A cash reserve enlarges the loan that sizes it, and then earns a deposit rate on borrowed money.
A debt service reserve account is sized as the next six months of scheduled debt service, and when it is funded in cash from the sources at financial close it enlarges the loan that sizes it. On an illustrative 400 million project geared at 75 per cent, the reserve is 16.45 million, which raises the loan from 300.00 to 312.34. Funding it in cash costs 0.58 a year of negative carry; a letter of credit at 1.75 per cent costs 0.28, a present value saving of 2.74 over the loan's life.
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 →
The project is an illustrative contracted asset financed with a fifteen-year senior loan repaid in level semi-annual instalments. The lenders require a reserve equal to the next six months of debt service, in place from financial close. The sponsor can put it in cash, funded in the sources and uses, or provide a letter of credit from a bank, which keeps the reserve out of the funding requirement.
| Input | Value |
|---|---|
| Project cost before the reserve | 400.0 |
| Gearing, debt to total uses | 75% |
| Loan interest rate, all-in | 6.5% |
| Tenor, years, semi-annual level instalments | 15 |
| Reserve requirement | 6 months |
| Interest earned on reserve cash | 3.0% |
| Letter of credit fee, per year | 1.75% |
| Letter of credit upfront fee | 0.50% |
DSRA = scheduled principal and interest over the next six months
Instalment per 100 of loan, semi-annual = 3.25% / (1 − 1.0325−30) = 5.268
On a loan of 300.00: instalment = 15.80, which is the reserve if it sits outside the loan
In Excel: =-PMT(6.5%/2, 30, 300) for the instalment, and in a periodic model =SUM(OFFSET(DS_next,0,0,1,months/6)) for a forward-looking reserve target.
On a level instalment the target is constant until the final payment. On sculpted debt it is not: the reserve target moves with each period's scheduled service, and the model must release or top up the difference through the waterfall every period.
If the reserve is a use of funds, the loan is 75 per cent of a total that includes the reserve, and the reserve is six months of service on that loan. Each depends on the other. Iterating:
| Pass | Loan in | Reserve | Loan out |
|---|---|---|---|
| 1 | 300.00 | 15.80 | 311.85 |
| 2 | 311.85 | 16.43 | 312.32 |
| 3 | 312.32 | 16.45 | 312.34 |
| 4 | 312.34 | 16.45 | 312.34 |
Closed form: Loan = gearing × cost / (1 − gearing × instalment factor)
= 0.75 × 400.0 / (1 − 0.75 × 0.05268) = 312.34; reserve = 312.34 × 0.05268 = 16.45
The cash reserve adds 12.34 of debt and 4.11 of equity, takes total uses to 416.45 and raises annual debt service from 31.61 to 32.91, an extra 1.30 a year that the cover ratios must absorb. A closed form avoids an iterative calculation setting in the spreadsheet; where the loop has more than one element, as it does once interest during construction and fees are in it, unrolling it one pass per column is the robust alternative.
A cash reserve is borrowed money earning a deposit rate. Treated at the loan rate, which is the most favourable view of the cash route because the equity share costs more, the reserve loses 3.5 points a year: 16.45 × 3.5% = 0.58. A letter of credit for the reserve on the 300.00 loan costs 1.75 per cent of 15.80, or 0.28 a year, plus 0.50 per cent upfront.
| Route | Reserve | Annual cost | Present value |
|---|---|---|---|
| Cash, funded in the uses | 16.45 | 0.58 | 5.42 |
| Letter of credit | 15.80 | 0.28 | 2.68 |
| Saving from the letter of credit | 2.74 |
The break-even letter of credit fee is 3.59 per cent a year. Below it, the letter of credit is cheaper, before counting the equity it saves at close.
| Months of cover | Loan, cash route | Cash reserve | Cash carry a year | Letter of credit fee a year |
|---|---|---|---|---|
| 3 | 306.05 | 8.06 | 0.28 | 0.14 |
| 6 | 312.34 | 16.45 | 0.58 | 0.28 |
| 9 | 318.90 | 25.20 | 0.88 | 0.41 |
| 12 | 325.74 | 34.32 | 1.20 | 0.55 |
| Letter of credit fee | Annual fee | Present value with upfront | Saving against cash |
|---|---|---|---|
| 1.25% | 0.20 | 1.94 | 3.48 |
| 1.75% | 0.28 | 2.68 | 2.74 |
| 2.50% | 0.40 | 3.79 | 1.62 |
| 3.50% | 0.55 | 5.28 | 0.13 |
The letter of credit is not free of other terms. If it is drawn, the reimbursement claim of the issuing bank usually ranks with the senior debt, and the bank will want the sponsor's or the project's credit to support it. A sponsor guarantee behind the letter of credit is a contingent liability on the sponsor's balance sheet, which is the real price of the 2.74.
The frequent error is to size the reserve on the loan before the reserve: 15.80 instead of 16.45. The model then shows sources equal to uses at close, but the reserve is 0.65 short of six months of the debt service the loan actually carries, and the first reserve test after close fails. The second is a backward-looking target, last period's service rather than the next six months, which on sculpted debt understates the reserve exactly when service is rising.
Size the reserve on the loan that includes it: 16.45 here, solved in closed form or by an unrolled loop. Then price the funding route; at 1.75 per cent a letter of credit saves 2.74 in present value against cash. The book's Northgate model draws the reserve on the first day and carries it through the build, and its funding loop is unrolled column by column in the free workbook for this case. For how the reserve interacts with coverage over the loan's life, see how to calculate the LLCR.
Six months is the common requirement on project loans with semi-annual payments, sometimes three for very stable contracted assets and twelve for merchant exposure. On the illustrative project, three months is a reserve of 8.06 and twelve months 34.32, which adds 13.40 of loan over the six-month case when funded in cash.
Because a cash reserve is a use of funds, so the loan sized as a share of total uses includes it, and the reserve is six months of service on that loan. On the illustrative case the loop converges in four passes to a 312.34 loan, or directly from loan = 0.75 x 400.0 / (1 - 0.75 x 0.05268).
When the letter of credit fee exceeds the negative carry on the cash, the gap between the funding cost and the deposit rate. On the illustrative project, funded at 6.5 per cent and earning 3.0, the break-even letter of credit fee is 3.59 per cent a year; at 1.75 the letter of credit saves 2.74 in present value.
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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: infrastructure, data centres and energy → · All 368 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.