exercise their discretion under the loan agreement in accordance with the ECA’s directions. This is understandable in that the ECA is assuming the risk of payment default under the loan agreement. In addition the terms of both commercial and political risk guarantees usually provide that the ECA may purchase the banks’ interest in the guaranteed loans and so enable them to step into the banks’ shoes. Where all of the parties in a multi-sourced financing agree to have all the credit documentation governed by one law (usually English or New York law) it is possible to simplify the documentary structure for the loans by having a “financing agreement” or a “common terms agreement”. This agreement will set out all of the common provisions (see section 9.15 below). ECAs are now very used to the idea of inter-creditor agreements to govern the relationship between the different groups of financiers or themselves. Indeed, it is usually in the best interests of an ECA to have an inter-creditor agreement as an ECA frequently lends for a longer maturity than the commercial banks. An ECA will therefore need to protect itself against the banks taking a short-term view. 8.8 MULTILATERAL AGENCIES The multilateral agencies consist of the various global and regional development banks and funds. They are becoming increasingly important sources of project finance. In many cases, their original objective was to channel financing for infrastructure projects and other public works to governments and state-controlled agencies in the relevant part of the world. However, there is currently an increasing emphasis on these multilateral agencies providing project finance for private sector projects. Typically, the involvement of a multilateral agency is used to draw in commercial banks and other private sector providers of project finance to finance projects which the private sector would otherwise find uneconomic or uncommercial. There are a variety of multilateral agencies. Set out below is a review of the World Bank Group and the major regional development banks which are active in Europe and Asia. 8.8.1 World Bank Group The World Bank Group consists of the International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), the International Development Association (IDA), the Multilateral Investment Guarantee Agency (MIGA) and the International Centre for Settlement of Investment Disputes (ICSID). IDA was created in 1960 to provide soft loans to low-income countries which lack the creditworthiness to obtain loans from the IBRD. ICSID was set up in 1966 to provide conciliation and arbitration services for disputes between foreign investors and host governments arising out of an investment. 201 CU IDOL SELF LEARNING MATERIAL (SLM)
The World Bank is mainly funded from the international capital markets and is the largest source of market-based loans to developing countries. It disbursed nearly $20 billion in loans and grants in the year to 30 June 2002. Although it mainly lends to sovereign states and government agencies, it also lends to private sector entities so long as they are backed by guarantees given by the relevant host government. It will also provide guarantees to commercial lenders for public and private sector projects. The IFC is the largest multilateral source of loan and equity financing for private sector projects in the developing world. It finances the private sector by both loan and equity investments. IFC does not accept government guarantees and prices its finance and services in line with the market. IFC will usually make loans available on the basis of the A/B loan technique. This technique encourages commercial banks to lend to projects which would otherwise not be sufficiently attractive to them. The A loan is advanced by IFC at its own risk. The B loan is made available by IFC (as the lender of record) but the funds are provided by commercial banks. The end result is that the lending is effectively made by the commercial banks at their own risk. However, the commercial banks will benefit from IFC’s preferred creditor status. Both World Bank and the IFC loans have preferred status which usually results in them being repaid and excluded from any sovereign debt rescheduling. The sanction for the failure to repay these loans is that neither the World Bank nor IFC would make any further credit available to the relevant government. The structure of this A/B loan structure is set out. The relationship between IFC and the commercial banks is set out in a participation agreement. IFC will only lend amounts actually made available to it by the commercial banks under the terms of the participation agreement. IFC will not commit to requiring the commercial banks to make amounts available to it and the borrower therefore has no right to require drawdown of the B loan. This is because IFC wishes to be viewed as the lender of record (rather than the agent of the commercial banks) in order to ensure that the commercial banks are not regarded as the beneficial owners of the interest payments received by IFC. If the commercial banks were viewed as the lender of record then the exemption which the IFC has with regard to withholding tax on payment of interest may be prejudiced. The tax authorities in a particular jurisdiction might still regard the structure as an attempt to avoid tax liability. MIGA was created in 1988 as an independent member of the World Bank Group. MIGA offers investors insurance against non-commercial risk and technical services in order to promote private investment in developing countries. It offers political risk insurance to foreign investors in a project without requiring counter-guarantees from the host government. The World Bank also makes guarantees available in respect of risks which the market will not bear. A guarantee will take the form of either a partial credit guarantee, 202 CU IDOL SELF LEARNING MATERIAL (SLM)
a partial risk guarantee or a policy-based guarantee. A partial credit guarantee is typically used to extend maturities of finance beyond those which private creditors could otherwise provide: for example, by guaranteeing late-dated repayments or providing incentives for short-term loans. Partial risk guarantees are typically used in limited recourse private projects. The partial risk guarantee will cover the risk of non-performance of sovereign contractual obligations or political Force Majeure Events (for example maintaining an agreed regulatory framework or allowing a power plant to be connected to the national grid in the case of an IPP). A policy-based guarantee covers borrowings for agreed structural, institutional and social policies and reforms. The legal structure for a World Bank guarantee consists of a guarantee agreement, an indemnity agreement and a project agreement. The guarantee agreement is entered into between the World Bank and the relevant lenders and sets out the terms of the guarantee. The indemnity agreement is entered into between the World Bank and the host country under which the host country counter-indemnifies the obligations of the World Bank under the guarantee agreement. The project agreement is entered into between the World Bank and the borrower and will contain a variety of undertakings (for example, regulating the use of the guaranteed loan and obliging compliance with environmental rules and regulations). The purpose of the World Bank guarantees is to facilitate the financing of projects which would otherwise be unattractive. This is achieved by the World Bank assuming risks which the market either cannot bear or which would be prohibitively expensive. Therefore, the guarantee may lower the financing costs resulting in an extended loan term. This can be important for long-term infrastructure projects. 8.8.2 European Bank for Reconstruction and Development (EBRD) The EBRD was established in 1991 in order to assist the countries of central and eastern Europe and the CIS with the transition from a state-planned to an open market economy. It aims to achieve this by both investing in projects and assisting the development of financial infrastructure in the relevant countries. EU countries own over 50 per cent of the equity in the bank whilst the US owns 10 per cent and Japan 8.52 per cent. EBRD operates both as a merchant bank and a development bank. Investments are made on a commercial basis and at market rate of return. It will typically fund up to 35 per cent of the total cost of an individual project and requires significant equity funding and debt funding from other co-financiers. The EBRD does not aim to compete with commercial banks, rather it seeks to act as a catalyst to lead other banks into projects. The governments which founded it have provided it with a preferred creditor status (akin to the status enjoyed by IFC). It also utilises the A/B loan structure which was pioneered by the IFC EBRD has a lot of experience of multi-source financing, lending alongside ECAs and/or other commercial lenders. EBRD involvement will usually increase the attractiveness of a project to an ECA 203 CU IDOL SELF LEARNING MATERIAL (SLM)
as EBRD is often prepared to take on significant project risk. Furthermore EBRD is willing to structure its repayment schedule to suit ECAs. 8.8.3 European Investment Bank (EIB) The EIB was set up in 1958 under Article 129 of the Treaty of Rome. Its role is to “contribute ... to the balanced and steady development of the common market in the interests of the Community” by facilitating the financing of certain types of project. These projects include those which assist less-developed regions, the modernisation of undertakings and projects which are of common interest to several member states and cannot be financed otherwise (e.g. Channel Tunnel). A big advantage of EIB involvement in a project is that EIB can provide long-term fixed rate funding. EIB will consider maturities of 25 years and more. EIB funds itself relatively cheaply in the international bond markets due to its credit standing. It is, therefore, able to offer borrowers long-term fixed rate funding by charging a margin on its own cost of funds. This margin will include an element of profit and a further element to cover its statutory reserves. EIB can also offer more traditional floating rate loans and hybrid loans where the rate is fixed for a period and may then be floating for a further period. EIB will typically lend directly to the borrower; however, in some jurisdictions it may prefer to lend to a bank which then on- lends the funds. EIB does not usually accept completion risk in a project financing. However, the borrower may still wish to benefit from EIB funding throughout both the construction and operation phases of the project. This is achieved by providing EIB with bank guarantees or a standby letter of credit from a syndicate of commercial banks during the construction phase. This structure will result in the bank syndicate taking the completion risk. EIB will usually be prepared to assume post-completion risk. Although it may be possible to achieve this by the release by EIB of all the bank guarantees and letters of credit on completion it is more likely that EIB will release the bank guarantees and letters of credit following completion on a phased basis subject to periodic compliance with cover ratio tests. 8.8.4 Asian Development Bank (ADB) The ADB was founded in 1966 with the purpose of promoting the social and economic progress of the developing member countries in the region by lending funds and providing technical assistance. The bank’s operations are based on detailed studies which determine the needs of the relevant country. The bank will lend to private sector projects so long as the project is intended to create jobs or otherwise positively affect the relevant country’s economy. Whilst it will generally expect its loans to be guaranteed by the relevant host government, it will lend to projects which provide essential items or services without sovereign guarantee backing. Its two largest shareholders are Japan and the US followed by the People’s Republic of China, India and Australia. In 2001 India was the largest borrower from the bank with 28.1 per cent of the loans by value. Like EBRD, ADB seeks 204 CU IDOL SELF LEARNING MATERIAL (SLM)
to act as a catalyst to draw private funds into the region. In 2001, ADB provided loans totalling US $5.3 billion. ADB does not seek to compete with commercial banks and, to some extent, acts as a lender of last resort 8.8.5 Commonwealth Development Corporation Group Plc (CDC Group Plc) CDC Group Plc was originally established as the Commonwealth Development Corporation by Act of Parliament in 1948 (then supplemented by a further Act of Parliament in 1978) to create long-term, self-sustainable business in the less developed countries of the world. Despite its development role, it does seek a commercial return on its investments. PFI for central government in the UK is now promoted using a public/private partnership (PPP). In line with becoming a public private partnership, CDC Group Plc was transferred in December 1999 to a public limited company. At a later stage, CDC Group Plc plans to become a public private partnership with the government retaining a significant minority shareholding. As at 31 December 2001, CDC had £805 million invested in over 400 businesses in 54 countries. Activities include power, transport, telecommunications, retail, IT, property and mining. It has a network of offices around the world situated throughout sub-Saharan Africa, Southeast Asia, the Pacific Islands and the Americas. 8.9 INTER-CREDITOR ISSUES IN MULTI-SOURCE PROJECT FINANCE 8.9.1 Complexity of Inter-creditor Issues Project sponsors, borrowers and financiers should not underestimate the problems which may arise when dealing with the varying interests of the different classes of financier in a project financing. These issues usually take a great deal of time to resolve and can contribute significantly to the costs of a transaction. All parties in a project financing are best advised to address the inter-creditor issues as early as possible in order to minimise the risk of financial close being delayed by these issues. Large projects with significant financing requirements need multiple sources of financing. In recent years such sources of finance have included: • “traditional” senior debt project finance loans provided by commercial banks • Bonds (with or without a monoline insurer) • Export credit agencies • International or regional development banks • Equipment leasing • Mezzanine debt (akin to the leveraged buy-out market) • Providers of interest and currency swaps and other hedging instruments 205 CU IDOL SELF LEARNING MATERIAL (SLM)
• shareholders/sponsor loans. Each class of financier will have different interests and priorities which will need to be reconciled in order to produce a complete financing package for the borrower/project company. In addition, it is not unusual for some sources of finance to be put in place following financial close (especially for a bond or lease financing). It is difficult to anticipate the requirements of a subsequent class of financiers and therefore inter-creditor arrangements may need to be sufficiently flexible to allow for subsequent variation to accommodate a further tranche of finance. 8.9.2 Typical Inter-creditor Issues There are seven main categories of issue: 1. Order of drawdown of funds 2. Maturities of the differing classes of finance 3. Priority of distribution of project revenues to the various classes of financier 4. Restrictions on financiers amending the terms of their own financing documents 5. Voting powers for waivers and amendments to financing documents and inter- creditor arrangements 6. Who has the right to accelerate loans and to control the enforcement of security 7. Priority of distribution of the proceeds of enforcement of security. 8.9.3 Common Terms Agreement The common terms agreement is the preferred method of documenting a multi-source project. It is an agreement between the borrower/project company, all classes of financier, the agents, the security trustee and (usually) an inter-creditor agent (acting for each class of financier). The document will set out common terms which apply to each class of debt finance and will usually contain provisions dealing with the following areas: • Definitions • Conditions precedent • Drawdown mechanism for all facilities, including the order of drawdown of the separate facilities • Representations, covenants and events of default • Financial and project information, budgets and financial projections. 8.9.4 Insurance • Project accounts including the order of disbursement to the varying classes of creditor • General agency and account bank provisions 206 CU IDOL SELF LEARNING MATERIAL (SLM)
• Inter-creditor provisions dealing with the issues outlined in paragraphs (1) – (7) above. There will still be a loan agreement for each facility but it will only deal with the unique aspects of that facility (for example, the principal amount, interest rate, fees and repayment terms). Where an ECA is involved the facility agreement may not even be in English or governed by the same law as the common terms agreement. However, this is less of a concern as the important provisions are contained in the common terms agreement. The common terms agreement will typically be governed by English or New York law. The common terms agreement is often driven by the sponsors in order to simplify complex financing terms and inter-creditor arrangements and to facilitate financial close. In addition, where there is a common terms agreement it is more difficult for each class of financier to justify having separate legal representation, insurance and other technical advisers and so can reduce the borrower/project companies’ costs. If a refinancing or a further round of financing is anticipated the common terms agreement may need to provide for subsequent amendments to be made to the document. 8.9.5 Hedging Instruments It is usual for most project companies/borrowers to enter into hedging arrangements (in respect of interest rate or currency exposure or both). The swap bank will want its exposure under the hedging arrangements to be secured. In addition, the banks will want the hedging arrangements to remain in place until all facilities are accelerated. It is usual for it to be a requirement that the swap bank be a member of the lending syndicate. The usual inter-creditor arrangements will provide that payments to swap counterparties will rank equally on enforcement. The swap counterparty will receive no voting rights (however it can exercise its voting rights as a bank). The termination events in a standard ISDA Master Agreement will be amended to provide for cross-acceleration, rather than cross-default. 8.10 EVENTS OF DEFAULT AND REMEDIES 8.10.1 Events of Default Each of the following events shall be an “Event of Default”: a. The Borrower shall fail to pay any instalment of principal or interest, fees, expenses, charges or other amounts required hereunder or under the other Loan Documents or to make any deposit of funds required hereunder when due; or b. Any representation or warranty made by the Borrower, or any of its officers or directors under or in connection with any Loan Document shall prove to have been incorrect in any material respect when made; or 207 CU IDOL SELF LEARNING MATERIAL (SLM)
c. The Borrower shall fail to perform or observe any term, covenant or agreement contained in or take any action prohibited ; or d. The Borrower shall fail to deliver the financial statements, Borrowing Base Certificate, or Compliance Certificate or any other document or report required to be provided within five (5) Business Days of the date due; or e. The Borrower shall fail to perform or observe any term, covenant or agreement contained in any Loan Document on its part to be performed or observed (other than the covenants to pay the Loan Obligations) and any such failure shall remain unremedied for ten (10) days after written notice thereof shall have been given to the Borrower by the Agent; provided, however, that no Event of Default shall be deemed to exist if, within said ten (10) day period, the Borrower has commenced appropriate action to remedy such failure and shall diligently and continuously pursue such action until such cure is completed, unless such cure is or cannot be completed within thirty (30) days after written notice shall have been given; or f. Any provision of any Loan Document shall for any reason cease to be valid and binding on the Borrower or the Borrower shall so state in writing, and such provision is deemed to have a Material Adverse Effect; or g. The Mortgage or the Security Agreement shall for any reason, except to the extent permitted by the terms thereof cease to create a valid lien, encumbrance or security interest in any of the property purported to be covered thereby; or h. The Borrower should breach or be in default under a Material Contract in any material respect, or any other event which would permit any party other than the Borrower to cause a termination thereof, or any Material Contract shall have ceased for any reason to be in full force and effect prior to its stated or optional expiration date; or i. The Borrower should terminate, change, amend or restate, without the Agent’s prior consent any Material Contract, and such event could reasonably be expected to have a Material Adverse Effect; or j. The Borrower shall fail to pay any indebtedness in an amount in excess of One Hundred Thousand and No/100 Dollars ($100,000.00) (either in any individual case or in the aggregate) excluding indebtedness evidenced by the Notes and excluding Ordinary Trade Payable Disputes, or any interest or premium thereon, when due (whether by scheduled maturity, required prepayment, acceleration, demand or otherwise) and such failure shall continue after the applicable grace period, if any, specified in the agreement or instrument relating to such indebtedness; or any other default under any agreement or instrument relating to any such indebtedness, or any other event, shall occur and shall continue after the applicable grace period, if any, specified in such agreement or instrument, if the effect of such default or event is to accelerate, or to permit the acceleration of, the 208 CU IDOL SELF LEARNING MATERIAL (SLM)
maturity of such indebtedness (excluding Ordinary Trade Payable Disputes); or any such indebtedness shall be declared to be due and payable, or required to be prepaid (other than by a regularly scheduled required prepayment), prior to the stated maturity thereof (excluding Ordinary Trade Payable Disputes); or k. The Borrower shall generally not pay its debts as such debts become due, or shall admit in writing its inability to pay its debts generally, or shall make a general assignment for the benefit of creditors; or any proceeding shall be instituted by or against the Borrower seeking to adjudicate it a bankrupt or insolvent, or seeking liquidation, winding up, reorganization, arrangement, adjustment, protection, relief, or composition of it or its debts under any law relating to bankruptcy, insolvency or reorganization or relief of debtors, or seeking the entry of an order for relief or the appointment of a receiver, trustee or other similar official for it or for any substantial part of its property, and, in the case of any such proceeding instituted against it (but not instituted by it) either such proceeding shall remain undismissed or unstayed for a period of thirty (30) days or any of the actions sought in such proceeding (including the entry of an order for relief against it or the appointment of a receiver, trustee, custodian or other similar official for it or for any substantial part of its property) shall occur; or the Borrower shall take any corporate action to authorize any of the actions set forth above in this subsection; or l. Any one or more judgment(s) or order(s) for the payment of money in excess of One Hundred Thousand and No/100 Dollars ($100,000.00) in the aggregate shall be rendered against the Borrower and either: (i) enforcement proceedings shall have been commenced by any creditor upon such judgment or order; or (ii) there shall be any period of ten (10) consecutive days during which a stay of enforcement of such judgment or order, by reason of a pending appeal or otherwise, shall not be in effect; or m. The termination of any Long Term Marketing Agreement prior to its stated expiration date, unless such Long Term Marketing Agreement is replaced by another Long Term Marketing Agreement acceptable to the Agent, within thirty (30) days of the termination of such Long Term Marketing Agreement; or n. The Borrower shall dissolve, merge, consolidate with another Person, or suspend or discontinue doing business; or o. Any event, change or condition, not referred to elsewhere in this Section 6.01 should occur which results in a Material Adverse Effect on the Borrower, any subsidiary or any guarantor of the Obligations hereunder; or p. Any guaranty, suretyship, subordination agreement, maintenance agreement, or other agreement furnished in connection with the Borrower’s obligations hereunder and under any Note shall, at any time, cease to be in full force and effect, or shall 209 CU IDOL SELF LEARNING MATERIAL (SLM)
be revoked or declared null and void, or the validity or enforceability thereof shall be contested by the guarantor, surety or other maker thereof, or the guarantor shall deny any further liability or obligations thereunder, or shall fail to perform its obligations thereunder, or any representation or warranty set forth therein shall be breached, or the guarantor shall breach or be in Default under the terms of any other agreement with the Agent (including any loan agreement or security agreement); or q. The loss, suspension or revocation of, or failure to renew, any franchise, license, certificate, permit, authorization, approval or the like now held or hereafter acquired by the Borrower, if such loss, suspension, revocation or failure to renew could reasonably be expected to have a Material Adverse Effect on the Borrower or any regulatory or Governmental Authority replaces the management of the Borrower or assumes control over the Borrower. 8.10.2 Remedies. Upon the occurrence of an Event of Default and at any time while such Event of Default is continuing, the Agent: a. may accelerate the due date of the unpaid principal balance of the Loans, all accrued but unpaid interest thereon and all other amounts payable under this Agreement and the Loan Documents making such amounts immediately due and payable, whereupon the Notes, all such interest and all such amounts shall become and be forthwith immediately due and payable, without presentment, notice of intent to accelerate or notice of acceleration, demand, protest or further notice of any kind, all of which are hereby expressly waived by the Borrower; provided, however, that in the event of an actual or deemed entry of an order for relief with respect to the Borrower under the Bankruptcy Code, the Loans, all such interest and all such amounts shall automatically become due and payable, without presentment, demand, protest or any notice of any kind, all of which are hereby expressly waived by the Borrower; b. May, by notice to the Borrower, obtain the appointment of a receiver to take possession of all Collateral of the Borrower, including all Personal Property, including all fixtures and equipment leased, occupied or used by the Borrower. The Borrower hereby irrevocably consents to the appointment of such receiver and agrees to cooperate and assist any such receiver to facilitate the transfer of possession of the Collateral to such receiver and to provide such receiver access to all books, records, information and documents as requested by such receiver; and c. may, by notice to the Borrower, require the Borrower to pledge to the Agent as security for the Loan Obligations an amount in immediately available funds equal to the then outstanding Letter of Credit Liabilities, such funds to be held in an 210 CU IDOL SELF LEARNING MATERIAL (SLM)
interest bearing cash collateral account at the Agent without any right of withdrawal by the Borrower; provided, however, that in the event of an actual or deemed entry of an order for relief with respect to the Borrower under the Bankruptcy Code, the Borrower shall, without notice, pledge to the Agent as security for the Loan Obligations an amount in immediately available funds equal to the then outstanding Letter of Credit Liabilities, such funds to be held in such an interest bearing cash collateral account at the Agent; and d. may exercise all other rights and remedies afforded to the Agent under the Loan Documents or by applicable law or equity. Remedies Cumulative. Each and every power or remedy herein specifically given shall be in addition to every other power or remedy, existing or implied, given now or hereafter existing at law or in equity, and each and every power and remedy herein specifically given or otherwise so existing may be exercised from time to time and as often and in such order as may be deemed expedient by the Agent, and the exercise or the beginning of the exercise of one power or remedy shall not be deemed a waiver of the right to exercise at the same time or thereafter any other power or remedy. No delay or omission of the Agent in the exercise of any right or power accruing hereunder shall impair any such right or power or be construed to be a waiver of any Default or acquiescence therein. 8.11 SUMMARY • Loan agreements define and regulate the financing instruments and interrelations amongst the various parties participating in the project financing. Another role of loan documentation is to ensure that the initial credit risk profile remains unchanged over the life of the facility. • Credit agreement includes Condition’s precedent; Drawdown mechanics; interest clause; repayment clause; Margin protection clauses; The illegality clause etc. • The main provisions of project finance credit agreements are Additional indebtedness ;Distribution of dividends ;Grace periods prior to default ;Restrictions on intercompany loans ; Reserve accounts &Insurance • Covenants are undertakings given by a borrower as part of a term loan agreement. Their purpose is to help the lender ensure that the risk attached to the loan does not unexpectedly deteriorate prior to maturity. • The main covenants usually found in commercial bank loan agreements cover nonfinancial and financial covenants as well as events of default, which can be triggered by covenant violations. • Export credit agencies (ECAs) have typically been established by governments to assist in the export of goods or services which are sourced from that country. 211 CU IDOL SELF LEARNING MATERIAL (SLM)
ECAs can also be used by a government to provide aid or assistance to developing countries by helping to finance the export of goods or services to those countries. • The multilateral agencies consist of the various global and regional development banks and funds. In many cases, their original objective was to channel financing for infrastructure projects and other public works to governments and state- controlled agencies in the relevant part of the world. • The World Bank Group consists of the International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), the International Development Association (IDA), the Multilateral Investment Guarantee Agency (MIGA) and the International Centre for Settlement of Investment Disputes (ICSID). • IDA was created in 1960 to provide soft loans to low-income countries which lack the creditworthiness to obtain loans from the IBRD. • ICSID was set up in 1966 to provide conciliation and arbitration services for disputes between foreign investors and host governments arising out of an investment. • The World Bank is mainly funded from the international capital markets and is the largest source of market-based loans to developing countries. Although it mainly lends to sovereign states and government agencies, it also lends to private sector entities so long as they are backed by guarantees given by the relevant host government. • The IFC is the largest multilateral source of loan and equity financing for private sector projects in the developing world. It finances the private sector by both loan and equity investments. IFC does not accept government guarantees and prices its finance and services in line with the market. • European Bank for Reconstruction and Development (EBRD) established in 1991 in order to assist the countries of central and eastern Europe and the CIS with the transition from a state-planned to an open market economy. It aims to achieve this by both investing in projects and assisting the development of financial infrastructure in the relevant countries. • European Investment Bank (EIB) was set up in 1958 and its role is to “contribute to the balanced and steady development of the common market in the interests of the Community” by facilitating the financing of certain types of project. • Asian Development Bank (ADB) was founded in 1966 with the purpose of promoting the social and economic progress of the developing member countries in the region by lending funds and providing technical assistance. • Commonwealth Development Corporation Group Plc (CDC Group Plc) was originally established as the Commonwealth Development Corporation by Act of 212 CU IDOL SELF LEARNING MATERIAL (SLM)
Parliament in 1948 to create long-term, self-sustainable business in the less developed countries of the world. 8.12 KEYWORDS • ECA-Export Credit Agencies • OECD-Organisation for Economic Cooperation and Development • GNI-Gross National Income • CIRR-Contractual Interest Rate • EBRD-European Bank for Reconstruction and Development 8.13 LEARNING ACTIVITY 1. Make a brief note on your understanding on the prominent role played by Credit agencies in Project Finance and prepare a list of top 5 credit agencies in India ________________________________________________________________________ ________________________________________________________________________ 8.14 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are the significant provisions of the project finance credit agreement? 2. What is a covenant and what are its types? 3. What role does the export credit agencies play in project finance? 4. What do you mean by OECD consensus? 5. What categories of ECA support are provided in project financing? Long Questions 6. Explain the basic terms that any credit agreement will have. 7. Explain the major non-financial covenants. 8. When will a default arise? 9. What is commercial risk insurance? 10. Explain the contribution of European Investment Bank in project financing. B. Multiple Choice Questions 1. IBRD refers to a. World Bank b. European Investment Bank c. Asian Development Bank 213 CU IDOL SELF LEARNING MATERIAL (SLM)
d. Commonwealth Development Corporation Group 2. Normal CIRR shall apply for repayment term upto a. 10 years b. 11 years c. 12 years d. 14 years 3. EBRD was establishes in a. 1981 b. 1991 c. 2001 d. 2011 4. Who was the largest borrower of ADB as on 2001 a. People’s Republic of China b. Australia c. India d. Pakistan 5. Consensus seeks to establish __________________ between its members a. Covenants b. Guarantee c. Level Playing field d. Contract Answers 1-a, 2-c, 3-b, 4-c, 5-c 8.15 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 214 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 9- FINANCIAL MODELING Structure 9.0 Learning Objectives 9.1 Introduction 9.2 Structure 9.3 User and Function Modelling 9.4 Flow of Control Modelling 9.4.1 Set Theoretic Background and Flow of Control 9.5 Risk Management 9.6 Risk Management in Project 9.7 Summary 9.8 Keywords 9.9 Learning Activities 9.10 Unit End Questions 9.11 References 9.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain what Financial Modelling is • Know what user and function modelling is • State the risk management 9.1 INTRODUCTION A project encompasses all stages of work from inception through to demolition and possible reuse of a particular artifact. To manage and understand what happens in a project, a model is required of the various actors involved and the responsibilities and tasks they play in the project. The development of a project model also provides an understanding of which data models are required in a project and what data transfer is required between these models. This influences the work done on schema development and on mappings between schemas. A project model provides a formal description of the various users who will be involved in the project, and formalises the roles they will be fulfilling in the design task. The various design roles can be further refined to individual design functions which can, in turn, be associated with the design tools available to perform them. The set of design functions must be able to be scheduled, to allow a project 215 CU IDOL SELF LEARNING MATERIAL (SLM)
manager to ensure that design policies are followed, quality assurance conventions are maintained, handover points between contractors are formalised, and design progress can be monitored. Without the ability to model and manage these aspects, an integrated design system offers a meaningless data transfer mechanism unrelated to a real-world project. A large design and construction project involves many development phases, some of which may be independent of each other, and, in many cases, need not be specified (and may not even be known) at the start of the project. To understand and manage the large scale of projects, and their initial indeterminacy, they are often conceptualised as happening in stages, though these stages often overlap. Common stages in a project may include inception, management, design, construction, maintenance and demolition. Stages may be very broad, or quite specific; for example, the structural design stage in a particular design office. In COMBINE, the term ‘project window’ was introduced to describe these coherent portions of a project (see Figure ). This term is used throughout this thesis. The project windows represent a given time-slice of the project, or some sub- process. Therefore, a project is considered as being divided into multiple, conceivably overlapping, project windows which are specified prior to the execution of a new phase of a project. Fig 9.1 Even splitting a project into multiple project windows is unlikely to provide enough flexibility for real projects. A single project window may model weeks of work, over which period the participants in the design team could change (e.g., bringing in an expert to help with unforeseen problems) and various flows between design functions may need to be modified (e.g., to ensure new aspects of the design are checked). To cope with this variability, a previously specified project window model must be able to be modified and updated as the design progresses, with immediate flow-on effects to the running control system. The modelling of projects and project windows requires many aspects of a project to be captured. Other research in this area has been examined to provide an understanding of the requirements for project modelling. The notion of project models outlined above has 216 CU IDOL SELF LEARNING MATERIAL (SLM)
great similarity to the concepts of project and process in software engineering. Curtis et al. (1992) provide a review of process modelling which categorises requirements and various approaches to process modelling. Their four most commonly utilised perspectives in process representation (functional, behavioural, organisational and informational) are used to rate previous process models, and are also used to evaluate the CombiNet model developed here. The meaning of these four perspectives are: Functional: represents what process elements are being performed, and what flows of informational entities (e.g., data, artifacts, products) are relevant to these process elements. • Behavioural: represents when process elements are performed (e.g., sequencing), as well as aspects of how they are performed through feedback loops, iteration, complex decision-making conditions, entry and exit criteria, and so forth. • Organisational: represents where and by whom (which agents) in the organisation process elements are performed, the physical communication mechanisms used for transfer of entities, and the physical media and locations used for stored entities. • Informational: represents the informational entities produced or manipulated by a process; these entities include data, artifacts, products (intermediate and end), and objects; this perspective includes both the structure of informational entities and the relationships between them. Requirements Considering the four most common perspectives offered by Curtis et al. (1992) led to the definition of a set of views that must be able to be supported. These views include users, tasks, data and workflow. The requirements of these views are as follows: • User View: all the actors involved in a project window and the tasks they must undertake to ensure completion of the project window role. This view must capture the responsibilities of the various actors and their rights in terms of viewing and modifying information in a project. Task View: all design functions that can be performed by the design tools within the project window. The granularity of a design function can vary from atomic changes to a design, through to a complete design. The level of granularity is determined by the requirements of individual projects. The only fixed requirement is that each design function must happen between a starting and ending exchange event of information with respect to the integrated design system. Everything that goes on between these exchange events is invisible in the project window model, being the domain of the design function. Thus, design functions can be both on-line atomic CAD design tool operations and off-line batch mode design tool runs. 217 CU IDOL SELF LEARNING MATERIAL (SLM)
• Data View: all schemas concerned with design functions and users. In the project windows described here this includes: • The complete IDM schema. • The IDM subschemas corresponding to the input of design functions. • The IDM subschemas corresponding to the output of design functions. • The IDM subschemas corresponding to the input view of actors. • The IDM subschemas corresponding to the change access of actors. This offers a purely static view of the project window definition, not addressing aspects of control over instances (unless it can be modelled in the schema). The subschemas do, however, define the state that the project must reach before a particular design function may be utilised, or before an actor can be called into the project. Workflow View: defines all possible flows from a particular point in a project. It ties the design functions together and provides the way of describing the handover between various actors in a project. The workflow defines how tightly managed and controlled a project is going to be, from highly specified to very open. To enable the workflow view to be used, a management system will have to be able to determine all states of a design function, the state of the integrated design system, and control over exchange events according to control flow constraints. This will include the following aspects: • Whether a design function is being performed. • Whether a design function is a candidate to be invoked (in view of design functions that it depends on). • Whether a design function is a candidate to be re-run because the running of another design function changed its original input. • The design function state and integrated design system state resulting from previous exchange events The views specified above describe aspects of a project which must be modelled to ensure that required project perspectives can be supported. However, they do not provide a measure of the level of control that will be exerted on a project through the views. The level of control could vary widely, from very rigid and autocratic management through to very free and autonomous management. Current perspectives on this include: • No control as typified by current integrated design systems. These systems are merely able to transfer data around without any in-built process context and purpose of data exchange events. For such a system to be operational in a particular design project, a project manager needs to establish work procedures, 218 CU IDOL SELF LEARNING MATERIAL (SLM)
task scheduling, etc. among the team of users. The system is an insensible data router which provides no guidance on what should be done next. • Shallow control is seen in several of the more recent integrated design system efforts, e.g., COMBINE, and ToCEE. This approach uses a scheduler which deals only with the control over who, or what task, is next, and which monitors the states resulting from exchange events. At this level of control, a project manager can enforce much rigour in the use of the system. Although this might suit project windows for parametric (routine) design, it is to be expected that most project windows will require a more flexible approach, where the human users may interact with the control layer as well as with each other (outside the system). • Deep control is the level that integrated design system developers aspire to and AI researchers still ruminate over. This type of control deals with much greater complexity than just scheduling. Deep control must deal with the pre- and post- conditions which are related to exchange events. It should have the ability to look inside exchange events and DT interfaces, and propose remedial actions for any failure of a DT invocation or analysis, or propose and control how the system can recuperate from deadlocks in design scheduling. Deep control should also deal with declarative knowledge on the meaning and purpose of design functions and thus support goal-driven design strategies. A deep control system, while perhaps being the type of control system that should be aimed for in the future, is out of the scope of this thesis. Deep control, as defined above, requires the solution of many hard research problems in the artificial intelligence field. As a first step towards introducing process control into integrated design systems, shallow control has been selected for use in all the large EU funded projects and this is the approach implemented. 9.2 STRUCTURE To cover the four most commonly utilised perspectives specified in above section, and meet the requirements, the CombiNet formalism developed here defines three main types of information to be modelled for a project window: project window requirements, defining part of the informational perspective; user requirements, defining most of the functional, organisational and informational perspectives; and flow of control requirements, defining the behavioural perspective. Project window requirements allow the specification of starting conditions for entry into a project window, and exit conditions (e.g., data that is required by the end of the project window). User requirements allow the specification of the participants and their design functions in a particular project window. These participants (actors) perform certain design roles in a project and these design roles can be completed through the application of various design functions. A design function 219 CU IDOL SELF LEARNING MATERIAL (SLM)
can be represented as a particular design tool used in a certain manner, e.g., to perform one type of analysis from the range a design tool offers. Flow of control requirements allow the specification of the paths that may be followed between various design functions to complete the design phase encapsulated by the project window. Fig 9.2 The CombiNet formalism utilises two specification notations to model user requirements and flow of control requirements. Though two notations are described, they are used in an integrated manner in the specification environment, with explicit links between diagrams in both notations. 9.3 USER AND FUNCTION MODELLING A majority of the functional, organisational and informational perspectives, as introduced in above Section, can be grouped together and defined in a single formalism. Functional and informational perspectives can be defined for design functions, actors and the project window through the definition of input and output models. These schemas specify structures and constraints of the models used by, and produced through, the use of a particular design function, actor or project window. Organisational perspectives can be partially defined in the same model through connections between actors, their design roles, and the design functions required to complete the design roles. In above Figure , a 220 CU IDOL SELF LEARNING MATERIAL (SLM)
graphical specification of user and function, detailed in a CGE (Configurable Graphical Editor, Vogel 1991) project window formalism (developed by the author), is presented. There are three main types of icon in this diagram, connected by arrows representing performs and requires relationships for actors and design roles respectively. Actor: the oval icons in the left column of the diagram represent actors (users) participating in the project window being specified. An actor has a name defining either the actor or, as in above Figure the type of actor which will be performing particular roles in the project window. Each actor is associated with a pair of schema defining both the subset of the IDM that they are able to view, and the subset of the IDM that they are allowed to modify. These two schemas define the area of responsibility of a particular actor, and are used to ensure the actor acts within a specified domain. These schemas can also be used to check that the roles an actor plays are not outside the actor’s area of responsibility. Actor responsibility can be checked against design role responsibility, as the area of responsibility of a design role can be determined by the union of the schemas associated with each design function it utilises. An actor is associated with one or more design roles. In above Figure each actor has unique design roles, but this is not mandatory, multiple actors are allowed to perform the same design role. Design Role: the rectangular icons in the centre column of the diagram represent the various design roles which are performed by actors in this project window. Each named design role can be fulfilled through the application of various design functions (the scheduling of which is specified at a later stage). Several design roles can utilise the same design function in the completion of their role. For example, the documentation design function is used by most of the design roles. Design Function: the icons in the right column of the diagram represent the various atomic design functions which can be carried out in the completion of design roles in the project window. A design function has a name defining the type of function it performs and directly under the icon the name of the design tool which will be used to perform the named function. Each design function is associated with two schemas defining both the subset of the IDM which will be the input to the design tool, and the portion of the IDM which can be updated at the completion of the design function. These two schemas define the responsibilities of the design function. Though not shown in above Figure, several design functions can be accomplished with the same design tool, but often with different input and output schemas defining responsibilities for the tool. The definition of the different functions performed by the same design tool is indicated by the two schemas specified along with the design function. In the CGE environment the modeller can navigate from this user and function view to the top-level flow of control view through a menu item in the environment. The CGE environment is not as sophisticated as the MViews environment utilised ,limiting the type of environment that can be offered to the modeller. The main restrictions are that it can only provide a single view of a model (i.e., 221 CU IDOL SELF LEARNING MATERIAL (SLM)
one user and function view) and sophisticated navigation facilities are not available (e.g., it is not possible to navigate from a design function to all flow of control views which reference that design function). 9.4 FLOW OF CONTROL MODELLING A Petri net formalism provides much of the behavioural perspective required for project specification, and, along with the DT schemas for actors and design functions defined in the user specification detailed in above Section, many properties of a project’s state can be calculated. In this section the calculable properties of a flow of control specification are defined, along with a formalism for describing them. This formalism is based around the design functions defined in the user specification. However, it also overlays actor’s areas of responsibility to provide the link to organisational perspectives for the project specification. 9.4.1 Set theoretic background for flow of control The control view states defined in above Section are calculable from analysis of data flows in the integrated design system based on the schemas associated with each design function (DF). The basis of the analysis is to assume that the input and output schemas for a design function together describe a subset of the IDM schema. This is not strictly true, as the schema for a design function is likely to have cardinality constraints, keys and value constraints which differ from the IDM. However, these added constraints can be ignored when checking subset relationships and when performing intersections of various schemas. What will be used for the set operations will be the definition of entity names and their inherited entities, and attribute names and types which appear in the design function schemas and the IDM. In the following conditions and constraints in is used to denote the input schema to a design function or actor, and Out to denote the output schema of a design function or actor. There are two conditions which must hold on the design function and actor schema definitions: This just states formally that the input and output schemas of all design functions and actors must be a subset of the IDM, and that the input and output of any design function used by an actor is a subset of that actor’s schemas. In practice, this means that the input and output schemas must be defined in terms of the IDM (i.e., using the same entity, relationship, method and attribute names), as well as being defined by the model structure used in the actual design tool or actor view. Using these definitions enables a static check 222 CU IDOL SELF LEARNING MATERIAL (SLM)
of all schemas in the integrated system. The schemas can be checked against the IDM to determine whether they are valid subsets of the IDM (i.e., whether the schema has been defined properly. This will mainly pick up typing errors). The allowable differences in schemas of a design function or actor over that of the IDM are that the former may define: different uniqueness constraints (keys); different constraint clauses or ones which are additional to those defined in the IDM; different cardinalities on attributes; and different optional specifications for attributes. Given a system which contains the IDM schema and the input and output schemas of the various design functions used in a particular project window, and the definition of a flow of control for a given project window, there are various properties which can be calculated. To derive these properties from the design function schemas two constraints are defined: This constraint is a concurrency check, or an invocation check, stating that a design function (c) is a candidate to be invoked if its input schema has no intersection with the output schema of any of the running design functions (written as running DF in the constraint) This constraint is a re-invocation check, stating that if the output schema of a design function which has just terminated (DFj Out) intersects with the input schema of any other design function which was previously run (DFi In), then the previously invoked design function (DFi) is a candidate to be rerun. It must be noted at this point, that intersections between design functions are described only at the schema level (i.e., static determination). Where the design functions require a model of a full building this will be sufficient to determine the properties detailed above. However, if a design function models only a small portion of a building (e.g., calculates properties for a single space) then the properties calculated above could present a design function as a candidate to be rerun in more cases than necessary. In the implementation of the flow of control system, this is handled by also tracking the objects which are used by each design function. The intersections between design function schemas gives a static determination of whether a design function needs to be further examined at run time to determine the properties defined above. The working of the two constraints described above is illustrated in the figures below: 223 CU IDOL SELF LEARNING MATERIAL (SLM)
The above fig presents the situation where, even though the two design functions share data in their input schemas, neither of the design function input schemas have an intersection with a design function output schema. In this case, both design functions may run concurrently, and the result of either tool will not cause the re-invocation of the other design function. Above Figure presents an example where there is an intersection between an input and output schema of two design functions. In this case, if DF1 is running then DF2 may not start. This figure also illustrates what may happen with Constraint 2. If DF2 was run at some time in the past, and then DF1 is run, then the output of DF1 may overwrite what was previously supplied to DF2, so DF2 becomes a candidate to be rerun. 224 CU IDOL SELF LEARNING MATERIAL (SLM)
Above Figure presents a case where the two design functions may not run concurrently, as the input schema of each design function intersects with the output schema of the opposite design function. This figure illustrates a situation where the invocation of either of these design functions can cause the other design function to be a candidate for a rerun, apparently causing a cycle. However, this is not problematical as the design functions are only candidates to be run. The final decision of what can be run at any particular time is made via the project window control flow information. Above Figure presents a definition which could apparently lead to inconsistencies. The two design functions have the same properties as those in Figure 7.5, but with the additional complication that they overwrite portions of each other’s output. Again, this is acceptable, as the running of each of these design functions is determined by the project window definition which by its own definition gives rights to a design function to place its output in a portion of the resultant data store. The termination of either design function will mark the opposing design function as a candidate to be rerun, making explicit the fact that the output of the design function has been overwritten. While these examples demonstrate the interaction between just two design functions, the constraints described earlier are general and the results can be applied over any number of design functions. 225 CU IDOL SELF LEARNING MATERIAL (SLM)
9.5 RISK MANAGEMENT The management system contains a routine (named routine XX in this thesis) which describes how risks should be managed in projects and at operational level. The headlines in the routine are listed below, followed by a short explanation of the content. Purpose The purpose according to the routine is to set the framework for how risk management should be carried out, so it becomes uniformly in the whole company. Demands Internal and external demands are listed that have an affect how risk management should be carried out. Examples of internal and external demands according to the routine: Internal ▪ Risk management should create value for the company and should be a continuous ongoing progress. ▪ Risk management should be integrated in both with the company’s project model and at the line operational level. ▪ Risk management should be act as support before any decision is made Scope Risk management should be done in all arias at the company, both project and at line operational level. The main target for the routine is manages, sponsors, project managers, central risk coordinators, risk coordinators and risk owners. Definition Defines what the company means with: • Risk factor: The likelihood and consequence of an event if it occurs, affects the business goal, project goal, environment and work environment in a negative way. • Probability: Possibility of the current risk to occur under a determined time interval. • Consequence: The result/effect that would occur, if the risk occurs. • Remedy: Planned activities associated with a specific risk, with the purpose to minimize it to happen. The activity should reduce the probability or consequence. The routine explains responsibilities and what authorities they have within the organisation, regarding risks. The company’s risk management routine described the risk management process to increase awareness and facilitate experience reversals also traceability in their process. Their risk management process: 226 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 9.3 Each part of the process is described in the routine, and what risks the company have chosen to use in the identification process, they are: • Technology • Infrastructure • Staff and Organization • Economy • Politics and Society • Laws and requirements • Work • External Environment The company uses a 5x5 matrix in the qualitative risk analysis process. The process is carried out as shown below: R= L x C (Risk factor= Likelihood x Consequence) 227 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 9.4 The routine then describes how the risks should be reported, depending if the risk is in a project or owned by the line operations. The routine doesn’t describe further how to work with risk, just that red risks should be reported and described in the project plan, if it’s a project risk. 9.6 RISK MANAGEMENT IN PROJECT The company have a routine that describes a project life circle (called Routine YX in this report), which includes an illustration of the project model with all phases and tollgates shown below. The routine gives the reader an overview on how projects are carry out at 228 CU IDOL SELF LEARNING MATERIAL (SLM)
the department, but doesn’t go into details on any methods. In order to go into details, Routine YX refers to other routines or instructions. The project review board have an instruction called instruction XC, which describes how they make decisions regarding tollgates. As projects progresses, project manager’s needs to fill in all headers in instruction XC to make a decision basis for the review board if the project is ready to pass a milestone. The instruction XC exists because decision-makers in the review board should ask same questions for all projects within the organization. The instruction describes all tollgates and has different questions depending on which tollgate that are put up for decision. One of the questions for tollgate three is: “Is the balance between risk and value of the project taken into consideration? “ The question is followed by nine questions that are project risk related. One of the nine questions are; “are the working methods from the risk management established, and works for the project?” There are also questions regarding the project budget and time schedule. The instruction doesn’t name any method in order to meet the demands; it works as a checklist with 25-30 questions that should be answered. The department have an instruction on how to write a project plan (called instruction DG in this report). Instruction DG has all the titles with an explanation what the project needs to find in each header in order to get it approved. Both project budget and project risk management have own headers. Instruction DG header for ‘project budget’ and ‘cost monitoring’, recommends that budgets should be based on the project WBS and use the budget template that the company was. Neither the header nor the template mentions any method to actually do the budget. The instruction just recommends following project structure with activities, for estimating cost and cost for resources. 229 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 9.5 The title that describes how project should handle risks is a little more defined; Projects should refer to a separate risk management plan, or describe the following in directly in the project plan; • Specify the risk profile established for the project • Define when and how risk assessments should be carried out during the project, also how the risks should be followed up. • Refer to the project's risk register, and specify where the risk identification analysis is stored. • Reference to the risk list and how they are measured, established, monitored and reported according to routine XX. 9.7 SUMMARY • Project modelling is a task that must be undertaken at the start of every project as participants and their tasks will vary for almost every project. • A project encompasses all stages of work from inception through to demolition and possible reuse of a particular artifact. To manage and understand what happens in a project, a model is required of the various actors involved and the responsibilities and tasks they play in the project. • To understand and manage the large scale of projects, and their initial indeterminacy, they are often conceptualised as happening in stages, though these 230 CU IDOL SELF LEARNING MATERIAL (SLM)
stages often overlap. Common stages in a project may include inception, management, design, construction, maintenance and demolition. • The project windows represent a given time-slice of the project, or some sub- process. Therefore, a project is considered as being divided into multiple, conceivably overlapping, project windows which are specified prior to the execution of a new phase of a project. • Their four most commonly utilised perspectives in process representation (functional, behavioural, organisational and informational) are used to rate previous process models, and are also used to evaluate the CombiNet model developed. • A design function can be represented as a particular design tool used in a certain manner, e.g., to perform one type of analysis from the range a design tool offers. • Given a system which contains the IDM schema and the input and output schemas of the various design functions used in a particular project window, and the definition of a flow of control for a given project window, there are various properties which can be calculated. • A Petri net formalism provides much of the behavioural perspective required for project specification, and, along with the DT schemas for actors and design functions defined in the user specification detailed, many properties of a project’s state can be calculated. 9.8 KEYWORDS • PROJECT WINDOW - The project windows represent a given time-slice of the project, or some sub-process. • ACTOR - actors (users) are participants in the project window being specified. An actor has a name defining either the actor or, as the type of actor which will be performing particular roles in the project window. • Design Function - A design function has a name defining the type of function it performs and directly under the icon the name of the design tool which will be used to perform the named function. • Risk factor: The likelihood and consequence of an event if it occurs, affects the business goal, project goal, environment and work environment in a negative way. 9.9 LEARNING ACTIVITY 1. Design a small financial design function model for a manufacturing industry with all its components included. 231 CU IDOL SELF LEARNING MATERIAL (SLM)
________________________________________________________________________ ________________________________________________________________________ 9.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define financial modelling 2. What is functional modelling. 3. What is design function. 4. What is risk management. Long Questions 1. Explain external and internal demands with examples. 2. Explain about user and functional modelling 3. Discuss about the risk management in a project. B. Multiple Choice Questions 1. Users participating in the project window being specified are called ________ a. functions b. Units c. Actors d. node 2. Planned activities associated with a specific risk, with the purpose to minimize it to happen is called _____ a. remedy b. risk factor c. probability d. scope Answers 1.c 2. a 232 CU IDOL SELF LEARNING MATERIAL (SLM)
9.11 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 233 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 10 - FINANCIAL MODELING Structure 10.0 Learning Objectives 10.1 Introduction 10.2 What is a Financial Model Used for? 10.3 Who builds Financial Models? 10.4 How do You Build a Financial Model? 10.5 Summary 10.6 Keywords 10.7 Learning Activity 10.8 Unit End Questions 10.9 References 10.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain why a financial model is used for? • State who builds a financial model • Also learn how to build a financial model 10.1 INTRODUCTION A financial model is simply a tool that’s built-in spreadsheet software such as MS Excel to forecast a business’ financial performance into the future. The forecast is typically based on the company’s historical performance, assumptions about the future, and requires preparing an income statement, balance sheet, cash flow statement, and supporting schedules (known as a 3-statement model). From there, more advanced types of models can be built such as discounted cash flow analysis (DCF model), leveraged buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis. Below is an example of financial modelling in Excel 234 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 10.1 10.1 WHAT IS A FINANCIAL MODEL USED FOR? The output of a financial model is used for decision making and performing financial analysis, whether inside or outside of the company. Inside a company, executives will use financial models to make decisions about: • Raising capital (debt and/or equity) • Making acquisitions (businesses and/or assets) • Growing the business organically (e.g., opening new stores, entering new markets, etc.) • Selling or divesting assets and business units • Budgeting and forecasting (planning for the years ahead) • Capital allocation (priority of which projects to invest in) • Valuing a business • Financial statement analysis/ratio analysis • Management accounting 10.2 WHO BUILDS FINANCIAL MODELS? There are many different types of professionals who build financial models. The most common types of career tracks are investment banking, equity research, corporate development, FP&A, and accounting (due diligence, transaction advisory, valuations, etc). What are financial modelling best practices? 1. Excel tips and tricks 235 CU IDOL SELF LEARNING MATERIAL (SLM)
It’s very important to follow best practices in Excel when building a model. For more details you can take our free Excel course, which outlines the following key themes: • Limit or eliminate the use of your mouse (keyboard shortcuts are much faster) • Use a blue font for hard-codes and inputs (formulas can stay black) • Keep formulas simple and break down complex calculations into steps • Ensure you know how to use the most important Excel formulas and functions • Use INDEX and MATCH instead of VLOOKUP to query data • Use the CHOOSE function to build scenarios 2. Formatting It’s important to clearly distinguish between inputs (assumptions) in a financial model, and output (calculations). This is typically achieved through formatting conventions, such as making inputs blue and formulas black. You can also use other conventions like shading cells or using borders. 3. Model layout and design It’s critical to structure a financial model in a logical and easy to follow design. This typically means building the whole model on one worksheet and using grouping to create different sections. This way it’s easy to expand or contract the model and move around it easily. The main sections to include in a financial model (from top to bottom) are: • Assumptions and drivers • Income statement • Balance sheet • Cash flow statement • Supporting schedules • Valuation • Sensitivity analysis • Charts and graphs Below is an example of the grouped sections of a well laid out financial model: 236 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 10.2 10.3 HOW DO YOU BUILD A FINANCIAL MODEL? Financial modelling is an iterative process. You have to chip away at different sections until you’re finally able to tie it all together. Below is a step-by-step breakdown of where you should start and how to eventually connect all the dots. 1. Historical results and assumptions Every financial model starts with a company’s historical results. You begin building the financial model by pulling three years of financial statements and inputting them into Excel. Next, you reverse engineer the assumptions for the historical period by calculating things like revenue growth rate, gross margins, variable costs, fixed costs, AP days, inventory days, and AP days, to name a few. From there you can fill in the assumptions for the forecast period as hard-codes. 2. Start the income statement With the forecast assumptions in place, you can calculate the top of the income statement with revenue, COGS, gross profit, and operating expenses down to EBITDA. You will have to wait to calculate depreciation, amortization, interest, and taxes. 237 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 10.3 3. Start the balance sheet With the top of the income statement in place, you can start to fill in the balance sheet. Begin by calculating accounts receivable and inventory, which are both functions of revenue and COGS, as well as the AR days and inventory days assumptions. Next, fill in accounts payable, which is a function of COGS and AP days. 4. Build the supporting schedules Before completing the income statement and balance sheet, you have to create a schedule for capital assets like Property, Plant & Equipment (PP&E), as well as for debt and interest. The PP&E schedule will pull from the historical period and add capital expenditures and subtract depreciation. The debt schedule will also pull from the historical period and add increases in debt and subtract repayments. Interest will be based on the average debt balance. 5. Complete the income statement and balance sheet The information from the supporting schedules completes the income statement and balance sheet. On the income statement, link depreciation to the PP&E schedule and interest to the debt schedule. From there, you can calculate earnings before tax, taxes, and net income. On the balance sheet, link the closing PP&E balance and closing debt balance from the schedules. Shareholder’s equity can be completed by pulling forward last year’s closing balance, adding net income and capital raised, and subtracting dividends or shares repurchased. 238 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Build the cash flow statement With the income statement and balance sheet complete, you can build the cash flow statement with the reconciliation method. Start with net income, add back depreciation, and adjust for changes in non-cash working capital, which results in cash from operations. Cash used in investing is a function of capital expenditures in the PP&E schedule, and cash from financing is a function of the assumptions that were laid out about raising debt and equity. 7. Perform the DCF analysis When the 3 statement model is completed, it’s time to calculate free cash flow and perform the business valuation. The free cash flow of the business is discounted back to today at the firm’s cost of capital (its opportunity cost or required rate of return). We offer a full suite of courses that teach all of the above steps with examples, templates, and step-by-step instruction. Read more about how to build a DCF model. 8. Add sensitivity analysis and scenarios Once the DCF analysis and valuation sections are complete, it’s time to incorporate sensitivity analysis and scenarios into the model. The point of this analysis is to determine how much the value of the company (or some other metric) will be impacted by changes in underlying assumptions. This is very useful for assessing the risk of an investment or for business planning purposes (e.g., does the company need to raise money if sales volume drops by x percent?). 239 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 10.4 9. Build charts and graphs Clear communication of results is something that really separates great from merely good financial analysts. The most effective way to show the results of a financial model is through charts and graphs, which we cover in detail in our advanced Excel course, as well as many of the individual financial modelling courses. Most executives don’t have the time or patience to look at the inner workings of the model, so charts are much more effective. 240 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig 10.5 10. Stress test and audit the model When the model is done, your work is not over. Next, it’s time to start stress-testing extreme scenarios to see if the model behaves as expected. It’s also important to use the auditing tools covered in our financial modelling fundamentals course to make sure it’s accurate and the Excel formulas are all working properly. 10.5 SUMMARY • A financial model is a tool that’s built in spreadsheet software such as MS Excel to forecast a business’ financial performance into the future; based on the company’s historical performance, assumptions about the future. Advanced models can be built such as discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis. • A financial model used for decision making and performing financial analysis, whether inside or outside of the company. Decisions like Raising capital, making acquisitions, valuing a business, capital allocation, and more. • Financial models are most commonly used by investment bankers, equity researchers, corporate development, FP&A, and accounting (due diligence, transaction advisory, valuations, etc). 241 CU IDOL SELF LEARNING MATERIAL (SLM)
• Financial modelling best practices are important to follow as it makes it easier to build models and following a set of guidelines standardizes the process where anyone will be able to understand and make modifications to the model, if necessary. Some tips: o Limit or eliminate the use of your mouse (keyboard shortcuts are much faster) o Colour code inputs and formulas o Keep formulas simple and break down complex calculations into steps o Use INDEX and MATCH instead of VLOOKUP to query data o Use the CHOOSE function to build scenarios • Formatting: Use of formatting conventions. It’s important to clearly distinguish between inputs (assumptions) in a financial model, and output (calculations). • Model layout and design: Model to be in a logical and easy to follow design so that it’s easy to expand or contract the model and move around it easily. • Sections to include in a financial model (from top to bottom) are: o Assumptions and drivers o Income statement o Balance sheet o Cash flow statement o Supporting schedules o Valuation o Sensitivity analysis o Charts and graphs •Building a financial model: Financial modelling is an iterative process. You have to chip away at different sections until you’re finally able to tie it all together. Step-by-step breakdown of building a financial model: 1. Historical results and assumptions: You begin building the financial model by pulling three years or more of financial statements and inputting them into Excel. Reverse engineer the assumptions for the historical period by calculating things like revenue growth rate, gross margins, variable costs, fixed costs, AP days, inventory days, and AP days, to name a few. From there you can fill in the assumptions for the forecast period as hard-codes. 242 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Start the income statement: With the forecast assumptions in place, you can calculate the top of the income statement with revenue, COGS, gross profit, and operating expenses down to EBITDA. You will have to wait to calculate depreciation, amortization, interest, and taxes. 3. Start the balance sheet: With the top of the income statement in place, you can fill in the balance sheet. Calculate accounts receivable and inventory, which are both functions of revenue and COGS, as well as the AR days and inventory days assumptions. Next, fill in accounts payable, which is a function of COGS and AP days. 4. Build the supporting schedules: Before completing the income statement and balance sheet, create a schedule for capital assets like PP&E as well as for debt and interest. 5. Complete the income statement and balance sheet: The information from the supporting schedules completes the income statement and balance sheet. On the income statement, link depreciation to the PP&E schedule, interest to the debt schedule, earnings before tax, taxes, and net income. On the balance sheet, link the closing PP&E balance and closing debt balance from the schedules and calculate shareholder’s equity. 6. Build the cash flow statement: Using the reconciliation method build the cash flow statement. 7. Perform the DCF analysis: With the 3-statement model, calculate free cash flow and perform the business valuation. 8. Add sensitivity analysis and scenarios: Once the DCF analysis, incorporate sensitivity analysis and scenarios into the model. This is very useful for assessing the risk of an investment or for business planning purposes. 9. Build charts and graphs: The most effective way to show the results of a financial model is through charts and graphs. 10. Stress test and audit the model: Begin stress-testing extreme scenarios to see if the model behaves as expected to make it fool proof. 10.6 KEYWORDS • COGS – Cost of Goods sold • PPE-Property plant and Equipment 243 CU IDOL SELF LEARNING MATERIAL (SLM)
10.7 LEARNING ACTIVITY 1. Take the historic data of a company (last 5 years) and build a financial model to forecast it revenue. ________________________________________________________________________ ________________________________________________________________________ 10.8 UNIT END QUESTIONS A.Descriptive Questions Short Questions 1. What is Financial Modeling and the Use of Financial Modeling? 2. What are the Steps for Preparing Financial Modeling? 3. What are the Various Techniques of Company Valuation? Explain Briefly Long Questions 1. How do you build a financial model? Explain in detail. 2. How would you forecast revenues? 3. What is sensitivity analysis and how would you perform one in Excel? B. Multiple Choice Questions 1.Graphs are preferred in financial model. a. True b. False c. Partly True d. None of these 2.Financial models can be built without the historic data of a company. a. True b. False c. Partly True d. None of these 3.Find the advanced models that can be built using financial modelling: a. Discounted cash flow analysis b. Leveraged buyout c. Merger and acquisition d. All of these 244 CU IDOL SELF LEARNING MATERIAL (SLM)
4.Why is stress testing important? a. Scalability b. Identify hidden vulnerabilities c. For making provisions for M&A d. Clear data representation 5. Standard formatting convention is important in building financial modelling. a. True b. False c. Partly True d. None of these Answer 10.9 REFERENCES Textbooks: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 245 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 11- BASIC EXCEL FOR FINANCIAL 246 MODELING Structure 11.0Learning Objectives 11.1Introduction 11.2The Analysis Tool Pak 11.3Arguments of Functions 11.4Entering Functions 11.5Financial Functions 11.5.1 Annuity Functions 11.5.2 PV 11.5.3 FV 11.5.4 PMT 11.5.5 NPER 11.5.6 RATE 11.5.7 IPMT 11.5.8 PPMT 11.5.9 CUMIPMT 11.5.10CUMPRINC 11.6Other Time Value of Money Functions 11.6.1 NPV 11.6.2 IRR 11.6.3 MIRR 11.6.4 XNPV 11.6.5 XIRR 11.6.6 FV SCHEDULE 11.7Bond Functions 11.7.1 Yield 11.7.2 Duration 11.7.3 M Duration 11.7.4 ACCRINT 11.7.5 ACCRINTM 11.7.6 TBILLEQ 11.7.7 TBILLPRICE 11.8 Statistical Functions 11.8.1 Normal Probability Distribution 11.8.2 NORMDIST CU IDOL SELF LEARNING MATERIAL (SLM)
11.8.3 NORMINV 11.8.4 NORMSDIST 11.8.5 NORMSINV 11.8.6 Standardize 11.8.7 Random Numbers 11.8.8 RAND 11.8.9 RANDBETWEEN 11.9Calculating Various Statistics 11.10 Summary 11.11 Keywords 11.12 Learning Activity 11.13 Unit End Questions 11.14 References 11.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Use Excel for Financial Modelling • Discuss use of various statistical tools • Learn various Bond Functions in Excel • Explain the Time value of Money functions • Learn about various financial functions 11.1 INTRODUCTION Excel provides numerous useful built-in functions in several different categories as well as several useful tools in the Analysis ToolPak. In this chapter, I selectively cover only the functions and tools that I think you will find useful for financial modelling. Of those, I discuss in some detail the functions that I think you will use most often or that you may have difficulty fully understanding from Excel’s Help. For the others, I provide only short descriptions so that you know they are there, and if you need to use any of them you can look them up in Help. In the Financial Functions category I have included all the available functions. However, I have not covered here any of the functions in the Database and Engineering Functions categories, because financial modelers will rarely use any of the functions in these categories. In organizing the functions, I have used the same categories that Excel uses in the Paste Function dialog box. Within each category, though, instead of including the functions in alphabetical order (as Excel does), wherever possible I have grouped similar functions together. This should be helpful when you are not looking for a specific function by name, but rather for a function to do something you want done. Many 247 CU IDOL SELF LEARNING MATERIAL (SLM)
people look at functions as “black boxes.” You input the arguments, and the functions provide the answers. In a way this view is true, but it is also somewhat dangerous. It is true that you can get answers by providing the arguments, but in many cases, especially for financial functions, if you do not understand how a function calculates its answer, there is some chance that you will use it incorrectly and get wrong answers. You should therefore make an effort to understand exactly how a function does its calculations before using it. It is also important to understand how Excel treats inputs that are not numbers, and so on, in order to use a function or tool correctly. You should be especially careful about using the functions in the statistical category and the tools in the Analysis ToolPak, which mostly do statistical analysis. All these functions and tools make it seem easy to do statistical analysis. The reality, though, is that trying to do any statistical analysis without knowing the underlying theory can be dangerous—you may use a function or tool incorrectly or misinterpret the results. For this reason I have purposely kept the discussion of the statistical functions and Analysis ToolPak tools brief. If from the short descriptions you do not understand what one of these functions or tools does, chances are you do not know the underlying theory. You will be better off not using the function or tool until you have studied the theory. Conversely, if you understand what a function or tool does, look up its description (which often includes examples as well) in Excel’s Help. 11.2 THE ANALYSIS TOOLPAK The Analysis Tool Pak is part of Excel, but you have to add it in. It includes a number of analysis tools as well as a number of functions. If you do not find a function that I mention in the Paste Function dialog box or you need to use the Analysis Tool Pak itself, then you have to add it in as follows: Select Tools ➩ Add-Ins, in the Add-Ins dialog box check the box to the left of Analysis Tool Pak, and click OK. 11.3 ARGUMENTS OF FUNCTIONS Most functions require arguments (inputs) that you enter in a pair of parentheses after the function name. Even for the few functions that do not require arguments, you have to include an empty pair of parentheses. You can, of course, enter values as arguments. You can also use cell/range references or cell/range names, expressions (that is, formulas that Excel can evaluate), and other functions. As long as Excel can unambiguously evaluate what you provide to come up with a value for the argument, it will accept it. If you are in doubt about if you can input an argument in a certain way or how Excel will interpret it, check it out first in a small, made-up example. For arguments, it is generally preferable to enter cell/range references or cell/ range names instead of values because then you can easily change them if necessary. Also, make sure that you enter the required extra commas if you are not providing values for one or more optional argument. However, you can omit 248 CU IDOL SELF LEARNING MATERIAL (SLM)
the extra commas for optional arguments that are at the end of the list of arguments, that is, are not followed by any other argument for which you are providing values. 11.4 ENTERING FUNCTIONS There are two ways of entering functions in formulas: you can type in the function name and the arguments or you can use the Paste Function dialog box, followed by the Function Arguments dialog box. I find it easier and safer to use the second approach because the Function Arguments dialog box helps both in entering the arguments and in making sure that you enter all the arguments. If you see a scroll bar on the right side of the boxes for entering arguments, it indicates that there are more arguments than can be shown in the space available, and you have to scroll down to enter values for all of them. (If the Function Argument dialog box gets in your way, left-click on it, hold down the button, and drag the dialog box out of the way. 11.5 FINANCIAL FUNCTIONS 11.5.1 Annuity Functions Excel provides several functions to do different kinds of calculations for constant annuities, which you can use for both loans and investments. Constant annuities are equal cash flows (either all inflows or all outflows) that take place at equal time intervals. Constant annuities are governed by a set of 4 variables; if you specify 3, then the fourth can be calculated. The Excel functions for calculating these variables are: PV, FV, PMT, RATE, and NPER. These functions actually go one step beyond handling just constant annuities in that in addition to the annuity payment you can also specify a cash flow pv at time 0 and another cash flow fv at the end of the annuity period, that is, nper periods from time 0. I have also included a few other functions here that Excel provides for annuity related calculations. However, you will use the five functions I mentioned before much more frequently than these others. In the annuity functions, the commonly used arguments have the following meanings: • Rate is the interest rate per period (month, year, etc.). It must be consistent with the measure of period used for specifying nper. You can enter the rate in decimal or percent (that is, 0.08 or 8%). If you use percent, be sure to include the % symbol. • Nper is the total number of periods (same as total number of payments) for the annuity. It must be an integer or else it is truncated to an integer. • Pmt is the annuity amount per period. • Pv is an additional cash flow now (time 0) • Fv is an additional cash flow nper periods from now. 249 CU IDOL SELF LEARNING MATERIAL (SLM)
• Type is 0 for a regular annuity or annuity in arrears where the first payment occurs one period from now and 1 for an annuity due or annuity in advance where the first payment occurs now. If a function allows a type argument, you can use it to specify whether payments will be made at the beginning or at the end of the periods. Here are a few things to keep in mind about these functions. When you choose type 0, present values are calculated and the pv argument relates to one period before the first cash flow (that is, now). Future values are calculated and the fv argument relates to the time of the last annuity cash flow. For type 1, it works the other way around. • Time Value of Money, with some modifications you can use constant annuity functions to do calculations for growing annuities. You can also use these functions to calculate present value or future value of a single cash flow by using 0 for pmt. • You must consistently use the same definition of period in specifying the arguments for a function. If you are measuring period in months then the payments must be monthly payments, the interest rate must be the monthly interest rate, the number of periods must be in number of months, and so on. • You must specify the signs for the arguments of a function consistently from the point of view of one entity. For example, if you are borrowing money from a bank and specifying signs from your point of view, then the sign for the borrowing would be positive because it is a cash inflow and the signs for the loan payments would be negative because they are cash outflows. By using proper and consistent signs you can use all these functions both for loans and investments. 11.5.2 PV The PV function calculates the present value of a constant annuity. You can also include an additional cash flow that will occur at the end of the annuity period. By setting the annuity amount equal to zero you can use this function to calculate the present value of a future cash flow. The syntax of the PV function is: PV(rate,nper,pmt,fv,type) Fv and type are optional arguments and if omitted, they are assumed to be zeros. Example: You are told that to pay off a loan that carries an 8% annual interest, you have to make 10 equal annual payments of $1,000 each at the end of each year. What is the loan amount? Enter the formula =PV(0.08,10,-1000,0,0) to get the answer $6,710.08. What if the loan involves an additional payment of $2,000 at the end of 10 years? Enter the formula =PV(0.08,10,-1000,-2000,0) to get the answer $7,636.47 250 CU IDOL SELF LEARNING MATERIAL (SLM)
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