Session7-dscr+conventional Risk Mitigation

Infrastructure Project Finance Investment Decisions DSCR

DSCR • The amount of cash flow available to meet annual interest and principal payments on debt. • This ratio should ideally be over 1. That would mean the project is generating enough income to pay its debt obligations. • In general, it is calculated by: Amount available to repay (Service) debt/ Debt to be repaid i.e (PADT+ Dep+ Interest on debt) / (Interest on debt + Principal)

DSCR • A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. • Generally DSCR greater than 1.5 to 2 preferred. However this is not a set rule

Project Risks • Capital budgeting / investment decision techniques were discussed assuming that projects do not involve any risks • However, in real situation risks exist -inability or limitation of the decision maker to anticipate risks and include them in project forecasts • Large number of events influence forecasts which cannot be generalized. However, Broadly can be grouped as follows. – Risks related to General economic conditions • Govt. Fiscal policies, political changes, social conditions etc

– Sector specific factors • Change in sector policy, innovations in the technologies in the sector, changes in the cost of raw material etc

– Project Specific factors • Change in management, natural disaster, labour issues etc.

Project Risks • Project Structuring • Contracts and Agreements • Conventional Techniques to handle risks – Payback – Risk Adjusted discount rate – Certainty equivalent coefficient.

Project Risks • Payback – Oldest and commonly used method – Used more often as risk handling method rather than investment decision – Payback period fixed considering risk factors based on sector experience – Usually prefers short payback to longer ones. Limitations: • Intuitive • Assumption that project would go exactly as per plans for certain fixed period (payback period) • Ignores time value of money

Project Risks • Risk Adjusted discount rate – Riskier projects may have higher uncertainty of returns and hence higher risk premium. – Risk premium rate to be added to the risk free rate while discounting the cash flows NPV= -C0+C1/(1+kf+kr)+C2/(1+kf+kr)^2….. – If IRR method used then IRR>= kf+kr. Limitations: • No easy way of estimating risk adjusted discount rate • Does not make all types of risk adjustment in the cashflows that are forecast over future years

Project Risks • Certainty equivalent coefficient – Riskier projects may have conservative cash flows. NPV= -C0+C1*α1/(1+kf)+C2* α 2/(1+kf)^2….. – If IRR method used then IRR>= kf. However conservative cashflows will be used Limitations: • Intuitive α • If forecasts pass through several layers in larger organization forecasts may become ultra conservative • Some good cashflows may also get reduced in the process