Project Finance Explained: Structure, DSCR, Modeling

Mohammed Aamir ShaikhFounder, Aamir Capital

Updated 5 October 202610 min read

The short answerProject finance funds a single large project mainly from the project's own future cash flow. A separate company owns the project, lenders are repaid from its revenue, and the debt is sized so that cash flow covers payments with a cushion, measured by DSCR.

What project finance is

In project finance, lenders look to the project's revenue, not to the owners' wider balance sheet, to be repaid. It is widely used for power plants, water and wastewater, roads and rail, ports, telecom towers, pipelines and large property developments.

Because the lenders rely on the project alone, every part of the project is examined closely: the contracts, the costs, the revenue and who carries each risk.

How a project is structured

Exhibit 1: A typical project finance structure

Simplified. Real projects have more contracts and parties.

The sponsors set up a special purpose vehicle (SPV) that owns the project. The SPV signs the contracts, borrows from the lenders and receives the revenue. After the project is complete, lenders usually have limited or no recourse to the sponsors, which means they cannot claim against the sponsors' other assets.

The key contracts

Concession or licence. The right to build and operate, usually from a government.
Offtake or sales agreement. Someone agrees to buy the output at an agreed price, for example a power purchase agreement or a water purchase agreement.
EPC contract. A fixed-price, fixed-date contract to engineer, procure and construct the project.
O&M contract. A contract to operate and maintain the project.
Financing agreements. The loan agreements and the security given to lenders.
Shareholders' agreement. How the sponsors own and govern the SPV.

Who carries which risk

Construction and completion: the EPC contractor, backed by the sponsors and by insurance.
Demand and price: the offtaker, through a long-term contract.
Operating: the O&M contractor.
Regulatory and political: the government, with insurance where available.
Currency and interest rate: managed by matching the currency of debt to revenue, and by hedging.

Lenders are only comfortable when each major risk sits with the party best able to manage it.

How debt is sized

Debt is sized so that cash flow covers payments with a cushion. Lenders set a minimum DSCR and a maximum gearing, which is the share of total funding that comes from debt.

Maximum annual debt service = Cash flow available for debt service ÷ Minimum DSCR

Example. Cash flow available for debt service is 100 a year for 15 years. With a minimum DSCR of 1.30x, maximum annual debt service is 100 ÷ 1.30 = 76.9. At 7% over 15 years the repayment annuity factor is about 9.11, so debt capacity is about 76.9 × 9.11 = 700.

You can try this logic in our debt capacity calculator. In practice, repayments are often sculpted to follow the cash flow so that DSCR stays steady.

Key ratios and reserves

DSCR: cash flow divided by debt service in each period.
LLCR: the present value of cash flow over the loan life divided by debt outstanding.
Gearing: debt as a share of total project funding.
Debt service reserve account: cash set aside to pay lenders if cash flow falls short.
Maintenance reserve account: cash set aside for major repairs.

The phases of a project

Development. Studies, permits, contracts and financing are arranged.
Construction. Money is drawn from lenders and sponsors, and interest builds up during construction.
Operation. Revenue arrives, debt is repaid and distributions are paid to sponsors.

Returns are measured for the project as a whole (project IRR) and for the sponsors' equity (equity IRR).

PPP and concessions

Governments in the GCC, India and Europe use public-private partnerships (PPP) and concessions to bring private money into infrastructure. Common models are build-operate-transfer (BOT) and build-own-operate-transfer (BOOT). The public side sets service standards and payment terms. The private SPV builds and runs the asset.

What a project finance model must do

Cover the construction and operating periods on a clear timeline.
Show funding drawdowns and interest during construction.
Calculate the debt repayment profile, including sculpting.
Test DSCR and LLCR against the lender's minimums.
Include reserve accounts, tax and depreciation.
Calculate distributions and equity IRR.
Run downside cases: delay, cost overrun, lower revenue and higher interest rates.
Follow the loan agreement and the project contracts exactly.

See our project finance modeling service.

Common pitfalls

Ignoring construction delay and its cost.
Optimistic demand or price assumptions.
Debt in one currency and revenue in another, with no hedge.
Too little equity.
No downside case.
A model that does not match the loan terms.

Questions

What is the difference between project finance and corporate finance?

In corporate finance, lenders look at the whole company's cash flow and assets. In project finance, lenders look mainly at the cash flow of one project held in a separate company.

What does limited recourse mean?

It means lenders can claim against the project's assets and cash flow, but only to a limited extent against the sponsors' other assets.

What is a good DSCR in project finance?

Lenders often look for between about 1.2x and 1.5x or more, depending on how certain the revenue is. Contracted revenue usually needs a lower cushion than revenue exposed to market prices.

How much of a project is funded by debt?

Often between 60% and 80%, depending on the sector, the risks and the lending market.

Related explainers

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For education only. This page is general information. It is not financial, investment, legal or tax advice, and it does not take your situation into account.

Project finance explained: structure, risks, debt sizing and modeling