The average-balance rule of thumb misses draw timing, compounding and the fee drawn on day one, and the gap travels into every ratio downstream.
Interest during construction is calculated period by period on the whole drawn balance, including the arrangement fee drawn at close and the interest already capitalised, with the loan sized to cover the result. On an illustrative 480 million build funded 65 per cent by debt over two years at 7.0 per cent, IDC is 26.63 million, against 21.84 from the usual shortcut of average balance times rate times years. The shortcut misses 4.79, or 21.9 per cent.
Worked in full in The Project Finance Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An illustrative project is built over eight quarters with hard cost spent evenly. Debt funds a fixed share of each quarter's hard cost, drawn at the start of the quarter, and the loan also funds its own arrangement fee on day one and every quarter's interest, which is capitalised rather than paid. Equity funds the rest of the hard cost.
| Input | Value |
|---|---|
| Hard cost | 480.0 |
| Construction period, quarters | 8 |
| Hard cost per quarter | 60.0 |
| Debt share of hard cost | 65% |
| Debt drawn per quarter | 39.0 |
| Interest rate, all-in, compounding quarterly | 7.0% |
| Arrangement fee on the final commitment, drawn at close | 2.0% |
Interestq = (opening balance + drawq) × 7.0% / 4
Closing balanceq = opening balance + drawq + interestq
Opening balance at close = arrangement fee = 2.0% × final commitment, and the final commitment is the closing balance in quarter 8
In Excel, row by row: =(C10+C11)*$B$3/4 for interest and =C10+C11+C12 for the closing balance; the fee in the first column refers to the last closing balance, which is the loop.
| Quarter | Interest | Closing balance |
|---|---|---|
| 1 | 0.80 | 46.71 |
| 2 | 1.50 | 87.21 |
| 3 | 2.21 | 128.42 |
| 4 | 2.93 | 170.35 |
| 5 | 3.66 | 213.02 |
| 6 | 4.41 | 256.43 |
| 7 | 5.17 | 300.60 |
| 8 | 5.94 | 345.54 |
The loan at completion is 345.54: 312.0 of hard cost, 6.91 of arrangement fee and 26.63 of interest. Total project cost is 513.54, the equity 168.0, and the gearing 67.3 per cent rather than the 65 per cent applied to hard cost, because the debt funds all of the financing cost.
The usual back-of-envelope is half the debt drawn on hard cost, times the rate, times the construction period: 312.0 / 2 × 7.0% × 2 = 21.84. It misses three things, each of which can be priced on this case.
| Step | IDC | Added |
|---|---|---|
| Shortcut: average balance × rate × years | 21.84 | |
| Draws at the start of each quarter, simple interest | 24.57 | 2.73 |
| Interest on capitalised interest | 25.60 | 1.03 |
| Interest on the fee drawn at close, with the loop solved | 26.63 | 1.03 |
Timing is the largest piece: money drawn at the start of a quarter carries a full quarter of interest, and the average-balance rule implicitly assumes mid-period draws. Compounding comes next, since capitalised interest bears interest. The fee is the piece most often left out entirely: it is drawn on the first day and carried for the whole build, so it bears interest for longer than any construction draw. The circularity is small but real: the fee depends on the commitment, which depends on the interest, which depends on the fee.
Size the commitment to the closing balance in the final quarter, not to the hard cost plus a round number. A commitment short of 345.54 leaves a funding gap in the last quarter that the sponsor fills with equity at the worst possible time.
| Rate | Shortcut | Period by period | Loan at completion |
|---|---|---|---|
| 5.0% | 15.60 | 18.78 | 337.53 |
| 6.0% | 18.72 | 22.68 | 341.51 |
| 7.0% | 21.84 | 26.63 | 345.54 |
| 8.0% | 24.96 | 30.63 | 349.62 |
| 9.0% | 28.08 | 34.68 | 353.76 |
A delay is more expensive than a higher rate, because after the last draw the whole balance keeps accruing with no revenue to service it. With the fee fixed at signing:
| Delay | IDC | Extra IDC | Loan at completion |
|---|---|---|---|
| None | 26.63 | 0.00 | 345.54 |
| 3 months | 32.68 | 6.05 | 351.59 |
| 6 months | 38.83 | 12.20 | 357.74 |
| 12 months | 51.46 | 24.83 | 370.37 |
Each month of delay costs about 2.03 of interest, and every euro of it lies above the signed commitment. That is why lenders size a contingency inside the commitment and why delay liquidated damages are struck against the carry: the interest is the most predictable part of what a late project costs.
Charging interest only on the construction draws. A model that excludes the fee and the capitalised interest from the interest-bearing balance reports IDC near 24.57 instead of 26.63, and the gap travels into the loan, the first instalment, the cover ratio and the equity return. The book's Northgate model records exactly this correction: interest charged on the whole drawn balance, fee and reserve included, moved 2.8 million through the loan and everything downstream of it.
Compute IDC period by period on the whole drawn balance and size the loan to the final closing balance: 26.63 here, 21.9 per cent above the shortcut. Then test a delay, which adds about 2.03 a month. The Northgate data centre funding loop, unrolled one pass per column, is in the free workbook for this case. For the cap that often decides how much of this the lender will fund, see how much debt a 65 per cent loan-to-cost cap refuses.
Because the loan funds its own interest and fees, and the arrangement fee is a percentage of the final commitment, which itself includes the interest. In the illustrative build the loop settles at a 345.54 commitment with a 6.91 fee; it can be solved by iteration or by unrolling one pass per column.
In the project model it is capitalised into the loan and the project cost during the build, then the loan amortises from completion. In the illustrative case IDC of 26.63 and a fee of 6.91 lift total cost from 480.0 to 513.54 and gearing from 65 to 67.3 per cent.
After the last draw the whole balance accrues with no revenue to service it. On the illustrative build, six months of delay adds 12.20 of interest and a year adds 24.83, about 2.03 a month, all of it above the signed commitment unless a contingency was sized for it.
This article is one calculation from The Project Finance Handbook. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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