Summary of the Project example:
A project developer has established a special purpose company (SPC) to develop an onshore windfarm in Norway. The SPC has undertaken environmental studies to define the availability of the specific location wind resource, the geology of the site ground, access routes, and grid connection requirements.
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What is the Internal Rate of Return (IRR)?
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero.
Enhancement of equity rate of return considered parameters
As seen in Table 1, the loan grace period, gearing ratio, increase of PPA, and WTGs degradation factor were adjusted to potentially enhance the equity rate of return of the base model without compromising the bankability of the SPC. Financial parameters such as the grace period included a range of 2 to 4 years with the gearing ratio ranging from 75D/25E to 95D/5E.
Technical parameters such as the WTG’s annual degradation factor ranged from 1.2% to 1.57% with the PPA ranging from the average value of 52.5 EUR/MWh (base model assumption) to the maximum value given of 60 EUR/MWh.
Parameters of Equity IRR and minimum DSCR were assessed for every option with results shown in Figure 1.
The enhancement of the Equity IRR of this example is based on the cash flow model below. Click the link to find out more and download for FREE the excel spreadsheet
Enhancement of equity rate of return cash flow model results summary
As seen in Figure 1, the equity IRR of all options has increased in a range of 2-18%. Option 3 has the highest Equity IRR with an increase of 18%. This could be justified due to the financial leverage of the high gearing ratio of 95D-5E.
It could also be pointed out that a minimum DSCR of 1.25 suggests a strong bankable option. Nevertheless, it could be argued that when project finance is heavily dependent on debt, a change in loan interest rate could jeopardize the overall operations of the SPC.
Comparing options 2 and 4, a difference of 4% on equity IRR and a more acceptable minimum DSCR (1.16 to 1.03) could be observed which suggests adjusting a lower WTG degradation factor and a higher PPA per year will improve shareholder profits.
However, the degradation factor is a dependent variable on the cash flow of the project, as this is based solely on technology improvements in the industry and cannot be predicted. Overall, it could be seen that a grace period of 3 years (Option 1 and 3) has the best bankability for the project as well as having a minimum DSCR is an acceptable range.
Furthermore, it should be also pointed out that the base model dividends to cash reserve ratio are at 90-10, which means increasing the dividends paid will subsequently increase shareholder’s return. However, by doing so, a higher risk is accrued if an unexpected maintenance cost is required.
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Other parameters that affect the equity rate of return of the project
It can be argued that a PPA agreement with the North Sea link could be arranged to provide energy to the UK at a higher price to increase revenues, however, recent market values suggest that the latest agreements of €48 (£41.61)/MWh, which is much lower than supplying energy to locals as assumed in the base model.
Furthermore, a more in-depth debt sculpting could be carried out to reduce the interest payments and adjust the annual earnings and the DSCR to acceptable levels for the bankability of the project.
Also, an increase in the year period of the cash flow will subsequently increase the equity return to investors as the loan is accounted for a 12-year tenor which is over in 14. A technical parameter that could also benefit the profitability is to maximize the efficiency of the farm by using higher capacity WTGs and standardizing proven design procedures to bring down the capital costs.