Polar Works-Inlet Cooling Technology Overview-Economics and Financing-Financing

Economics and Financing

Financing

The following explanation of power plant financing and cost of capital might be too simplistic for most power financiers, but it will explain much of the mystery to the rest of us.

Most engineers and plant managers use "payback" as the financial screening tool to determine if a "capital improvement" project should be undertaken. The old rule of thumb for capital improvement projects used to be a three-year payback. The corporate finance people usually communicate an acceptable payback period down to the plant technical level. That payback period has shrunk considerably in the last ten years, to times of one year or less, due to the financing agreements that underpin these projects.

The more accurate means of screening a project is "Net Present Value," or NPV. See our explanation of the difference between these two financial tools in the next section.

Most new independent power plants are financed with a mix of debt and equity. The debt portion is provided by major commercial banks, sometimes through the float of a bond issue. The developer and other project sponsors put up the equity portion, which is like a down payment on a mortgage. The debt portion is like the mortgage itself. The debt-holders need to see a significant equity infusion of capital into a project, so that they can be sure that the developers are serious, and that if the developers default, the remaining debt load can still be met by the project's projected cash flows.

The cost of each of the financial components is different. Debt instruments can be secured for much less than 10% interest for strong projects. The equity portion must usually return about 30%. For a typical project structure of 65% debt and 35% equity, the weighted average cost of capital is

(65%) * (10%) + (35%) * (30%) = 17%

This is a gross simplification of the process; but it shows that the more low-cost debt in the mix, the lower the overall cost of capital.

The agreement for obtaining debt financing usually involves certain promises known as restrictive covenants. These covenants involve provisions for maintaining cash flow as some multiple (usually at least 2.0) above the amount needed to make debt payments. This provision is called a "coverage ratio." Another provision is that the plant will not take on any major hardware or contract changes, or any new debt associated with those changes, which could somehow jeopardize the coverage ratio. Coverage ratios are the sacred cows of financing agreements. Failing to meet the coverage ratio, even if the debt is successfully being repaid on time, can throw a project developer into default.

Assume this same power plant has a weighted average cost of capital of 17%. Although it is not exactly technically correct, it is sometimes estimated that this plant has a financial "horizon" in years of 1/0.17, or approximately 6 years. So the basic plant financial structure has a payback equivalent to maybe 6 years. If an inlet cooling project is studied, and it has a payback of about 3 years, that looks better than the original 6 years of the base power plant. It should be approved; but more often than not, it is disapproved. Here's why...