Debt and Project

Corporate Governance & Restructuring Petrolera Zuata Petrozuata C. A. Maastricht University School of Business and Economics Maastricht, 19th September 2012 Driessen, G. (i6060635) Koerselman, W. (i561398) Park, D. (i6051671) International Business – Finance Corporate Governance and Restructuring Course Code: EBC4052 Tutor: Dr. S. Kleimeier Case 2: Petrolera Zuata, Petrozuata C. A.

Introduction Petrolera Zuata, hereinafter referred to as Petrozuata, was the first joint venture in a series of strategic associations between PDVSA, Venezuela’s state-owned enterprise entrusted with the task to “efficiently develop and manage the country’s hydrocarbon resources and promote economic development”, its subsidiaries and foreign companies from the oil business. More specifically, PDVSA’s subsidiary Maraven would enter into a joint venture agreement with Conoco Inc. , petroleum subsidiary of one of the world’s largest chemical producers, E. I. u Pont de Nemours and Company (DuPont). The project targeted the Orinoco Belt, located in the middle of Venezuela, which held the largest reserves of heavy/extra heavy oil in the world. After its completion, the project would be a fully integrated facility, covering production, transportation, and refining of crude oil. After early feasibility studies in 1992, Maraven and Conoco formed Petrozuata, a project company responsible for the construction, financing and management of the joint venture. Employing project finance structure, Petrozuata was looking to cover 60% of the $ 2. 25 billion financial need with debt financing. The remaining $ 975 million of equity would be provided via paid-in capital, early production cash-flows and additional equity contributions. After considering several options for debt financing, the project team decided on issuing bonds on the Rule 144A market as these bonds combined the advantages of public bonds (large amounts, long maturities, fixed interest rates, and fewer, more flexible covenants) with the advantage of speed. However, a requirement for this procedure was that the project would need to get an investment-grade rating. 1. 1.

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What criteria do the rating agencies use to establish a rating? A credit rating is a judgment about the general creditworthiness of a debtor, or the creditworthiness of specific debt securities or other financial requirement. The credit ratings are generally used by lenders to assess if a certain potential investment is rational to make. The ultimate purpose of ratings is to protect potential lenders from making too risky investments. Therefore a rating can be explained as an indicator of the risk-level and as indicator in which degree the borrower will be able to repay their contractual obligations.

The different rating agencies use somewhat similar criteria to assess a company, government or project’s creditworthiness, though there is a slight variance in the rating system. They focus on the weakest links in the project’s financing and operations, namely the sponsor’s creditworthiness, the project’s economics and finally the sovereign risk associated with the project. The creditworthiness of a sponsor in general is of extreme importance, as the higher the creditworthiness the smaller the probability that the sponsor would default on its contractual obligations.

This is surely a factor potential creditors keep in mind when they consider investments. The sponsor’s creditworthiness is particularly important for projects with low leverage as these projects strongly depend on the sponsor’s input and capacity to back up the project. Of at least same importance for a project’s rating are its specific characteristics: technology, performance, competition, counterparties, forecasts of market price and demand of the output, construction and business risk are 1 thoroughly analyzed and evaluated.

Last but not least, rating agencies incorporate an assessment of the sovereign risk linked to a project in their ratings, including the probability of actions by the host country’s government with negative effects on the outcome of the project and other factors like currency market volatility and the general economic state of the host country, which also have an impact on the general riskiness of the investment in question. 1. 2. How does the Petrozuata project perform regarding these criteria? Does the project finance structure mitigate some of the risks that the rating agencies consider? If so, how is this mitigation done?

The aim for Petrozuata is to get an investment grade rating. This is necessary for the ability to issue project bonds. If Petrozuata would not have an investment grade rating, the bond price would decrease at the same dividend, or the dividend would have to increase, resulting in a situation less favorable for Petrozuata. As mentioned in the previous section, the rating is established based on three elements, these being: the sponsor’s creditworthiness, the projects economics and the sovereign risk of the country, Venezuela. The two main sponsors of the Petrozuata project are Conoco and Maraven.

Since these companies are subsidiaries without publicly-traded debt, they have no rating. As a result, we have to look at the credit-ratings of the respective parent companies. Conoco is part of the energy subsidiary of DuPont, which has a 100% stake in Conoco. DuPont was rated by both S&P and Moody’s, AA- and Aa3 respectively, an investment grade rating. Maraven is a subsidiary of PDVSA, which in turn is wholly owned by the Venezuelan government. This means that the rating for PDVSA is equal to Venezuelan’s sovereign rating, Ba2 (Moody’s) and B (S&P) respectively, each a sub investment-grade.

However, in the case of PDVSA it is mentioned in the case that if it was located in the United States, it would get an AAA credit rating. This statement is supported by a comparison between the financial data of PDVSA and similar companies from the US with a rating in range of A+ to AAA (Exhibit 8) which reveals that PDVSA outperforms all. It is quite obvious that PDVSA’s rating is capped by the Venezuelan sovereign rating. There, one might still consider PDVSA an investment grade company. Speaking in favor of Petrozuata, as far as the sponsors’ creditworthiness is concerned, is the comparable project of Ras Laffan in Qatar.

As can be seen in exhibit 8, the key figures for Ras Laffan are similar to Petrozuata’s. With a slightly higher leverage, they managed to achieve a BBB+ rating. This is higher than Qatar’s rating, which is BBB. Using this example, and taking into account the above mentioned ratings from the parent companies, Petrozuata should be able to achieve an investment grade rating. There are however some points of notice which might not favour Petrozuata. Equity compared to debt is lower than comparable projects, which can be seen in exhibit 8.

Next to this, the sponsors plan to use cash-flows from early production to fund $530 million in financial needs. A third point to mention is the guarantees that are backed by the sponsors. These are severally backed, which means that the 2 parent companies are only liable for their own share, while a jointly backed liability is more favorable for the lenders. These advantages are countered by the fact that Petrozuata shows commitment by not making use of the full capacity for debt financing. Also, the guarantees from the sponsors are backed by their respective parental companies.

This means, that although they are only severally backed, the chance that they will default on their obligations is very small. Regarding the early production cash-flows Mr Sifontes mentions that although it is risky they have: ”… a good execution plan, strong sponsor guarantees, and experience marketing heavy crude. ” If we look at the creditworthiness of the project’s economics, there are several aspects that have to be taken into account, these are: the contractual foundation, the pre-construction risk, the construction risk, and financial risk.

The contractual foundation can be split up in two parts, the off-take agreement and the cash-flow distribution. The off-take agreement assures a minimum amount of sales. If a minimum amount of sales can be guaranteed, a minimum amount of positive cash-flows can be guaranteed. It is agreed, that Conoco will buy 104,000 barrels per calendar day (BPCD) of Petrozuata syncrude during the first 35 years of the contract, at the market price. 62% of this would be refined at its Lake Charles refinery, while the rest of the syncrude will be bought by Maraven and will be refined at its Cardon refinery in Venezuela.

The deal includes that Petrozuata has the right to sell syncrude at a higher price to third parties. In the case it is mentioned that Chem Systems estimated that the development of a third-party market would take 3 to 5 years and would approximately fetch one dollar per barrel above the market price. The guaranteed off-take of the amount on barrels would also guarantee positive cash-flows, which is good for the credit worthiness of Petrozuata. Petrozuata’s cash-flows are received on a dollar-denominated off-shore account maintained by a bankers trust. Payment priority is done according to “cash-waterfall”. This means that the funds are distributed according to the following order: first the cash-flows are distributed to a 90-day operating expense account, secondly they are distributed to all debt obligations, thirdly the funds are put in a reserve account to maintain a six month principal and interest, finally the remaining funds will be transferred to Petrozuata so they can be distributed to the equity holders. This cash-flow waterfall is an assurance for debt-holders, because they are guaranteed that they are the first in line to receive the cash-flows after operating costs.

Pre-construction risks depend on the assessment of the project by the consulting and engineering firms. This includes the design of the of the operation, performance and cost projection, the schedule of construction, the compliance with local and international laws, regulations and standards. Regarding the technology used in the project, this includes the engineering and design, Conoco has a large advantage. It is a recognized as a leader in refining technology, project development, technical knowhow, capacity and experience.

The drilling technique they will be using at Petrozuata has already been proven as successful and because established technology is used in the project, it allows for analysis of 3 similar projects. Another consultancy firm, Stone and Webster Overseas Consultants evaluated the design, planning, costs and feasibility of the construction and came to a positive conclusion, although they mentioned the construction schedule was aggressive. The fact that a leader in technology is used, the chances of something going wrong operationally are decreased, which again insures positive cashflows.

Location risk is also part of the pre-construction risk. The estimation of the reserves is a very important part of the project. For this, DeGolyer & MacNaughton is hired, an experienced oil and gas consulting firm. They estimated a 21. 5 billion barrels reserve. This exceeds the amount planned of 120,000 BPCD for the duration of the project. The location itself is relatively flat and sparsely populated and most of the pipeline is to be laid underground. This means that there is a low probability of additional costs arising for laying the pipelines.

Lower location risks decrease the risk of delays in construction due to location factors, which is important for the early production schedule crude to be achieved. Construction risks include the sourcing out of the engineering, procurement, construction of pipelines and downstream facilities. This is done through a bid including the world’s leading engineering and construction companies: Mitsubishi Heavy Industries & Bechtel. The sourcing out of the construction risk mitigates a large portion of the risk to experienced companies. During the production process, the sponsors agreed to pay for project expenses, including cost overruns.

The upstream construction would be completed by local companies. These companies would be from PDVSA’s business registry of authorized contractors. Despite this, there would still be exposure Venezuelan business risk. However, the involvement of local companies would build goodwill, also among the local government. This would to a certain extent mitigate local government risks. As mentioned above, the sponsors will be liable for cost overruns during the production process. Next to this an all risk insurance policy covers up to $1. 5 billion in losses or damage during construction.

A limitation which is difficult to guarantee is the construction schedule. There is no buffer for unexpected events. As mentioned earlier, the construction schedule is aggressive. A problem with this is the fact that cash-flows from early production crude are needed to complete the funds to finish the project. This is a liability that could severely hamper the project in the early stages. However, this is not a risk for the debt-holders, for the debt is non-recourse only after construction has been completed. Before the construction is complete, the project has to meet a set of criteria.

A 90 day operation test of the whole facility, to check if projected production level can be met and if the production meets the quality requirements. This objective reliability test decreases the operation risk, because the 90 day operations test is included in production time. It is assured that once production starts, problems will have been solved, that would have otherwise have occurred during production. The last risk to be addressed is the financial risk. A very important part of the success of the project is the calculated future cash-flows.

The reliability of these financial projections always seems ambiguous. One can never be sure in the case of oil prices and demand of oil. However, the off-take agreement 4 takes a great part of this risk away. The agreed sale of 104,000 BPCD to Conoco will generate significant cash-flows for Petrozuata. For the debt-holders this is an important element. Combined with the cash-waterfall this would ensure that cash-flows are distributed to them. The base case projects an oil price of $12. 96 per barrel, well below the per barrel price at the time. This price is to increase the years after.

At a break-even per barrel price of $8. 63 Petrozuata have a comfortable margin regarding the oil price. Also, the pricing formula was assessed as reasonable and consistent with the market development by Chem Systems Inc. They also projected a third party market for Petrozuata’s syncrude would be developed within 3 to 5 years, which would increase revenues by one dollar per barrel. This third party market can be seen as a buffer and as a way to increase cash-flows by increasing output. Operation costs for Petrozuata are very low compared to the industry average.

This is a reason for the low break-even price per barrel. Cash operation costs per barrel are $3. 19 while the industry median is $8. 55. If this is compared to a more typical oil and gas project: Athabasca, whose costs were $9. 36, there is even a bigger difference. The state of the Venezuelan economy is a big driver for the low costs. The high unemployment rate reduces the labour costs, while the high inflation leads to a depreciation in local currency, which would further reduce local costs in Bolivar compared to the dollar denominated incoming cash-flows.

Next to the operating costs the finding and development costs are comparably low to both the industry and Athabasca. This is due to the extensive reserves in the Orinoco belt mentioned earlier. These low costs assure a comfortable margin for Petrozuata. This margin is beneficial for debt-investors because positive cash-flows can be generated to pay out the debt-obligations. The third element that should be considered is the country risk of Venezuela. The political risk factor of Venezuela should be considered as minimal, as one of the sponsors of the project is owned by the Venezuelan state.

Maraven is wholly owned by PDVSA, which in turn is the most important oil company for the Venezuelan state. The importance of the company can be seen from the fact that its operations account for 78% of the export revenues for the country, 56% of the fiscal revenues and 26% of the nations GDP. Another sign of the importance of the company is the fact that it is exempt from local and state taxes. It is only subject to the corporate income tax. Next to the factors of the Venezuelan state being owner of one of the sponsors, the project is structured in a way that mitigates political risk.

To ensure that the cash-flows from Petrozuata are distributed to the right parties, they are distributed according to a certain prioritization or “cashwaterfall”. The cash-flows are deposited to an offshore account, maintained by Bankers Trust in New York. From here, the first cash-flow services a 90 day expense account while the second payout services the project’s debt obligations. The third cash-flow will be deposited in a debt service reserve account, which holds 6 months of principal and interest.

Any remaining funds will be distributed to Petrozuata’s equity holders, under the condition that the DSCR based on the most recent year and the projection of the successive year does not drop below 1. 35. This makes it impossible for the 5 government to seize the cash-flows before they are paid to the debt-holders. Due to the non-recourse debt, development agencies and major banks, who have invested in the project would pressure the government to behave in their favor, the so called political umbrella.

The high leverage of the project amplifies the effects mentioned above. With regard to the Venezuelan market volatility, it can be said that changes in the value of the local currency have no influence on the project’s total revenue as the output is sold to customers that pay in dollars. However, an appreciation of the Bolivar leads to an increase in operational expenditures as well as an increase in tax liabilities relative to the total revenues, denominated in dollars. Also, Venezuela’s economy was quite instable.

Despite a decrease in total debt per GDP, the unemployment rate as well as the interest and exchange rate were skyrocketing. In order to counter these undesirable developments, the Venezuelan government brought into being “Agenda Venezuela” which aimed to calm down the economic turmoil via the deregulation of interest and exchange rates and a raise of taxes. These measures would have had a negative impact on Petrozuata. Yet, due to pressure by the public against this rather unpopular austerity course, the project’s team expected these political measures to be rather unlikely to be put into practice.

Consequently, the currency risk was expected to stay within a manageable range. The final element to be considered, as far as the sovereign risk is concerned, is the creditworthiness and reliability of local suppliers and contractors which were supposed to handle the upstream construction of the project. The relevance of this was partially mitigated as the project would be restricted to companies on the list of authorized contractors of PDVSA. 1. 3. Is the project finance structure essential to the project?

The project finance structure is vital to the success of Petrozuata as it mitigates or even eliminates problems and risks that endanger the project while opening new possibilities to acquire the required funds. Due to the nonrecourse debt, the sponsors’ could reduce the impact of the sub-investment-grade rating of PDVSA on the project’s rating. The joint ownership, with special attention to Maraven, a subsidiary of a state owned company, mitigates the risks of sovereign counteractive actions and guarantees special agreements regarding tax and royalty rates amongst others , beneficial to Petrozuata.

As PDVSA, the holding company of Maravan, contributes 26 percent to Venezuela’s GDP, 78 percent to its export revenues and 59 percent to its financial revenues, it is less probable that counteractive actions will be taken by the government, because it is in its own best interest to achieve maximum project’s profitability. Conoco Inc. the second sponsor of Petrozuata, has a long and successful history in the petroleum industry as it produces huge amounts of oil, sells several different products and employs a large number of employees in various countries worldwide.

Therefore the project should profit from Conoco’s reputation and expertise in the refining industry and development of projects. The development of a separate corporate entity will furthermore decrease acts of expropriation or other governmental interference, because this would be highly visible to the outside world. In case 6 illegal confiscation of assets would happen, this would be noted by the foreign affiliated parties which could lead to increased pressure on the government.

In the event of expropriation of tangible assets, however, putting pressure on the government could turn out to be rather difficult as the assets are physically present in Venezuela. Another mechanism that causes decrease in the risk of cash expropriation is de debt/equity ratio. High leverage pushes the management to use generated cashflows for repayment of debt resulting in less cash to expropriate. The setup with an offshore account also forces the management to retain less cash in the host country and deposit more to the offshore account, which is monitored by a syndicate f international banks and governed by the law of New York. Bad news about governmental interference could prevent potential investors from investing in future projects in Venezuela. This also mitigates the agency problem since managers have less leeway for discretion. Last but not least, project finance, also known as contractual finance, heavily relies on constructing, supply, purchase and maintenance contracts which has the benefit that those that bear the risk are the ones most capable of bearing it. In the case of Petrozuata, two major contractors were Mitsubishi an Bechtel, both world leaders in their respective fields.

In conclusion, the project finance structure was essential for the realization and success of Petrozuata. 2. Petrozuata’s economics in detail 2. 1. Consider the debt service cover ratio. Given the proposed capital structure, is the DSCR consistent with an investment-grade rating? The debt service coverage ratio (DSCR) shows the relationship between the project’s generated cashflows and the debt obligations. It indicates the ability of the project to repay the principal and the interest from the cash-flows generated by the project’s activities.

It is calculated as follows: DSCR = Cash available for for debt service or CADS Principal+Interest Table 2. 1. 1. shows the DSCR for Petrozuata, calculated from the data from exhibit 10a. It is assumed that annual data are as of 31st of December. Additionally, all tables are, if not specified else-wise, in thousands. CADS is the abbreviation for the Cash Available for Debt Service, the total revenues minus the operating costs. The debt service is the total of interest payments and interest. As shown in the formula above, the DSCR is calculated by dividing the CADS by the debt service.

The table on the right excludes the years before 2000. The reason for this is the fact that the years from 1997 to 2000 are the construction phase of the project. During this phase of the project, the sponsors guarantee the debt. Hence the coverage ratio is irrelevant in the first few years. From the year 2001 onwards, after the completion of the project in 2001, the debt becomes non-recourse. In order to achieve an investment grade rating, the minimum DSCR (minDSCR) would have to be at least 1. 8x to 2. 0x. Under stress the DSCR should not fall below 1. x and the break-even price should be low enough to cover all the operating expenses and financing costs. This would mean in the case of 7 Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 CADS 317,481 384,765 389,154 366,575 401,552 398,211 433,477 435,267 438,118 373,182 371,469 378,471 387,428 328,978 358,441 391,545 383,528 382,868 327,531 308,024 283,051 299,464 295,554 Debt Service DSCR a low oil-price it could still honor its debt obligations. According to the table above, the DSCR series reaches its 60,922 157,694 154,466 176949 188,009 200,307 201,204 210,153 166,148 150,455 158,377 164,964 85,668 87,403 124,573 137,103 68,691 6,653 6,653 6,653 6,653 81,653 Table 2. 1. 1 2,391003 2,467779 2,373176 2,269309 2,118042 2,164063 2,163312 2,084757 2,246082 2,468971 2,389684 2,348561 3,84015 4,101015 3,143097 2,797371 5,573772 49,23057 46,29851 42,54487 45,01187 3,619634 minimum in 2008, which is projected to be the year with the highest debt service, with a value of 2. 08. This would imply that Petrozuata should be suitable for an investment grade rating.

The average DSCR (AvDSCR) over the period from 2000 to 2022 is a DSCR 10,62x. This value is very high regarding the lower bound for the investment grade rating of 1. 8x. The reason why this value is so high are the years 2018 to 2021, where the debt service is very low compared to other years. Therefore, a weighted average should give a better picture for the project’s DSCR (wAvDSCR). For this, ?????????????? = ? 2022 ?? ?? =2001 the following ???????? ?????? formula denotes the annual total debt service. This formula gives an ? ?????????? ? , whereas TDS is used verage DSCR of 3. 00, which is a more probable estimate. Even the weighted average DSCR of 3. 00 would justify an investment grade rating, keeping in mind the minimum DSCR of 2. 08 in 2008. A reason for the fact that they will be able to receive an investment grade rating is the low production costs associated with Petrozuata. The break-even price for Petrozuata was estimated to be $8. 63 per barrel in 2008, which is forecasted to be the year of the highest debt service. Historical prices show that only in 1986 the price dipped below this level.

The mean prices, however, over the period from 1982 until the case date, have been around $15. This means that Petrozuata can confidently say that they can breakeven at all times. In the next step, Petrozuata’s performance will be tested in different scenarios to evaluate how exogenous variables like price affect the DSCR. In other words, the sensitivity of the DSCR will be measured. For simplicity reasons, we assume that all other variables stay the same while only certain factors change. We first test for an increase in oil price of 1% and second for an increase in production cost.

Third we present a worst case scenario in which Petrozuata would still maintain an investment grade rating. In the first scenario, the oil price increases with 1% which we assume to have the same effect as a 1% increase in demand. This increases the Cash Available for Debt Service because more revenues are generated. An increase in CADS in turn increases the DSCR. In this scenario, the minDSCR is 2. 12, the AvDSCR is 10. 88 and the wAvDSCR amounts to 3. 06. Thus, a one-percent increase in oil-price 8 leads to a 2. 41 % increase in AvDSCR (1. 92 % for wAvDSCR).

The fact that the results for Petrozuata improve is straight forward. The prices of oil, thus the incoming cash-flows, increase while there is no cost increase. Scenario two covers the event of a one percent increase of the expenditures. This means the cash-flows going out increase, while the cash flow coming in stays the same. Consequently, this has a negative effect on CADS and DSCR. The minDSCR is 2. 07, which is only slightly lower than our base case. The AvDSCR decreases to 10. 47, a change of -1. 38 % (wAvDSCR 2. 98 equals a change of 0. 90 %).

Notice that the DSCR is less elastic in costs than in oil price. Scenario three is the worst case scenario in which Petrozuata it still achieves the minDSCR for an investment-grade rating. Though the present scenario is not necessarily the worst possible case, it allows us to assess and estimate the risk buffer of the project. We assume that the price of oil and the produced output drop 7. 5% while expenditures increase 7. 5%. This results in a minDSCR of 1. 50, which is the minDSCR for an investment grade only acceptable if achieved in stress situations. The AvDSCR (5. ) and the wAvDSCR (1. 96) are both above the minDSCR of 1. 80 in a normal situation. This indicates that there are still considerable reserves in the case of deteriorating results. We conclude that, simply based on the assessment of the project’s DSCR, an investment-grade rating for Petrozuata is reasonable. 2. 2. How important is the DSCR for the investment grade rating? As described in section 1. 1. , the rating process involves an assessment of three main factors: the sponsors’ creditworthiness, the project’s financials and characteristics, and the sovereign risks.

Due to the employment of the project finance structure with nonrecourse debt, in the case of Petrozuata the importance of the sponsors’ creditworthiness is somewhat reduced compared to situations where corporate finance is applied. Since Petrozuata is structured as a project company, the sponsors’ assets do not act as collateral in case of a default. Hence, one can assume that the sub-optimal rating of Maraven’s parental company PDVSA will not affect the project’s rating too negatively.

Similarly, the project finance structure diminishes a considerable portion of the sovereign risks as well as of the project specific risks, as discussed in section 1. 2. and 1. 3. This leaves the project’s financials in the focus of the evaluation of the project’s overall creditworthiness. For the assessment of the project’s performance, the DSCR is a critical factor as it is a commonly used measure for assessing the credit strength of a project, not a sponsor. In order to objectively measure the performance, the DSCR relies on projected or achieved CADS, interest and principal.

In this case, these values are based on assumptions, forecasts, and estimates. Therefore, the results have to be interpreted with caution. In sum, in the particular situation of Petrozuata the DSCR is of great significance in order to receive an investment-grade rating. From the common criteria used to assess the project’s credit risk, the project’s economics has the most crucial role, because sponsor’s credit worthiness and the host countries sovereign risk are of less importance due to the financial structure chosen for Petrozuata. 9 2. 3 Could the project support more debt while maintaining an investment grade rating?

In order to evaluate whether the project could support more debt while maintaining an investment grade, several assumptions are made for simplicity reasons. As in section 2. 1. , the analysis will only cover the DSCRs from 2001 onwards. At this point, it has to be noted that a change in leverage would induce changes in the cash flow planning (compare Exhibit 7) in order to suit the financial needs during the construction phase. Due to the extensiveness of this problem, the subsequent calculation therefore does not include any adjustments to the cash-flows in the years between 1996 and 2000 except for total debt service.

The prices for syncrude, the sold quantities, the resulting total revenues, and the interest rates (cost of debt is constant) are the same as in the base case. Also, the financial structure, specifically the maturity and the relative, annual principal repayment, does not differ from the base case. The change in absolute amount of interest paid results in a change in total expenditures and therefore in CADS. The difference between the tax shield in the leveraged scenario and the tax shield in the base case is added/subtracted to the expenditures.

A negative difference would mean a lower tax shield and consequently lead to higher amount of expenditures (which include taxes) and less CADS. The following tables do not include the equity cash-flows and the deposits to the reserve account as these data are not relevant for the calculation of the DSCR. The assessment is solely based on the effect of the leverage on the DSCR, namely the AvDSCR as well as the wAvDSCR and the minDSCR, and does not claim to comprehensively answer the question if a higher leveraged roject would still maintain an investment-grade rating. In the base case with a leverage ratio of 59. 80 % (debt-to-total investment as specified by data given in Exhibit 7), the values for the DSCR are depicted in the table below. Leverage ratio 60 % AvDSCR (X) 10. 62 Table 2. 3. 1 wAvDSCR (X) 3. 00 minDSCR (X) 2. 08 (2008) In order to find an answer to the question, one has also to keep in mind what the requirements for an investment-grade rating are. There are three cases that should be considered: a minDSCR of 2. 0, 1. 8 and 1. , as stated to be the minimum DSCR under various stress situations necessary to achieve an investment-grade rating. In the next step, the effect of the leverage ratio on the DSCRs is calculated. We take the base case values for total revenues and interest rates and adjust expenditures, total debt service and CADS according to following principles: The total debt service is calculated by adding up principal payment (difference between total debt and total debt of the previous year) and interest (total debt multiplied by interest rate).

Between 1996 and 2000, there is no principal payment. Only interest is paid. Additionally, the tax shield is computed using the given tax shield ratio of 34 % and multiplying it with the interest. The difference between the tax shields (base case and leveraged scenario) leads to adjustments of the expenditures (difference in tax shield are added/substracted to the expenditures of the base case) and thus to more CAPS (total revenues minus expenditures). 10 The following table shows the DSCR calculation for the leverage ratio of 62. 5 %. ear 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 total revenue 0 0 78,524 429,059 804,108 569,156 583,597 598,398 613,568 629,117 645,052 661,386 678,126 695,283 712,869 730,892 749,365 768,299 768,798 769,309 769,831 770,365 770,911 771,468 781,859 782,441 783,036 783,644 484,916 182,519 192,621 230,050 210,291 229,268 210,046 224,712 238,747 321,001 340,411 351,556 361,217 438,735 409,836 377,329 386,004 387,355 443,278 463,342 498,706 482,875 489,744 489,066 319,192 86,637 390,976 368,348 403,277 399,849 435,006 436,674 439,379 374,282 372,458 379,336 388,148 329,564 358,962 391,980 383,827 383,010 327,633 308,126 283,153 299,566 293,292 294,578 -63,892 -90,733 -99,239 -116,589 -168,182 -164,809 -161,435 -184,933 -196,492 -209,344 -210,282 -219,635 -173,644 -157,243 -165,523 -172,407 -89,533 -91,346 -130,193 -143,289 -71,790 -6,953 -6,953 -6,953 -6,953 -78,384 0 Table 2. 3. 2 expenditures CADS TDS otal debt 0 1,045,118 1,070,513 1,324,457 1,515,421 1,474,777 1,434,133 1,393,490 1,326,104 1,241,196 1,136,002 1,021,586 887,886 789,207 699,327 592,725 469,401 419,812 363,953 263,405 140,514 78,384 78,384 78,384 78,384 78,384 0 0 principal interest tax shield interest rate DSCR (X) 63,892 90,733 99,239 116,589 40,644 40,644 40,644 67,386 84,907 105,194 114,416 133,700 98,679 89,880 106,602 123,324 49,589 55,859 100,548 122,891 62,130 0 0 0 0 78,384 0 127,539 124,165 120,792 117,546 111,584 104,150 95,866 85,935 74,965 67,363 58,921 49,083 39,944 35,487 29,646 20,398 9,660 6,953 6,953 6,953 6,953 0 0 1,723 30,849 33,741 39,640 43,363 42,216 41,069 39,966 37,939 35,411 32,594 29,218 25,488 22,903 20,033 16,688 13,581 12,066 10,080 6,935 3,284 2,364 2,364 2,364 2,364 0 0 8. 65% 8. 66% 8. 67% 8. 86% 8. 99% 9. 17% 9. 38% 9. 68% 9. 50% 9. 63% 9. 94% 10. 46% 9. 51% 9. 75% 11. 25% 14. 52% 12. 32% 8. 87% 8. 87% 8. 87% 8. 87% 0. 00% 0. 00% 2. 30 2. 37 2. 28 2. 18 2. 03 2. 08 2. 08 2. 00 2. 16 2. 37 2. 29 2. 25 3. 68 3. 93 3. 01 2. 68 5. 34 47. 12 44. 31 40. 72 43. 08 3. 74 Testing alternative leverage ratios gives following results: Base Case (60 %) minDSCR (X) 2. 8 Leverage 62. 5 % 2. 00 Table 2. 3. 3 Leverage 70 % 1. 80 Leverage 85. 4 % 1. 50 The leverage ratio can be raised to 62. 5 % in order to still maintain a minDSCR of 2. 00. If the requirement is relaxed a bit, the leverage can be raised to 70 %, leading to a minDSCR of 1. 80. If one would consider the forecasts for prices, quantities, costs and interest rates to have enough buffer, the leverage ratio for Petrozuata reaches its maximum at 85. 40 %. In this case, the project barely fulfills the requirement for the DSCR under various stress situations.

Given these results, we conclude that Petrozuata’s financial data suggest that the project could indeed support a higher leverage ratio and still meet the DSCR requirements for an investment-grade rating. 11 However, the results present here are not entirely resistant to criticism. Contrary to the calculations in our assessment, it is more realistic to assume that the cost of debt increase as the leverage ratio ? Petrozuata’s adjusted equity betas. The basic formula to calculate the “re-levered” betas is ???? = values for expected cost of equity are increasing in the leverage ratio.

In the case of debt financing, a using the formula ???? = ???? + ???? ????? ? ???? ? + ???? + ???? and the data given in Exhibit 11 as well as increases. This effect can be observed on the equity side when calculating the expected cost of equity ? ???? /((1 + (1 ? ?? )(?? /?? )), whereas ???? denotes the unlevered beta and ?? the tax rate. The resulting higher leveraged project carries more risk for the creditors and thus very likely faces higher cost of debt as lenders would demand a higher interest rate to balance out the additional risk. This effect is probably intensified by a lowered rating due to increased risk.

An extensive analysis would have to incorporate these adjustments. This, however, lies outside the scope of this paper. 2. 4 Would sponsors favor higher leverage? How much return would sponsors have to give up if leverage was reduced below 60% The following assessment is based on the same assumptions as section 2. 3. Answering the question, whether sponsors favor higher leverage, requires us to look at the sponsors’ equity cash-flows. The internal rate of return (IRR) defines the discount rate that equates the sum of net present values (NPV) of all equity cash-flows with zero.

It can be understood as the rate of return on invested capital. The equity cash-flows for Petrozuata at a leverage ratio of 60 % are given in Exhibit 10a. The IRR in the base case amounts to 25. 58 %. We compare this to the expected costs of equity at this level of the CAPM, the cost of equity is expected to be ???? = 5. 60 % + (0. 94)(7. 00 %) + 2. 1% + 6. 67 % = riskiness, using the formulas and information mentioned before in section 2. 3 (Exhibit 11). Based on 20. 95 %. In other words, an investment would have to yield 20. 95 % in returns under the given risks. Petrozuata is able to generate excessive returns of 25. 8 % – 20. 95 % = 4. 63 %. In order to answer the leverage ratios have to be compared to the corresponding expected returns based on CAPM. To calculate the specific IRRs, we draw back to table 2. 3. 2. To calculate the equity cash-flows (dividends) from 2001 onwards, we subtract total debt service and Cash Used for Debt Service Reserve Account (CUDRSA) from CADS. The new CUDRSA is calculated by dividing the debt service of the successive year by 2 (the reserve account has to cover 6 months of future debt service) and comparing it with the balance of the reserve account.

The difference is either added to the reserve account (in case the reserve account does not have enough funds to cover the next 6 months of debt service) or to the dividends. The years 1996 to 2000 are a special case. The sum of the cash-flows of these years needs to add up to the total amount of equity minus the sum of operating cash-flows in the same period, as the sponsors’ will likely try to reduce the use of own funds instead of operating cash-flows. For example, at a 70 % leverage ratio, the sum of equity cash-flows needs to equal the total equity of $ 2. 25 billion * 0. 3 = $ 727. 402 million minus the sum of operating cash-flows, which is constant for 12 question whether sponsors favor higher leverage, the IRRs achieved by Petrozuata at different various scenarios, $ 530. 127 million: $ 727,402,000 – $ 530,127,000 = $ 197,275,000. In order to ?????? ?????????? ??????????????????????????????? ???? . ?????? ?????????? ??????????????????????????????? ???? achieve this, one can multiply the equity cash-flows from the base case with the factor The resulting cash-flows are depicted in following shortened overview first 10 years): Year Equity CF base case Equity CF leveraged 1996 -79,035 -35,073 1997 -1,986 -881 1998 -550,148 -244,138 1999 1,576 699 2000 185,047 82,118 Table 2. 3. 4 2001 225,457 205,365 2002 233,074 213,346 2003 200,600 179,310 2004 218,903 194,476 2005 203,857 177,133 This solution, however, has several flaws: at higher leverage ratios, it leads to negative balances during the construction phase (1996 to 2000). Also, this calculation method only works until a leverage ratio of 78. 14 %.

If the ratio is even higher, the total amount of equity needed can be covered with operational cash-flows alone. The sponsors would only have to bridge the initial year. Under these circumstances, this method results in an error. We tried a slightly different approach which adjusts the equity cash-flows during the construction phase to match with the financial needs of the construction. As an explanation would go beyond the length constraints of this paper, we will simply calculate the IRRs for different leverage scenarios using the method described above.

We still give the results of our method as comparative values (IRR*) and further provide an additional explanation. 50 % IRR Levered beta Cost of equity Difference IRR* 20. 65 % 0. 787 19. 88 % 0. 77 % 21. 72 % 59. 80 % (base case) 25. 60 % 0. 94 20. 95 % 4. 65 % 25. 60 % Table 2. 3. 5 62. 50 % 27. 75 % 0. 996 21. 34 % 6. 41 % 26. 92 % 70 % 38. 71 % 1. 205 22. 80 % 15. 91 % 31. 77 % We can see that the Petrozuata’s IRR and also the difference between the project’s IRR and the cost of equity based on CAPM is increasing.

The results of our alternative approach show the same trend while indicating that the other method overestimates the IRRs. Nevertheless, we can conclude that sponsors’ would prefer a higher leverage ratio as they would benefit from higher yields. ? ? (see 2. 3. , unlevered beta = 0. 474) by transforming the equation to ???? = ???? ? ((1 + (1 ? ?? )(?? /?? )). The levered betas for each ratio have been calculated using the formula for the unlevered beta given 13 References Berk, J. & DeMarzo, P. (2007). Corporate Finance. 2nd Edition). Boston, USA: Pearson Education Inc. Esty, B. C. (2003). The Economic Motivations for Using Project Finance, working paper Hainz, C. , Kleimeier, S. (2012). Political risk, project finance, and the participation of development banks in syndicated lending. Journal of Financial Intermediation, Volume 21, 287-314 “Moody’s Investors Service. Rating Symbols and Definitions,” September 2012. Retrieved on 18 September 2012 from http://www. moodys. com/researchdocumentcontentpage. aspx? docid=PBC_79004 14

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