4.5.1. Components of a cash flow model

The capital investment is the cost of developing a project, regardless of funding sources. Typical components of capital investment cost are: land and site development costs, buildings and all civil works, plant and machinery, and technical, engineering and other professional service fees.

The terminal cash flow is the cash that is generated from the sale or transfer of assets upon termination or liquidation of the PPP contract tenure. In the case of a PPP project, the residual or transfer price is generally negotiated and included in the contract agreement.

The discount rate is the rate that is used to calculate the present value of future cash flows. It is often the weighted average cost of capital for the project from different sources.

In order to calculate the future cash flows, it is also necessary to make assumptions for important parameter values over the project's life. The main parameters for which values need to be assumed include: interest and inflation rates, the pricing mechanism, demand for the goods and services produced by the project, construction time, debt repayment method, depreciation schedule, tax structure, and physical and technological lifetime of assets. 

IDevice Icon How subordinate debt helps in debt financing

The revenue available for debt service is used first to meet the senior claims. If revenue is still available it is then used to meet the junior claims (subordinate debt and thereafter equity). A simplified example below shows how it works in reducing the burden of debt on a project.

Coverage Ratio
Revenue: $1,050  
Senior claims: $700 1,050/700 = 1.50
Junior claims: $200 1,050/(700+200) =1.17





On a combined claim (if the whole amount of loan was of the same type, i.e. senior debt), the coverage ratio is 1.17, which in most circumstances would be considered low and not qualify for cheaper credits. The coverage ratio, however, is significantly improved if the debt is divided into two parts: a senior debt and a subordinate debt. As the senior debt is only a portion of the total debt and has the first claim on all the revenues available for debt service, its coverage is increased to 1.5 and its credit quality would be enhanced. The credit quality is very important to debt financing. With a good credit rating the project may find cheaper debt financing.

The availability of subordinate debt helps in reducing the risk to senior debt lenders and allows the project sponsor to borrow at lower interest rates. The subordinate debt provider, however, absorbs a share of the risk if revenues fall short of debt service requirements.

Because of this feature of subordinate debt in reducing the monetary cost of debt, some governments provide loans to implementing agencies (under public credit assistance programmes) to improve the credit quality of senior debt. It lowers the risk to lenders and helps the implementing agency to obtain loans at a lower interest rate reducing the debt burden on the project.

Source: Based on an example given in Federal Highway Administration, US Department of Transportation (undated). Innovative Finance Primer, Publication Number FHWA-AD-02-004.


Copyright © 2008 by Transport Policy and Development Section, United Nations Economic and Social Commission for Asia and the Pacific (ESCAP).