Questions

1. What is the critical part of the case? Given the construction cost $ 100
million, why is the interest cost an important factor, according to sponsors?
Assumption for Cash flow projections is most Critical part of the case such as
a- Debt to Equity Ratio decision
b- Estimating the projects total cost-Though construction cost is 100 million
but permit cost, finance arrangement cost etc. need to be added,
contingency for overruns need to be prepared.
c- Revenue estimation based on purchase agreements.
d- Growth factors eg. Electricity charges, Gas Charges growth rate. Cash
Inflow and cash outflow growth rates have to be adjudged with defined
reasons
If the Interest cost is greater than net cash flows for any given year the
lenders will be vary of investment in the project. If the project is not capable
of paying interests even the sponsors can not expect any return. Since the
project is high on debt, Lender is the biggest risk taker in the project and he
needs to be satisfied with safety of his investment. This can only be achieved
if the lenders interest is being serviced properly.
2. In the case, explain the criterions used for determining the proportions of
debt and equity. What are the assumptions of cash flow projection for
cogeneration project?
The proportion of debt and equity is determined by analyzing the profitability
of the project. The Greater the level of operating Income that can be
assured , the greater the amount of debt a project can support. Since the
companys debt is non-recourse to equity investors , lenders look at project
cashflow for their repayment. Following ratios are looked at by lenders for
project approval
a- Debt coverage ratio (normally greater than 1.5) (current project has the
range of 1.89 to 2.23
b- Interest coverage ratio
c- Fixed charge coverage ratio
Assumptions for cash flow projection
1. Capacity utilization-90 %
2. Prices at the time plant is placed in service and contracted escalation factors
Electricity $40 /Megawatt Hour; 6% annually
Steam
$ 4 /thousand pounds ;PPI
Natural Gas $3/ Million BTU; 6% annually
3. Predicted Volumes
At capacity
Maximum Amount
Electricity
250 MW
2,190,000MWH
Production
Steam Production
150,000 PPH
1314 MP
Gas Usage
1950 MBTU/Hr
17082 BBTU
4. Operating and other cash expenses
First Year =$8 Million/year; escalation factor=PPI
5. Tax Rate 40%

At 90% Utilization
1,971,000 MWH
1182.6 MP
15,373.8 BBTU

3. Discuss the process of sensitivity analysis in the case with reference to returns on
equity, interest coverage and debt service coverage ratio ( Refer to tables 8.8 and
8.9)
What are the learning from the case?
Though utmost care is taken to decide on assumptions but the real life scenario
may be different. The real cash flows may differ from project one due to unforeseen
conditions. In order to avoid those contingencies sensitivity analysis is carried out.
For example uncertainty may be regarding interest rate on 10 year debt issue, the
current contract has power purchase agreement revenue may fall due to unplanned
outages. Sensitivity analysis is then carried out to judge projects viability under
different conditions (i.e. Worst case to best case scenario)
In Cogeneration Project has expected NPV of $44 at 15% discount rate and the NPV
is $13.79 at 25% discount rate i.e. the project is capable of giving return with
minimum of 15% to the extent of 25%.
Similarly Role of debt and its interest component on projects viability can be
studied by checking sensitivity of DSCR and ICR at different interest rates. The
current project is capable of handling 75% debt @ 14% interest rate (DSCR & ICR at
14% on year 1 is 1.55,1.52 respectively)
Learnings from the Case
The case emphasizes on the importance of assumptions before projecting cash
flows, the project finance structure can be decided based on Investors expected
return & debt repayment capacity of the project. The viability of the project also
improves if the stakeholders in the project are of strategic nature.
The sensitivity analysis acts as decision making tool by presenting best and worst
case scenarios. SA Tool helps in various decisions as debt to equity ratio, Interest
bearing capacity, Return to equity holder in different scenarios.