The evaluation of profitability from the point of view of a creditor, a bank, or a bond holder is based on the analysis of the relevant cash flows that the project will be able to generate for a creditor throughout its life. Let's go back to last week. We always said that from a capital budgeting point of view, an infrastructure can always be split into two basic portions of its life: the construction phase versus the operational phase. The first thing that a financial analyst must understand is which cashflows are relevant for a creditor during construction, and then analyze the same cash flows during the operational phase. You can understand very easily that during the construction phase, creditors are required to provide money to the SPV as long as the construction goes on. Typically, based on a work in progress milestone payment schedule. Then, once the construction has been completed, creditors are entitled to recover principal and interest based on a predefined amortizing schedule that creditors and the SPV have agreed upon as the way to repay as long as time goes on, the loans that creditors have granted to the SPV during the first phase, the construction phase. So, in nutshell, what you have to get when you want to calculate a profitability measure. For creditors, the typical, internal rate of return for a creditor is to take the relevant flows during the construction phase, the contributions to the project, and take the debt service. So, the repayment of principal and the repayment of interest. Throughout the operational phase. Based in this, we can calculate this internal rate of return. The internal rate of return typically is used by the creditor in order to be compared with another benchmark. We will see in the next session, which is the typical comparison that creditors perform in order to say if the project is profitable or if it is not sufficiently profitable for you. But, let me explain in a little more detail what can really happen. And, let's assume that. We can use a typical example in order to pinpoint the different cash flows that creditors are interested in using, when calculating their internal rate of return. Let's assume for example, that we are talking about a project, who's total value is 1000. Lets assume that this project of 1000. This fine is with a proportion of debt over equity of one to one which basically means that this project will financed 50% with debt and 50% with equity. Let's further assume that this loan pays an interest rate of five percent. That is composed by a base rate, Euribor, of one percent, plus a margin of four percent, 400 basis points. Let's then assume, that the SPV, and the share holders and the creditors have agreed that during construction. The value of 1000 will be paid in four different installments. 20% at year zero, 30% at year one, 30% at the end of year two and 20% at the end of year three. You can appreciate that the consequence in terms of creditors provision of money. During the first three years, of the construction phase. Will be that creditors given the proportion one to one, in terms of debt and equity. Will have to provide, to inject in the project. 100 Euro, at the end of year zero. 150 Euros at the end of year one, 150 Euros at the end of year two, and 100 Euros at the end of year three. You can appreciate that summing the four installments that creditors have injected in the project. The final result returns exactly 500 which is exactly one half of the total cost of the investment. Let's go back, one week ago when we analyzed the capital budgeting. You certainly remember that during the construction phase you can use the loans of the creditors. But you can't pay the interest, on the used portion of funds. Because all the money, is committed for construction. So, if you repeat exactly, the same calculations we made last week, you will have to capitalize from year zero, to year three. All the accrued interest on the used funds of creditors and this amount of capitalized interest increases the outstanding amount of the loan at the end of the construction phase from 500 to 538.64. So guys, these are the relevant flows that we have picked up for our evaluation. During the construction phase calculate the exact amount of money that is injected in the vehicle. Please notice that the capitalized interest is not affected into the calculation during the construction. It will be included in the calculation, during the operational phase. Because during the operational phase, the creditors are entitled to be repaid, not for the original amount of 500, but for the amount of loan plus accrued interest, 538.64. Which other input you must take into account now? Well, first you must pickup the information regarding the schedule of amortization of the loan that has been agreed between creditors and the SPV. Let's assume for example. That the loan will be repaid in five years. So, we have arrived at tier number three, the end of the construction phase, and we will end the amortization of the loan in year number eight. Let's assume that the percentages of principal repayment that we have agreed between creditors and SPVRs are 15% at end of year four, 15% at the end of year five, 15% at the end of year six, and seven and the remaining 40% at the end of year eight. If you apply these percentages to the outstanding amount of the loan at the end of year three, you can get the principal repayment for year four, five, six, seven, and eight. Obviously, the sum of the repayments in these five years must return exactly the original amount of the loan at the end of year three, 538.64. The second thing that you must take into account is the interest payment. And, keep in mind, that the interest payment is always calculated on the outstanding amount of the loan, for every remaining year of the life of the project. So, keep in mind that if you amortize the loan, the outstanding amount will fall down as long we move from year number four down to year number eight. If you take the principal repayment plus interest you get what in technical terms is called the installment of repayment. In project finance and more generally in finance, this is the also called the debt service. So, the debt service is the sum of the principal paid and the interest repaid. And you can easily get from our project that the cash flows that will return to creditors. During at the operational phrase would be 173 at the end of year four, 103.69 at the end of year five, 99.65 at the end of year six, 95.61 at the end of year seven, and 226.23 at the end of year eight. Now you have all the ingredients to calculate your internal rate of return. Because you have all the outflows for creditors during the construction phase. You have all the inflows for creditors during the operational phase. Putting together the two, and calculating the internal rate of return, becomes an easy task. It is exactly the interest rate that makes zero the difference between the present value of positive cash flow, to the present value of negative cash flows. Since in our example, we didn't apply any additional fee, any additional cost the bank charged to the borrower. You can understand that the internal rate on return would be exactly 5%. This is a profitability measure, it is a summing up number that is telling your creditor that overall. You are able to squeeze out 5% considering also the time value of money from your own project. You as a creditor must decide, given your benchmark, if this 5% is higher or lower than your benchmark reference rate. If 5% is higher than the benchmark the project can receive the first green light. Banks are saying, pretty satisfied from the point of view of the money in terms of profitability I can get out of the project.
