Impact of Interest rates on Project finance

A successful project financing initiative is based on a careful analysis of all

the risks the project will bear during its economic life. Such risks can arise
either during the construction phase, when the project is not yet able to
generate cash, or during the operating phase.

Risk is a crucial factor in project finance since it is responsible for unexpected

changes in the ability of the project to repay costs, debt service, and dividends
to shareholders. Cash flows can be affected by risk, and if the risk has not
been anticipated and properly hedged it can generate a cash shortfall. If cash is
not sufficient to pay creditors, the project is technically in default.

In project finance ventures, there is always the risk of fluctuations in interest

rates. If the project is being financed with fixed rate bonds or loans from
lenders providing fixed- rate funding, then, in principle, the project company
has no interest rate risk. Due to long life of the projects, the credit is always
granted with a variable rate of interest. In addition, unlike exchange rate risk,
interest rate risk indiscriminately strikes both domestic and international
projects as well as ventures with multi- currency cash flows. Sponsors and
their advisors have to decide whether or not to cover against this risk, a
decision that is not exactly identical throughout the life of the project.

Construction phase: Interest is not paid in cash on the financing until the
project is in operation. During the construction phase, the project doesn’t
generate revenues. However, draw downs begin to produce interest payable,
the amount of which depends on the level of interest rates during the years in
which the project is under construction. The accrued interest is normally
capitalized (i.e., added to the loan amount) or paid by making a new drawing
on the loan. Thus interest during construction becomes a part of the project’s
capital budget, and if the interest rate for the IDC is not fixed, and is
eventually higher than originally projected, this is a construction cost overrun.
Lenders do not normally allow the general cost contingency to be used to
cover this risk, as it is primarily intended to cover overruns in the “hard” costs,
or the effect of delay causing higher total interest costs.
The cost item represents a significant percentage of total costs; in fact, the
more intense the recourse to borrowed capital, the greater the weight of the
interest component. The risk the SPV runs is that unexpected peaks in the
benchmark rate to which the cost of financing is indexe d can cause an
increase in the value of the investments such as to drain project funds entirely.
For this reason, a rather widely used strategy is comprehensive coverage of the
variable rate loan throughout the entire project construction phase.

Operations phase: The most difficult problem for the SPV’s sponsors is to
select the best strategy for covering floating interest rate loans during the post
completion phase of the venture. Often advisors decide on the approach to
adopt on a case by case basis, depending on the specific features of the project
in question. Nonetheless, the key concept advisors focus on is self protection
of cash flows, i.e. valuing whether cash flows from operations are sustainable
in the face of negative variations in the value of the debt service. A rise in
interest rates impacts debt service value by increasing payouts to lenders.
Clearly this effect will abate over time (given same rate variation) due to the
progressive reduction in the outstanding debt. In any case, the main point is to
ascertain the capacity of operating cash flows, i.e., to verify how these flows
move over time. Naturally, self protection of cash flows depends on the
underlying connection among variables that move industrial cash flows and
interest payable. When this correlation is high and positive, any increase in
interest rates is counter balanced by variables that determine operating cash
flows. The project, at least in part, will be ‘self-immunized’ from rate risk. If
there is no such correlation, an unexpected increase in the cost of financing
would best be avoided because the project would not easily withstand such a
contingency.

For example, consider a PPP project in the hospital sector. The periodic
payments by the public administration to the SPV/concession holder can be
linked to the consumer price index as a benchmark for the rate of inflation.
This will be a considerable advantage, because nominal rates move in relation
to the inflation rate. As we know, nominal rates are made up of a real
component and a premium requested by investors to protect their purchasing
power. Ideally, therefore, the SPV would find itself in a situation where a
variation in debt service would be compensated by an increase in revenues.
The conditional must be used, however, since inflation can be determined with
different parameters in terms of revenues and interest rates.
The only risk remaining for the SPV to face would be that the trends in actual
interest rates may not be in line with the projections given in the financial
model. The ideal strategy, then, would be to draw up a swap contract on the
true interest rate or to use contracts that cover inflation risk.

In practice, interest rate risk tends to be completely covered during the post
completion phase; percentages usually run from 70% to 90% of the
outstanding debt; this gradually decreased as the outstanding debt diminishes.
However, we must keep in mind that this coverage eliminates variability and
in so doing prevents the SPV from taking advantage of possible drops in
interest rates. Coverage strategies, in fact, are subject to a very considerable
opportunity cost.

Measures to mitigate against interest rate risk:

1. Negotiate a fixed interest rate- Fixed rate debt removes one source of
risk from a project. Commercial banks relying on short term funding
sources are reluctant to lend at fixed interest rates for a long period,
they may be able to arrange a mix of floating and fixed rate funding,
which would reduce a project’s interest rate risk.
2. Convert the interest rate- Project sponsors may prefer to borrow at a
floating interest rate to take advantage of a later fall in interest rates.
They can however effectively convert their loans from floating to
fixed- interest rates by entering into interest rate swaps with borrowers.
3. Swap interest rates- Interest rate swaps are becoming a more and more
popular hedge for projects. Although such swaps are readily available
in the international risk management market, most developing market
projects do not have the necessary credit standing to be accepted as
counterparty in the market, at least at project start-up.