 | 20.7 | 21.4 | 22.2 | 23.0 |
| Sr Debt Service | 3,408.4 | 89.5 | 92.1 | 94.5 | 96.7 | 98.8 | 100.7 | 102.4 | 103.9 | 105.3 | 106.5 | 107.6 | 108.4 | 109.1 |
| Sub Debt Service | 854.6 | 35.9 | 36.7 | 37.3 | 37.8 | 38.1 | 38.3 | 38.3 | 38.1 | 37.8 | 37.3 | 36.7 | 35.9 | 35.0 |
| Cash Flow Available to Equity | 10,710.0 | 14.1 | 17.9 | 22.3 | 27.4 | 33.2 | 39.7 | 47.0 | 55.0 | 63.8 | 73.4 | 83.9 | 95.2 | 107.4 |
| Equity Investment | (357.9) | - | - | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,736.7 | - | - | - | - | - | - | 95.1 | 79.1 | 73.0 | 73.2 | 77.4 | 84.5 | 93.7 |
| Equity IRR: | 9.80% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 27 | 28 | 29 | 30 | 31 | 32 | 33 | 34 | 35 | 36 | 37 | 38 | 39 | |
| Revenue | 19,439.0 | 352.8 | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 |
| Opex | 65.1 | 67.1 | 69.1 | 71.1 | 73.3 | 75.5 | 77.7 | 80.1 | 82.5 | 85.0 | 87.5 | 90.1 | 92.8 | |
| Major Maintenance | 1,220.8 | 23.8 | 24.6 | 25.5 | 26.4 | 27.3 | 28.2 | 29.2 | 30.2 | 31.3 | 32.4 | 33.5 | 34.7 | 35.9 |
| Sr Debt Service | 3,408.4 | 109.6 | 110.0 | 110.1 | 110.1 | 110.0 | 109.6 | 109.1 | 108.4 | 107.6 | 106.5 | 105.3 | 103.9 | 102.4 |
| Sub Debt Service | 854.6 | 33.9 | 32.7 | 31.2 | 15.6 | - | - | - | - | - | - | - | - | - |
| Cash Flow Available to Equity | 10,710.0 | 120.4 | 134.4 | 149.4 | 179.4 | 210.2 | 226.4 | 243.4 | 261.4 | 280.4 | 300.5 | 321.6 | 343.8 | 367.2 |
| Equity Investment | (357.9) | - | - | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,736.7 | 104.4 | 116.4 | 129.6 | 149.5 | 173.8 | 194.8 | 214.3 | 233.1 | 252.0 | 271.4 | 291.5 | 312.4 | 334.3 |
| Equity IRR: | 9.80% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 40 | 41 | 42 | 43 | 44 | 45 | 46 | 47 | 48 | 49 | 50 | |
| Revenue | 19,439.0 | 625.3 | 653.4 | 682.8 | 713.6 | 745.7 | 779.2 | 814.3 | 850.9 | 889.2 | 929.2 | 971.1 |
| Opex | 95.6 | 98.5 | 101.4 | 104.5 | 107.6 | 110.8 | 114.2 | 117.6 | 121.1 | 124.8 | 128.5 | |
| Major Maintenance | 1,220.8 | 37.2 | 38.5 | 39.8 | 41.2 | 42.7 | 44.1 | 45.7 | 47.3 | 48.9 | 50.7 | 52.4 |
| Sr Debt Service | 3,408.4 | 51.6 | - | - | - | - | - | - | - | - | - | - |
| Sub Debt Service | 854.6 | - | - | - | - | - | - | - | - | - | - | - |
| Cash Flow Available to Equity | 10,710.0 | 440.9 | 516.5 | 541.6 | 567.9 | 595.4 | 624.2 | 654.4 | 686.0 | 719.2 | 753.8 | 790.1 |
| Equity Investment | (357.9) | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,736.7 | 417.0 | 456.8 | 490.7 | 521.6 | 551.1 | 580.3 | 610.0 | 640.4 | 671.9 | 704.7 | 1,096.8 |
| Equity IRR: | 9.80% | |||||||||||
To address financial viability, we could resort to increasing the toll rates. However, increasing the rates may not lead to the required increase in revenues, given that higher rates could dissuade some drivers from using the road. Also, there could be concerns about potential public opposition to higher toll rates. Another option to address financial viability is to offer a public capital subsidy for the project.
While we have maximized debt based on DSCR alone in this example, it should be noted that debt providers will limit the debt-to-equity ratio to ensure that equity investors have sufficient "skin in the game". This is an additional and important criterion that will need to be taken into account in determining financial viability. The optimal public subsidy (i.e., the lowest possible cost to the public agency) will need to simultaneously satisfy the requirements for minimum DSCR, debt-to-equity ratio (i.e., leverage), and required equity return. Due to the interdependence of these elements, calculations need to be performed iteratively to arrive at the optimal public capital subsidy.
Through iterative calculations using a financial model, we may determine an optimal funding plan by changing the upfront subsidy that is required to satisfy all financing criteria (minimum DSCR, equity return and leverage). The end result is represented in Table 19 on the next page as Cash Flow Waterfall with Public Subsidy counted as Revenue. It includes a $128.6 million public capital subsidy (shown as "Revenues" in Year 1), and $229.3 million of equity. Under this scenario, cash flow remains positive, our DSCRs are satisfied and our equity investors achieve their required pre-tax return of 11.7%.
As mentioned above, debt providers may require a lower debt-to-equity ratio than represented by the above funding plan. To reduce the debt-to-equity ratio, a larger equity contribution would be needed along with lower total debt. This would likely increase the weighted average cost of capital (WACC). To calculate the required public subsidy under a lower debt-to-equity ratio requirement, further iterations of the model would be needed.
Table 19. Cash Flow Waterfall (in Millions of Dollars) with Public Subsidy Counted as Revenue
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | |
| Revenue | 19,439.0 | 128.6 | - | - | - | - | 140.0 | 146.3 | 152.9 | 159.8 | 167.0 | 174.5 | 182.3 | 190.5 |
| Opex | - | - | - | - | - | 35.0 | 36.1 | 37.1 | 38.2 | 39.4 | 40.6 | 41.8 | 43.0 | |
| Major Maintenance | 1,220.8 | - | - | - | - | - | 11.5 | 11.9 | 12.4 | 12.8 | 13.2 | 13.7 | 14.2 | 14.7 |
| Sr Debt Service | 3,408.4 | - | - | - | - | - | 77.4 | 77.4 | 77.4 | 77.4 | 77.4 | 80.7 | 83.8 | 86.7 |
| Sub Debt Service | 854.6 | - | - | - | - | - | 31.2 | 31.2 | 31.2 | 31.2 | 31.2 | 32.7 | 33.9 | 35.0 |
| Cash Flow Available to Equity | 10,838.6 | 128.6 | - | - | - | - | (15.2) | (10.4) | (5.3) | 0.0 | 5.6 | 6.8 | 8.6 | 11.1 |
| Equity Investment | (229.3) | (38.9) | (38.9) | (38.9) | (38.9) | (35.0) | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,865.3 | (38.9) | (38.9) | (38.9) | (38.9) | (35.0) | - | - | - | - | - | - | - | - |
| Equity IRR: | 11.70% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 14 | 15 | 16 | 17 | 18 | 19 | 20 | 21 | 22 | 23 | 24 | 25 | 26 | |
| Revenue | 19,439.0 | 199.1 | 208.1 | 217.4 | 227.2 | 237.4 | 248.1 | 259.3 | 270.9 | 283.1 | 295.9 | 309.2 | 323.1 | 337.6 |
| Opex | 44.3 | 45.7 | 47.0 | 48.4 | 49.9 | 51.4 | 52.9 | 54.5 | 56.2 | 57.8 | 59.6 | 61.4 | 63.2 | |
| Major Maintenance | 1,220.8 | 15.2 | 15.7 | 16.3 | 16.8 | 17.4 | 18.0 | 18.7 | 19.3 | 20.0 | 20.7 | 21.4 | 22.2 | 23.0 |
| Sr Debt Service | 3,408.4 | 89.5 | 92.1 | 94.5 | 96.7 | 98.8 | 100.7 | 102.4 | 103.9 | 105.3 | 106.5 | 107.6 | 108.4 | 109.1 |
| Sub Debt Service | 854.6 | 35.9 | 36.7 | 37.3 | 37.8 | 38.1 | 38.3 | 38.3 | 38.1 | 37.8 | 37.3 | 36.7 | 35.9 | 35.0 |
| Cash Flow Available to Equity | 10,838.6 | 14.1 | 17.9 | 22.3 | 27.4 | 33.2 | 39.7 | 47.0 | 55.0 | 63.8 | 73.4 | 83.9 | 95.2 | 107.4 |
| Equity Investment | (229.3) | - | - | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,865.3 | - | - | - | - | - | - | 95.1 | 79.1 | 73.0 | 73.2 | 77.4 | 84.5 | 93.7 |
| Equity IRR: | 11.70% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 27 | 28 | 29 | 30 | 31 | 32 | 33 | 34 | 35 | 36 | 37 | 38 | 39 | |
| Revenue | 19,439.0 | 352.8 | 368.7 | 385.3 | 402.6 | 420.8 | 439.7 | 459.5 | 480.2 | 501.8 | 524.3 | 547.9 | 572.6 | 598.4 |
| Opex | 65.1 | 67.1 | 69.1 | 71.1 | 73.3 | 75.5 | 77.7 | 80.1 | 82.5 | 85.0 | 87.5 | 90.1 | 92.8 | |
| Major Maintenance | 1,220.8 | 23.8 | 24.6 | 25.5 | 26.4 | 27.3 | 28.2 | 29.2 | 30.2 | 31.3 | 32.4 | 33.5 | 34.7 | 35.9 |
| Sr Debt Service | 3,408.4 | 109.6 | 110.0 | 110.1 | 110.1 | 110.0 | 109.6 | 109.1 | 108.4 | 107.6 | 106.5 | 105.3 | 103.9 | 102.4 |
| Sub Debt Service | 854.6 | 33.9 | 32.7 | 31.2 | 15.6 | - | - | - | - | - | - | - | - | - |
| Cash Flow Available to Equity | 10,838.6 | 120.4 | 134.4 | 149.4 | 179.4 | 210.2 | 226.4 | 243.4 | 261.4 | 280.4 | 300.5 | 321.6 | 343.8 | 367.2 |
| Equity Investment | (229.3) | - | - | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,865.3 | 104.4 | 116.4 | 129.6 | 149.5 | 173.8 | 194.8 | 214.3 | 233.1 | 252.0 | 271.4 | 291.5 | 312.4 | 334.3 |
| Equity IRR: | 11.70% | |||||||||||||
| Cash Flow Waterfall with Subsidy Counted as Equity | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Project Year: | 40 | 41 | 42 | 43 | 44 | 45 | 46 | 47 | 48 | 49 | 50 | |
| Revenue | 19,439.0 | 625.3 | 653.4 | 682.8 | 713.6 | 745.7 | 779.2 | 814.3 | 850.9 | 889.2 | 929.2 | 971.1 |
| Opex | 95.6 | 98.5 | 101.4 | 104.5 | 107.6 | 110.8 | 114.2 | 117.6 | 121.1 | 124.8 | 128.5 | |
| Major Maintenance | 1,220.8 | 37.2 | 38.5 | 39.8 | 41.2 | 42.7 | 44.1 | 45.7 | 47.3 | 48.9 | 50.7 | 52.4 |
| Sr Debt Service | 3,408.4 | 51.6 | - | - | - | - | - | - | - | - | - | - |
| Sub Debt Service | 854.6 | - | - | - | - | - | - | - | - | - | - | - |
| Cash Flow Available to Equity | 10,838.6 | 440.9 | 516.5 | 541.6 | 567.9 | 595.4 | 624.2 | 654.4 | 686.0 | 719.2 | 753.8 | 790.1 |
| Equity Investment | (229.3) | - | - | - | - | - | - | - | - | - | - | - |
| Net Equity Flows | 9,865.3 | 417.0 | 456.8 | 490.7 | 521.6 | 551.1 | 580.3 | 610.0 | 640.4 | 671.9 | 704.7 | 1,096.8 |
| Equity IRR: | 11.70% | |||||||||||
34 We provide a highly simplified example for educational purposes. A more detailed calculation of CFADS would have to account for other projected cash flows into and out of the project, including taxes, and would address cash balances and reserve movements across periods.
35 The calculation of coverage for subordinate debt is cumulative, not residual. That is, the coverage factor would be calculated by comparing 100% of CFADS to the sum of senior and subordinate debt service.
36 While subordinate debt often features tenors shorter than senior debt, recent examples such as the US 36 project in Colorado show that the market can support subordinate loans with tenors of 30 years or even longer.
