The project finance structuring on this page addresses incorporation of debt fees and in particular fees on a DSRA letter of credit in sculpting analysis. Fees paid on debt including fees paid on a letter of credit can be viewed part of debt service and must thereby be incorporated in developing sculpted repayment. The discussion below demonstrates how the fundamental sculpting formulas can be adjusted to account for the debt fees. The amount of debt fees reduces the amount of debt that can be supported by cash flow — if you have the same cash flow and more fees, then the debt size from DSCR analysis will be reduced. As the size of the DSRA is affected by the fees and the fees depend on debt, a nasty circular reference arises.
There are a couple of key files where I put the financial formulas, modelling examples and the VBA code for cases where you run into circular references. You can file these file on the google drive in the Project Finance Section under exercises and then Section D for the Sculpting course. The second file is the circular reference resolution file attached to a model that deals with the DSRA as an L/C and includes provision for debt fees.
Including Debt Fees after COD and Commitment Fees on an Letter of Credit that Replaces the Funded DSRA Account
Before delving into detailed modelling issues, I think it is useful to review general some ideas of how debt fees fit into financial analysis. The fundamental point fees is that debt fees are just like interest from the standpoint of a lender — money is earned by the lender on the basis of the amount of debt outstanding. To evaluate the profitability of debt from the standpoint of a lender, you can compute the IRR earned. As with calculation of any IRR, the debt IRR is computed on the basis of cash flow coming out of your pocket compared to cash flow coming in. The cash flow going out is the debt draws. The cash flow coming in is the cash interest expense, plus the repayment and plus any debt fees before or after construction. The debt IRR which can also be called the all-in interest rate.
As debt fees that are paid after COD can be substituted for interest payments, it should be easy to see that debt fees should be included in debt service. This means that debt fees should be included in the denominator of the DSCR. You could even make an argument that the LLCR should be adjusted for debt fees as demonstrated in the formulas below:
Without Fees: LLCR = NPV(CFADS)/NPV(Debt Service) = NPV(CFADS)/Debt
With Fees: LLCR = NPV(CFADS)/NPV(Interest + Fees + Repayment) = NPV(CFADS)/(Debt + NPV(Fees)
Mechanics of Adjusting Debt Sizing for Fees with Debt Sizing from DSCR
To include the fees in the sculpting equations, you should subtract the present value of fees when you compute the net present value of debt.
To illustrate this, assume that the interest rate is zero and there are only fees on debt. If the interest rate was zero and there were no fees, then the present value of the debt payment would be the sum of the repayments. If there is either interest or fees, less debt service can support the same amount of cash flow. This is illustrated in the very simple two period example below. If there were no fees in the example, the debt would be 800 rather than 700 for the DSCR target of 1.5 (600/1.5 = 400). The target debt service at the bottom of the simple example is less — 350 per year. As the interest rate is zero, this represents the debt repayment. The target debt service is 600/1.5=400 – 50 = 350.
To compute the PV of debt service and reduce the debt service for fees, the PV of debt service computed without fees must be lowered for the fees.
Fees reduce the amount of debt service that can be supported by cash flow. This is just the same as deducting the interest to come up with the repayment. The fees reduce the amount of debt associated with CFADS compared to a situation without fees. Because the PV of debt service uses the debt interest rate without the effective rate that accounts for fees (which would be a higher interest rate), you can deduct the PV of fees at the debt interest rate and the debt schedule will work. To make the sculpting work you should also make the repayment lower by the fees as shown below:
DSCR = CFADS/Debt Service
DSCR = CFADS/(Repayment + Interest + Fees)
Repayment = CFADS/DSCR – Interest – Fees
Debt = NPV(Interest Rate, Debt Service-fees) = NPV(rate, Debt Service) – NPV(rate, Fees)
Mechanics of Sculpting with Fees when the Debt is Fixed
The bottom of the simple case below demonstrates the LLCR or the adjusted target DSCR can be adjusted. The PV of CFADS divided by the Debt plus the PV of Fees instead of just dividing the CFADS divided by the debt. As with the case above, after you have computed the adjusted LLCR to compute the target debt service, the repayment is computed by subtracting the both fees and interest from debt service.
LLCR = PV CFADS/(Debt + PV Fees)
Debt Service = CFADS/LLCR
Repayment = Debt Service – Interest – Fees
Analysis of Fees in Sculpting Exercise
A simple case with zero interest rate and a five percent interest rate is illustrated in the two screen shots below. The first screen shot shows that you can just add up the required debt service, then subtract the sum of the fees and the target DSCR of 1.5 will be achieved.
The second screen shot demonstrates the case with a 10% interest rate. There is lower debt in this case because of interest being paid, but the ideas are the same (the total debt amount falls from 480 to 332.
Very often in sculpting, the debt is given and the repayments must be sculpted. When the debt is given, the fees affect the synthetic LLCR that is used to compute the debt service from the CFADS. In this case, the amount of repayment must be reduced because of the fees and the synthetic LLCR should be reduced. The sculpting analyses include calculation of the LLCR to evaluate whether the debt to capital constraint is driving the constraint. In this case the PV of CFADS is not the correct numerator for the analysis. Instead, the PV of the LC fees should be added to the denominator of the LLCR as follows:
LLCR = PV(CFADS)/(Debt + PV of LC Fees), where
Debt = Project Cost x Debt to Capital
A problem here is that the NPV of the debt depends on the fees, but the LC fees depend on the DSRA, which in turn depends on the size of the debt and the NPV. This is a clear circular reference. Note Debt Service in the above equation means debt service without fees and debt is reduced by PV of fees.
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