Exercise with Cost Padding in Debt to Capital Constraint Case
As a follow-up to the first exercise, the issue as to what issue is more important with different constraints is addressed. Specifically, if the debt to capital constraint is in place, the investor would like to pad the cost without increasing the actual cash outflow. Examples of padding the cost without incurring a cash outflow include development fees, owners cost (e.g. CEO’s salary), land cost valuation, IDC on shareholder loans, exagerated development costs, EPC profits when the EPC is the same as the investor ….
To see how these things affect the returns to the investors only when the debt to capital constraint is in place, you can work with the exercise below. Items are added to the project cost that are not associated with equity cash investment. You can work with the spinner box on the development fee and then see how this only has an impact when the debt to capital is in place. Many of these items can come along with tax cost. For example, the development fee can be taxable income so if you put in development fees when the debt to capital constraint is not in place, you are just paying extra taxes with no financing benefit.
The exercise file for cost padding strategy and the debt to capital versus the DSCR constraint is in the file below.
The video below explains some of the theoretical issues with cost padding. It also explains a few of the issues associated with creating the focused model.
Other Debt Sizing Issues
There are a number of other issues that can affect debt sizing and the calculation of debt size in financial models. I have included some of these issues in the files below. One issue is the case of wind farms where there are two cash flow criteria for determining the debt size with different cash flows and DSCR’s. In this case the cash flow for debt sizing may be different than the cash flow you use for IRR analysis. Here the agreed and negotiated P90 or P99 case is like the downside case where you use a lower DSCR because you are already in the buffer situation. The P50 case is like the base case and you have a higher DSCR. Other cases include the use of different currencies for debt sizing where you may have a different DSCR in different currencies.
The videos associated with debt sizing demonstrate how to create models that assess strategy differences when the debt to capital constraint applies and when the DSCR constraint applies. The conclusions are that the debt to capital constraint tends to occur with (1) higher project IRR, (2) longer debt tenor, (3) lower interest rates, (4) lower DSCR, and (5) lower taxes. For each of the subjects there is a rather long and boring video describing how the focused model can be developed. I am also in the process of making shorter videos that discuss the strategic issues associated with debt sizing.
Carrying Charge Analysis.xlsm