Sizing DSCR, debt, gearing, equity IRR and covenant headroom worked on one illustrative contracted project, ratio by ratio.
A good DSCR for a project finance loan is the lowest sizing ratio that still leaves the cash flow room to fall before it hits the lock-up test, and that depends on how certain the revenue is. Illustratively, contracted projects size at around 1.25 to 1.35 times and merchant ones at 1.75 or more. On a 400.0 million project with 36.0 million of CFADS a year, sizing at 1.30 times raises 299.8 million of debt, 75.0 per cent gearing, and leaves CFADS 15.4 per cent of room before a 1.10 times lock-up.
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 →
Two different ratios carry the same name in a project finance term sheet. The sizing DSCR fixes how much debt the cash flow is allowed to support: debt service is set at CFADS divided by the ratio, and the loan is the present value of that debt service at the loan rate. The covenant DSCRs, a lock-up below which distributions stop and a lower default ratio, are tested every period afterwards. The gap between the two is the cushion. Asking what DSCR is "good" is asking how large that cushion should be for the revenue being financed.
The case below is illustrative: a contracted project with flat CFADS, an eighteen-year loan and a seven-year tail of unlevered life after it. All figures are in millions.
| Input | Value |
|---|---|
| Project cost, funded by debt and equity | 400.0 |
| CFADS a year, base case, flat | 36.0 |
| Operating life, years | 25 |
| Debt tenor, years (annuity) | 18 |
| All-in cost of debt | 6.0% |
| Sizing DSCR, base case | 1.30x |
| Lock-up DSCR / default DSCR | 1.10x / 1.05x |
Step 1: the debt service the cash flow supports. Divide CFADS by the sizing ratio.
Debt service = CFADS / DSCR = 36.0 / 1.30 = 27.69 a year
Step 2: the debt that debt service repays. On an annuity, the loan is debt service times the annuity factor at the loan rate over the tenor, 10.83 at 6.0 per cent over eighteen years.
Debt = 27.69 × 10.83 = 299.8; gearing = 299.8 / 400.0 = 75.0%; equity = 100.2
Excel: =PV(6%,18,-36/1.3)
Step 3: the headroom. The fall in CFADS that takes cover from the sizing ratio down to a covenant level is one minus the covenant over the sizing ratio.
Fall to lock-up = 1 − 1.10 / 1.30 = 15.4%; fall to default = 1 − 1.05 / 1.30 = 19.2%
In the first year the 27.69 of debt service is 17.99 of interest and 9.70 of principal, and over the tenor it adds to 498.5 against 648 of CFADS. The equity receives 8.31 a year for eighteen years and then the whole 36.0 for the last seven, an equity IRR of 9.95 per cent against a project IRR of 7.54.
Run the same three steps at each ratio and the trade-off a lender and a sponsor negotiate becomes explicit.
| Sizing DSCR | Debt | Gearing | Equity IRR | CFADS fall to 1.10x lock-up | DSCR if CFADS is 10% lower |
|---|---|---|---|---|---|
| 1.20x | 324.8 | 81.2% | 10.63% | 8.3% | 1.08x |
| 1.25x | 311.8 | 78.0% | 10.25% | 12.0% | 1.12x |
| 1.30x | 299.8 | 75.0% | 9.95% | 15.4% | 1.17x |
| 1.35x | 288.7 | 72.2% | 9.72% | 18.5% | 1.22x |
| 1.40x | 278.4 | 69.6% | 9.53% | 21.4% | 1.26x |
| 1.50x | 259.9 | 65.0% | 9.23% | 26.7% | 1.35x |
| 1.75x | 222.7 | 55.7% | 8.78% | 37.1% | 1.57x |
| 2.00x | 194.9 | 48.7% | 8.52% | 45.0% | 1.80x |
Each 0.05 times of sizing ratio around the base case is worth roughly 11 to 12 of debt: 12.0 more at 1.25 times, 11.1 less at 1.35. Moving from 1.40 to 1.20 times cuts the equity cheque from 121.6 to 75.2, so the 1.40 times case needs 1.62 times the equity, and adds 1.10 points of equity IRR. What the sponsor buys with that return is a thinner cushion: at 1.20 times a 10 per cent shortfall takes cover to 1.08 times, already through the lock-up.
The one that matches the volatility of the CFADS it is applied to. A useful test is to ask what ratio keeps cover at the lock-up in a bad but plausible year. If the bad year is 10 per cent below base, the answer is 1.10 / 0.90 = 1.22 times, which here supports 318.9 of debt and 79.7 per cent gearing. A revenue line that can fall 25 per cent needs about 1.47 times on the same logic, which is why merchant exposure sizes so much higher.
| Revenue | Sizing DSCR | Debt | Gearing |
|---|---|---|---|
| Availability payments (PPP) | 1.20x to 1.30x | 324.8 to 299.8 | 81.2% to 75.0% |
| Contracted offtake (PPA, long lease) | 1.25x to 1.35x | 311.8 to 288.7 | 78.0% to 72.2% |
| Hedged or partly merchant | 1.40x to 1.60x | 278.4 to 243.6 | 69.6% to 60.9% |
| Fully merchant | 1.75x to 2.00x | 222.7 to 194.9 | 55.7% to 48.7% |
These ranges are illustrative and vary with the lender, the market and the cycle. A ratio is also never the only test: lenders apply gearing caps, P90 tests and, on real estate style assets, loan-to-cost limits. The data centre in The Project Finance Handbook is sized at the lower of a 1.45 times cover test on year-one income and a 65 per cent loan-to-cost test, and the book's model names which one binds.
The common mistake is to compare sizing ratios without the CFADS definition behind them. A 1.30 times ratio on CFADS after a major maintenance reserve and tax can be a stricter test than 1.25 times on CFADS before them, and a ratio applied to a P50 forecast is a different loan from the same ratio applied to a P90 one. Sizing at 1.00 times on a CFADS 10 per cent lower is the same as 1.11 times on the base case and would support 350.8 of debt here, more than any line in the table. Read the definitions first, as set out in how CFADS is calculated, and then the ratio. The second mistake is reading an annuity result as the debt capacity of a growing cash flow: sculpting raises more, as shown in sculpted vs annuity debt.
The sizing and both coverage tests run live in the free workbooks for the book's two cases.
For contracted renewables, illustrative sizing ratios sit around 1.25 to 1.35 times on the base case, often combined with a lower ratio such as 1.00 times on a P90 case. Merchant exposure sizes higher, around 1.75 times or more. On a 36.0 million CFADS, an 18-year loan at 6.0 per cent sized at 1.30 times supports 299.8 million; at 1.75 times only 222.7 million.
The sizing DSCR sets the loan amount at financial close: debt service equals CFADS divided by the ratio. The lock-up DSCR is a covenant tested each period, below which distributions to equity stop. The gap is the cushion: sized at 1.30 times with a 1.10 times lock-up, CFADS can fall 15.4 per cent before distributions are blocked, and 19.2 per cent before a 1.05 times default.
Divide CFADS by the target DSCR to get the debt service the project can carry, then take the present value of that debt service at the loan rate over the tenor. With 36.0 of CFADS and 1.30 times, debt service is 27.69 a year; the eighteen-year annuity factor at 6.0 per cent is 10.83, so the loan is 299.8. In Excel, =PV(6%,18,-36/1.3).
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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