It is now time, to understand what the meaning of cover ratio is, and all banks typically calculate cover ratios. So, during this part of the course, we will first understand the meaning of the two most important cover ratios. That typically banks insert in the credit agreement with the SPV. And these 2 ratios are called DSCR, Debt Service Cover Ratio and LLCR, Loan Life Cover Ratios. My objective is to explain to you how you can get the result and what are the economic meanings of the two ratios. We will conclude this clip analyzing which kind of levels typically banks require in different sectors for these kinds of cover ratios. In order to explain to you with a very practical example and from a very intuitive point of view what cover ratios are we can go back to the capital budgeting exercise we went through our last week we spent together. And, when we analyze that budget, during the operational phase, of a given project finance transaction. We can start exactly from the final result that we got. So, the cash flows from year number one to year number five, of a given project for which we calculated the unlevered free cash flow. The debt service got calculated on an amount of loan, of 100 paying in interest of 5%, and for which we calculated the debt service, and the dividends, the cash flow available for profit sponsors, from year number one to year number five. The first, the most intuitive cover ratio banks calculate is based on a very intuitive reasoning. Banks compare every year of the operational life. The unlevered free cash flow that the project is able to generate and my recommendation is to think about that specific cash flow as the available cash in the project. So, it is the amount of cash that the project is able to make available for payments, and that the debt service. You must imagine that the debt service is the cash needed in the project. If you have agreed with the creditors that you will pay them a certain amount of money you need to have that money in the vehicle. So, the first ratio is the simple comparison between the unlevered free cash flow, the cash available in the project in that specific year and the cash needed in the project which is the debt service that you must pay to the creditors in that specific year. Lets go back to our example, you will certainly remember that the first relevant row for our calculation was the unlevered free cash flow. Let's now rename the unlevered free cash flow with the term Cash Available for the creditors. So, this is the cash that is available to service the debt for the creditors. The second row is the debt service, but we can rename the debt service as Cash that is needed in the project. So one basic intuition behind the first cover ratio is that if you want to have creditors on board, it must necessarily be that the cash available in the project must be more than the cash than you need to have in the project. If you want, if instead of making these equations, you calculate the ratio between the available cash and the needed cash, you can get exactly the first cover ratio, the debt service cover ratio. Let's do a very simple calculation, we have all the elements. Take for example, year number one. In year number one you have 50 available cash, and needed cash, 25. This basically means that if you take duration between 50, numerator, and 25, denominator, you will get a debt service cover ratio which is two times. This basically means that in that specific year, the project has two times as much cash available for every one Euro or one Dollar of debt service to be paid to the creditors. Which basically means that creditors feel them comfortable because there is head room, there is a cushion between the amount of money that you have to pay to them, and the amount that you have inside the project. Let's take for example, year number two. In year number two your cash available is 49.5, but you have promised to pay banks an amount of 24. If you take again the ratio between 49.5 numerator and 24 the denominator. You will see that the number 2, you have a ratio of 2.06 times. Which basically means that the project is able to generate twice as much cash compared with the cash that must be paid to creditors. And then the creditors feel happy because they have some head room, some safety cushion between the two values. If you replicate the calculations for the remaining three years, you will see that under number 3, you will take the ratio between 49 and 23 getting a value of that service corporation which is 2.13 times. In year on number four this value will become 2.20 times in year number 5 it will become 2.29 times. So you can appreciate that there is not only a good safety cushion, starting from year number one. But you also see that in our project, this safety cushion is becoming larger and larger, as long as the project reaches the end of the loan life. From this point of view creditors are pretty happy. There is much more cash then the cash that they need to receive. Typically they include a minimum level of debt service cover ratio as a minimum acceptable level in order to give the green light to the project and to start the project before, the project is completed. And you can understand, that this minimum level, will be higher if the project is riskier because if the project is riskier for creditors, creditors want to have a bigger cushion of safety, against unexpected risks. If instead the project is particularly safe it has been well risk managed. The security package and all the conference have been set up in a proper way, creditors can also accept lower levels of debt service cover ratios. We have the possibility to show you different degrees of debt service cover ratio it is for different kinds of sectors. More risky sectors command more higher level of debt service cover ratio than safer sectors where the degree of uncertainty is certainly no way. The second cover ratio that banks require from the point of view of creditors to carry out the project is represented by the so called Loan Life Cover Ratio. The meaning of Loan Life Cover Ratio is a little bit less intuitive than the Debt Service Cover Ratio. Just to give you a clear idea before making a simplification in terms of calculation. I can say that the debt service cover ratio is a point-in-time measurement. So you can calculate that service cover ratio for every year the project goes through the loan life. Loan life cover ratio is a summary value. So it is a one single value taking into account a certain time frame and this time is represented by the two letters of the acronym of these second Cover Ratio, LL, the Loan Life. Let me explain you what happens. Creditors say, take our example, we know that creditors are exposed in terms of loans to the SPV from year number one to year number five. Because only in year number five they would be completely repaid, they will be repaid in full. So, their reasoning is let's assume that, I want to calculate how much is the value of the available cash? Do you remember the numerator of the debt service cover ratio discounted to present. So they make a calculation of this kind. They take the cash flow of year number one and they discount it for one year. They take the cash flow of the second year and they discount this cash flow for two years. The same holds true for the third cash flow, your number three and then, here number four, and then here number five. So, in a sense they calculate the present value of all the available cash that the project will be able to produce during the life of the loan so until the loan has not been completely repaid. Creditors take in the Loan Life Cover Ratio a numerator that is represented by this bulk of money. They are saying in five years time how much is the present value of all the available cash of the project. And, they take the present value of this bulk of cash flows, and they compare this present value with the value of the outstanding amount of the loan at the beginning of the period. The economic meaning is very simple. If I have the certain amount of loan today that must be repaid, creditors are asking themselves, during the life of the project, the available cash, discounted to present, is sufficient to repay the outstanding amount. So you can appreciate guys that compared to the Debt Service Cover Ratio. The loan life cover ratio is not calculated on a point-in-time, but it is a sort of a summary of a whole period where we take into account the different cash flows. You can also understand that creditors will never give a green light to a project finance if the level of the Loan Life Cover Ratio, I repeat, the ratio between the present value of the cash flows available in the project during the life of the loan and the outstanding amount of the loan at a certain point in time is higher than one, and you can understand why. Only if it higher than one creditors can count on an amount of cash that is higher, more abundant, than the amount that the SPV owes to the banks, represented by the, outstanding amount. So, what we can do in our exercise is to calculate the present value of all the cash flows from year one to year five. Discounting them, using that the interest rate on the loan. Why this easy, because of the perspective of evaluation is the evaluation of creditors. And if creditors want to assess, from their own point of view, how much is present value, they will always use the interest rate they apply on the loan. If we calculate to the present value of the five available cash flows. From year one to year five discounted to present, we get a ratio that is calculated using the sum of the five cashflows divided by the outstanding amount at year zero. This amount is an amount of 2.1236 times the economic meaning of this ratio is in five years time, during the life of the loan, creditors today can count on available cash that is 2.12 times the outstanding amount of the loan. So again creditors feel happy because there is much head room between the outstanding and the available cash, in order to be repaid. Typically, creditors insert a minimum required level also for the Loan Life Cover Ratio. If the project is not able to demonstrate that in all of its life years the project is able to stay higher than the minimum. Banks will say, "I don't give you the green light. Let's return to the office, lets recalculate and see if we can improve the quality of this project." Of course, you can understand that the level of minimum level of Loan Life Cover Ratio will be set in accordance to the degree of risk of that specific project. The higher the risk the higher minimum required level in order to give more protections to creditors. So guys, summarizing what we have seen, two basic cover ratios in order to assess, whether or not the project is doable. The fist one, very easy to get. Year on year measurement, Debt Service Cover Ratio, The second, a little bit more complicated, the Loan Life Cover Ratio. This is an intuitive explanation, very easy to get. For those of you who are interested in getting it in a more formal setting with the underlying formula, let's go on with the further clip.
