Advantages of using project finance to obtain low cost of capital depend on: (1) the level of debt; (2) the funding of debt; (3) the tenor and repayment style of the debt; (4); the interest rate; and, (5) credit protections like the DSRA and sweeps. This section deals with issues relating to the size of debt and in particular the level of debt that arises from two constraints that are implicitly or explicitly used by lenders. These two constraints are:(1) the MAXIMUM DEBT TO CAPITAL ratio and the MINIMUM DSCR ratio. In structuring debt, lenders attempt to assure that the debt size does not exceed a given debt to capital ratio and that the DSCR does not fall below a given DSCR. Both of these constraints are often given by relatively arbitrary benchmarks used by financial institutions.

It may seem that all of this is not a big deal because once a term sheet is written, the amount of debt is given in the term sheet. That is wrong. The question here is just how do the lenders come up with this amount of debt. Advisors, bankers and lenders will discuss both the DSCR and the debt to capital as if they are somehow different issues or as if the amount of debt is magically determined to conform to both constraints at the same time.

## Debt Sizing and Banking Philosophy

The videos and files in this lesson set demonstrate differences in strategy that are applicable when the DSCR constraint applies relative to when a debt to capital constraint drives the debt size. The subject of debt sizing is introduced in the context of fundamentally different banking philosophies of “skin in the game” and “believing a forecast”.

The debt to capital constraint is founded on a banking philosophy that equity providers will be careful with their own money and if they have put money into the investment they will care about the downside risk. With no money invested, the investors do not give a hoot about the downside – they will of course stick with the investment in the upside case.

The DSCR or debt service coverage ratio constraint is derived from the notion that the debt service coverage buffer is one of the best possible measures of risk. Other measures of risk like beta and VAR are statistics that measure almost nothing. But a DSCR ratio measures the percent reduction in cash flow that occur before debt service cannot be met – a much more reasonable way to look at risk. For example, if the DSCR is 1.5, then the cash flow can decline by (DSCR-1)/DSCR or 33%. Alternatively, the formula can be expressed in terms of the percent reduction in cash flow relative to a reference or base case. Re-writing the formula results in DSCR = 1/(1-% Reduction in Cash Flow). For example, if the percent reduction in cash flow is 50%, 1-50% = .5 and 1/.5 = a required DSCR of 2.0x.

## Exercise with Fundamental Drives

I have prepared a couple of exercises so that you can see what really drives the debt sizing in different situations. When making these exercises, it is good to allow you to put in different DSCR’s, different debt tenors, different debt repayment methods, different operating cash flows and different interest rates. All of these factors can determine whether the MINIMUM DSCR constraint drives the debt size or whether the the MAXIMUM DEBT TO CAPITAL limits the amount of debt. Examples of factors that drive the debt size include:

- Higher cash flow means that debt to capital will more likely be a constraint.
- Shorter debt tenure means that DSCR will morel likely be a constraint.
- A higher interest rate will mean the the DSCR will more likely be a constraint.
- Sculpting will mean the the debt to capital will more probably be a constraint.

In my courses I have participants open one of the two files below. The first file focuses on the issue with a small exercise. The second file uses the circular template to evaluate the issue in a larger context. I do not bother with data tables and instead ask participants to tell what constraint applies when the debt tenure is 22 or 10 years and when the project IRR is either 12% or 7.5%. You can try the exercise and see what constraints apply with the two financial models below.

Excel File with Debt Sizing Exercise using DSCR or Debt to Capital Constraint with Focused Model

Unlike other lessons, I have set the files up with open-ended conceptual questions in the first page of the file. You should be able to answer the questions with the model that is developed in subsequent pages by messing around with the spinner boxes. Questions delve into whether the debt to capital constraint or the DSCR constraint will apply in Ghana or Holland (where the tenures and the project IRR’s are likely to be different).

The two videos below illustrate how to use the debt sizing file. These videos begin with some theoretical discussion and then move to technical details on program the different constraints. The second video deals with taxes and how to choose which constraint is in place in the face of circular reference problems.