Lesson Objective: To build the detailed construction phase model, including the construction drawdown schedule, the calculation of Interest During Construction (IDC), the modeling of construction contingencies, and the integration of the construction phase into the overall project cash flow statement.

In-Depth Notes:

1. The Construction Timeline and Drawdown Schedule:
The construction phase is the most capital-intensive period of a project finance deal. During this period, the project generates no revenue but consumes significant cash.

  • The Construction Period: The length of the construction period is defined in the EPC contract (e.g., “24 months from financial close”). The model must project the monthly or quarterly capital expenditures required to complete construction. These expenditures are typically phased based on an “S-curve” (slow start, rapid acceleration, tail-off).

  • The Drawdown Schedule: The model shows when the debt and equity are drawn down to fund the construction costs. The drawdowns are typically phased to match the construction expenditure pattern.

    • Equity Drawdown: Equity is typically drawn first, often as a percentage of the total equity commitment, to provide a “cushion” for the lenders.

    • Debt Drawdown: The debt is drawn down in tranches as construction milestones are reached and verified by the Independent Engineer (a third-party consultant hired by the lenders to validate construction progress).

    • The “Minimum Equity Contribution” Rule: Lenders require that the sponsors contribute a minimum percentage of the total project cost in equity before any debt is drawn down (the “equity bridge”). A common global standard is that the sponsors must contribute at least 20% to 30% of the total cost before lenders release the first tranche of debt.

2. The Capital Expenditure (CAPEX) Budget:
The total project cost is broken down into several key components.

  • Hard Costs: The physical construction costs, including civil works, equipment (turbines, panels, machinery), and installation. These are fixed under the EPC contract.

  • Soft Costs: The non-construction costs, including engineering design, project management fees, legal fees, financing fees, and the “construction contingency” (a buffer for cost overruns, typically 5% to 15% of hard costs).

  • Owner’s Costs: Costs incurred by the sponsor, such as due diligence, permitting, and insurance, which are not covered by the EPC contract.

  • The “Contingency” Drawdown: The model must include a contingency drawdown schedule. If the project experiences cost overruns (e.g., due to bad weather, labor shortages, or material price increases), the contingency is drawn upon. If the contingency is not used, it can be returned to the sponsors or used to reduce the debt.

3. Interest During Construction (IDC) and Capitalization:
A critical and complex element of the construction phase is the interest that accrues on the debt drawn down during construction. The project has no revenue to pay this interest, so the interest is “capitalized” – it is added to the outstanding debt balance and repaid during the operational phase.

  • The IDC Calculation: The model calculates IDC on a monthly or quarterly basis, based on the outstanding debt balance at the beginning of each period and the applicable interest rate.

    • Formula: IDC = Opening Debt Balance x Interest Rate x (Period / 360) (using a 360-day banking convention, which is standard in global project finance).

  • The “Roll-Up” Effect: The capitalization of IDC means that the total debt at commercial operation (COD) is significantly higher than the original debt drawn down. This increases the debt service burden during the operational phase.

  • The “Interest Reserve” Account: In some projects, the lenders require an “Interest Reserve” account to be funded at financial close to cover the IDC. This reduces the amount of debt available for construction and provides an additional layer of security to the lenders.

4. The “Commercial Operation Date” (COD) and the Transition:
The COD is the day the project is fully constructed, tested, and ready to begin commercial operations. At COD, the construction phase ends, and the operational phase begins.

  • The “Commissioning” Period: A short period (e.g., 1 to 3 months) during which the plant is tested and gradually ramps up to full output. Revenue may be generated during this period but at a reduced rate (e.g., 50% of the full PPA rate).

  • The “Final Acceptance” Test: The Independent Engineer certifies that the project meets the performance guarantees specified in the EPC contract (e.g., “The plant must achieve 90% availability and a heat rate of 7,500 BTU/kWh”). If the project fails to meet these guarantees, the EPC contractor must pay liquidated damages (reducing the project’s cost) or make performance adjustments.

5. The Construction Phase Cash Flow Statement:
The construction phase cash flow statement is relatively simple but must be rigorously integrated into the overall model.

  • Operating Cash Flow: Zero (no revenue, minimal operational expenses).

  • Investing Cash Flow: The CAPEX drawdowns (both equity and debt) are recorded as a single large negative investing cash flow (the construction capex).

  • Financing Cash Flow: The equity contributions are a cash inflow, and the debt drawdowns are a cash inflow.

  • The “Ending Cash” Check: The project must maintain a positive cash balance throughout the construction phase. If the cash balance goes negative, the model must automatically draw down additional debt (or require additional equity contributions) to cover the shortfall.

 
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