Journal of Modern Accounting and Auditing, ISSN 1548-6583

July 2012, Vol. 8, No. 7, 975-982

D DAVID PUBLISHING

Financial Model of a PPP Project

Altin Turhani, Ali Turhani

Aleksander Xhuvani University, Elbasan, Albania

Over the last decade or so, private sectors financing through public-private partnerships (PPPs) has become
increasingly popular as a way of procuring and maintaining public-sector infrastructure. Albania in the last few
years had improved the legal frame so as to give the local authorities the right to initiate PPP projects. The local
authorities have not built the expertise for such projects yet. The aim of this paper is to help the local authorities in
Albania to support the building of the expertise for such projects. A financial model is used to make the required
calculations for the bid at various phases of the project, although this paper is not intended to cover financial
modeling in depth, the key inputs and outputs for the financial model are reviewed, including the financing costs.
The model has to work within the constraints of: (1) the public authoritys requirements for the PPP contract term
and service fee profile; and (2) lenders requirements for the term and payment profile of their debt.

Keywords: public-private partnership (PPP), project company, operational expenditure, capital expenditure, service fee

Introduction
Over the last decade or so, private sector financing through public-private partnerships (PPPs) has become
increasingly popular as a way of procuring and maintaining public-sector infrastructure, in such sectors as
transportations (road, bridges, tunnels, railways, ports, and airports), social infrastructure (hospitals, schools,
prisons, and social housing), public utilities (water supply, waste water treatment, and waste disposal),
government office, and other accommodations or specialized services (such as communication networks or
defense equipment).
Albania in the last years has improved the legal frame so as to give the right to the local authorities to
initial PPP Projects. The local authorities have not built yet the expertise for such projects. The aim of this
paper is to help the local authorities in Albania to support the building of the expertise for such projects. This
paper deals with the process by which bidders and their lenders structure the financing for a PPP project. The
service fees are the final output of this process, since they have to cover the project companys financing and
operating costs and provide a return on the bidders equity investment.
A financial model is used to make the required calculations for the bid at various phases of the project,
although this paper is not intended to cover financial modeling in depth, the key inputs and outputs for the
financial model are reviewed, including the financing costs. The model has to work within the constraints of:
the public authoritys requirements for the PPP contract term, service-fee profile, and lenders requirements for
the term and payment profile of their debt. The financial model covers the whole of the project companys
operations, not just the facility itself.

Altin Turhani, Ph.D. candidate, Faculty of Economy, Aleksander Xhuvani University. Email: aturhani@bkt.com.al.
Ali Turhani, doctor, Department of Business Administration, Faculty of Economy, Aleksander Xhuvani University.
976 FINANCIAL MODEL OF A PPP PROJECT

This paper considers issues relevant to the:

(1) Financial model;
(2) Model inputs and outputs;
(3) Capital expenditure;
(4) Operating and maintenance costs;
(5) Revenues;
(6) Financing costs.

The Financial Model

A financial model was used in different ways during the bidding and development phase of a PPP project
(National Treasury, 2001):
(1) Initial feasibility from the public authoritys point of view: A shadow financial model will be
produced by the public authoritys financial adviser, which will attempt to predict the bidders costs, finance
structure, and other assumptions, and hence the outcome in terms of service fees is likely to be acceptable from
the public-sector point of view;
(2) Structuring the bidders financing and reviewing the benefits of different financial terms and
arrangements; Calculation of the service fees required to cover Capital Expenditure (CAPEX), Operating
Expense (OPEX), debt service, and the investors, return as a basis for the bid;
(3) As a part of the lenders Due-Diligence process;
(4) Fixing the service fees where these depend on interest rates at financial close. After financial close, the
model continued to be used (European Investment Bank, 2005);
(5) As a basis for lenders to review the changing long-term prospects for the project and their continuing
risk exposure;
(6) To price variations and compensation payments in the PPP contract;
(7) To calculate and refinance gain to be shared between the public authority and the project company;
(8) As a budgeting tool for the project company.
However, given that the original objective of the model had changed, it would require some adaption to
undertake these tasks, especially the last.
As there are three parties involved in the public authority, the sponsors, and the lenders, there can
theoretically be three parallel financial models, but this is seldom the case. The usual course for the public
authoritys financial adviser and the lenders is to review the model prepared by the preferred bidder (or the
latters financial adviser), calibrate it against the public authoritys shadow financial model to ensure that the
results are the same (given the same assumptions), and then use the bidders model, in the ways listed above.
Alternatively, there are some merits in the public authority that provide a template financial model which is
used with suitable adaption by all bidders, to make comparison of bids easier.
It may be asked why the public authority should have access to the preferred bidders financial mode in
this way. Isnt the data in this model commercially confidential? But this was unlikely to be the case because
(European Investment Bank, 2005):
(1) The public authority needs to be able to check whether the bid is financially viable, and can thus
deliver the initial investment in the PPP project and its long-term service requirements;
(2) If the financial model is used to calculate the service fees at financial close, it obviously has to be
 FINANCIAL MODEL OF A PPP PROJECT 977

agreed by both parties;

(3) There has to be an agreed base case, because compensation should be required later and it has to be
measured against the outcome in the PPP contract which both parties agree is reasonable originally.
Therefore transparency between the parties on model assumptions and calculations is the better practice.

Model Inputs and Outputs

It is not the intention to discuss modeling techniques in any depth here, but it is necessary to have a basic
understanding of what goes into and comes out of a financial model for a PPP, and how this output is used. The
models initial purpose (Klein, 1996) has been to calculate the service fees, based on various building blocks
of inputs. The basis for the inputs must be clearly documented. The standard way of doing this for an
assumptions book should be compiled. This takes each line of the financial model and sets out the source for
the input (or the calculation based on these inputs) in that line, with copies of the documentation to back this
up.
Macroeconomic Assumptions
Background assumptions are needed for interests rates and inflation. The public authority should ensure,
at the bidding stage, that the same assumptions were used by all bidders if changes in these would affect the
service fees.
Capital Expenditure
The CAPEX budget for the project takes into account costs incurred during the bidding, development, and
construction phases of the project, i.e., both hard construction costs and the soft costs for financing,
advisory fees, and administration. The main items here were likely to be included (Sorge, 2004):
Bidding and development costs. These are the main pre-Financial close costs, i.e., the sponsors own
staff costs and those of external advisers, including lenders advisers. There is often a time gap between the
lenders and financial close when the total CAPEX budget is agreed, and during that time there is a risk that
legal and similar cots which are not fixed may mount up more than budgeted. If they are not treated as part of
the initial equity investment, such development costs are normally reimbursed to the sponsors at financial close,
but if they are finally above budget by that time, lenders requirement of reimbursement may be allowed if
sufficient funds are then available.
Development fees. Project economics may allow one or more sponsors to take out an initial fee from the
project company for developing the project, and thus cover their time up-front costs and perhaps make a profit
on these. This figure may fluctuate (or be eliminated entirely) as the financial evaluation of the project
develops.
Project company costs. These include costs after financial close such as :
(1) Staff and administration; some administration costs such as accounting may be subcontracted; office
and equipment;
(2) Continuing external advisory costs, e.g., for construction supervision;
(3) Construction-phase insurance.
Apart from insurance premiums, the amounts should be relatively small in the context of the overall
CAPEX budget if most of the project companys activities have been contracted out to facilities management
(FM) subcontractors.
978 FINANCIAL MODEL OF A PPP PROJECT

Construction subcontract price. The construction subcontract, which will obviously form the largest part
of the CAPEX, should be normally on a fixed-price turnkey basis, with payments made pro rata to the
progress of construction. Taxes such as Valued Added Tax (VAT) on this price (and any other costs) will also
need to be taken into account if they cannot be recovered before the end of the construction period.
Working capital. The working capital is the amount of money required to cover the time difference
between payment of the project companys OPEX and receipt of revenues in cash. In effect, it was the
short-term (usually 30-60 days) cash-flow cycle of the project, which could not be calculated directly in a
financial model that runs for six-month period during the operating phase of the project (Valila, 2005). It is thus
the initial costs that the project company has to incur until it receives its first revenues. These costs are unlikely
to be substantial for the project company as long as its subcontractors are paid on a cycle which matches its
revenue cycle. The most significant initial cost may be the payment of the first operating-phase insurance
premium (as these premiums are normally paid annually in advance).
Reserve accounts. Reserve accounts are normally funded as part of the CAPEX rather than from
operating cash flow, as this improves the Internal Rate of Return (IRR) of investors equity. If IRR is funded as
part of the CAPEX, it means that most of the funding will come from lenders. If they are funded out of cash
flow, it effectively means that all of the funding is provided by the investors, who have to give up distributions
to do this, hence reducing their equity IRR.
Interests during construction (IDC) and funding drawdown. Project costs as set out above then give
rise to requirement for the total funding (in debt and equity) required for the project. However there was
circularity about this calculation (i.e., the answer changes the inputs), because (Valila, 2005):
(1) IDC, which is funded by further drawings on the funding sources, needs to be included in the total
funding requirement;
(2) The funding split between debt and equity is determined by the ability of the operating cash flows to
support that debt.
This means that the various iterations of the calculations are required to get the right balance of debt and
equity.
Contingency. Finally, an overall contingency may be added to the project cost to allow for unexpected
events. All of this these costs need to be reviewed carefully to ensure that there is no risk of cost over-runs.
Operating and Maintenance Costs
The next block of modeling deals with the operation phase. OPEX (and any payments to and from reserve
accounts) is deducted from projected revenues to calculate the cash flow available for debt service (CADS).
OPEX, which was typically smaller than the debt service for a PPP project with a heavy initial investment in
infrastructure and a consequent high level of debt, would include (Valila, 2005):
(1) The project companys own direct costs;
(2) Subcontract payments;
(3) Insurance;
(4) Taxation.
Maintenance costs were likely to form the largest part of the operating costs whether they were incurred
via subcontractors or by the project company, and it was difficult to predict if this cost risk had not been
subcontracted (Dewatripont & Legros, 2005). Typically, maintenance costs can be split into several categories,
 FINANCIAL MODEL OF A PPP PROJECT 979

although the dividing lines between them (and hence the scope of any subcontract) is not a fixed one. In the
case of a building, these categories may be:
Soft FM. This could include items such as cleaning, security, and catering. If such services form part of
the PPP contract, they are typically provided under a Soft FM subcontract, with the costs fixed to the extent that
they are fixed under this subcontract.
Hard FM. This is routine maintenance for the building. This would include matters such as servicing and
maintaining the heating, toilets, painting, and other utility systems, replacing broken windows or light bulbs
etc., maintaining, paving, and repairing the roof, etc.. This is typically provided under a Hard FM
subcontract.
Lifecycle costs. These costs relate to aspects of the facility which require renewal or replacement on a
regular cycle. For example, the boilers in a building may need to be replaced after so many years. Again, these
costs may be included within the scope of the Hard FM subcontract, but it is probably more common for this to
be on a cost-plus basis, i.e, leaving the real risk with the project company.
In the case of a road, maintenance requirements may consist of:
Routine maintenance. This might cover such matters as repairing potholes or cracks, clearing any
obstructions, cleaning drainage and sinks, and maintaining grass verges, often via a maintenance subcontract.
Major maintenance. There was normally a cycle whereby the skimmed surface of the road is resealed
every five years, the road is resurfaced every 10-12 years, and the underlying concrete layer was
strengthened or renewed every 18-20 years (International Organization of Supreme Audit Institutions, 2004).
The costs get greater for each of these procedures, and are difficult to estimate because they are so far ahead
(and timing depends on usage levels very much). The higher these costs are, the less likely that a
maintenance subcontract will be applied. Similarly, major maintenance is often a significant cost item for
process plant (e.g., a waste incinerator may have been shut down for a major maintenance every three-five
years or so).
Revenues
There were natural caps on the level of service fees which could be fed into the financial structure at the
time of bidding, insofar as the project companys revenues had been derived from service fees (UNICITRAL,
2001):
(1) In the case of concession, projected demand and willingness to pay will determine the levels of
usage and the rates to be charged for tolls, etc.;
(2) In the case of a PFI-Model (Public Finance Initiatives Model) project, the public authoritys VFM
(Value for Money) and affordability requirements have to be taken into account.
Subjected to these overall constraints, there is some circularity about calculating the minimum required
service fees as these have to be sufficient to pay debt service and provide the investors return, i.e., there was a
requirement for a certain level of CADS (UNICITRAL, 2001). There is thus a logical sequence in arriving at
the level of service fees to bid, these need to be sufficient to:
(1) Cover OPEX;
(2) Fit within the envelope of the public authoritys requirements;
(3) Meet lender-debt service and other requirements;
(4) Give the investors their required rate of return.
980 FINANCIAL MODEL OF A PPP PROJECT

Having established the first of these requirements as listed above, the interplay among the latter three
requirements is quite complex.
Model Output
The model outputs included a series of calculation (Guidance Material, 2005):
(1) CAPEX;
(2) Drawdown of equity;
(3) Drawdown of debt;
(4) Service fees;
(5) Other operating revenues;
(6) OPEX;
(7) Interest calculations;
(8) Tax;
(9) Debt repayments;
(10) Profit and loss account (income statement);
(11) Balance sheet;
(12) Cash flow (source and use of funds);
(13) Lenders cover ratios;
(14) Investors returns;
(15) The NPV (Net Presented Value) of these payments, to enable the public authority to compare bids.
A summary sheet usually sets out the key results on one page.
Sensitivities
The financial model also needs to be sufficiently flexible to allow both investors and lenders to calculate a
series of sensitivities (also known as cases) which show the effects of variations in the key input assumptions.
Such sensitivities might include calculating the effect on cover ratios and the equity IRR of (Eurostat, 2002):
(1) Construction-cost overrun;
(2) Delay in completion (say for six months);
(3) Deduction or penalties for failure to meet availability or service requirements;
(4) Reduced usage of the project (where the project company assumes usage risk);
(5) Higher OPEX and maintenance costs;
(6) Higher interests rates (where these are not fixed);
(7) Changes in inflation.
In summary, the sensitivities look at the financial effect of the commercial and financial risk of the project
which does not work as originally expected. Lenders also run a combined downside case to check the effects
of several adverse things which happened at once (e.g., three-month delay in completion, a 10% drop in usage
if relevant, and 10% increase in OPEX). This calculation of several different adverse events which happened at
once is also called scenario analysis.
Model Audit
Lenders usually require the model to be audited by a model auditor, a service provided by specialist
departments within major firms of accountants, or by specialized financial-modeling companies. The functions of
the model auditor have been to confirm that (International Organization of Supreme Audit Institutions, 2004):
 FINANCIAL MODEL OF A PPP PROJECT 981

(1) The model properly reflects the project contracts and other stated assumptions (e.g., as to the rate of
inflation);
(2) Accounting and taxation calculations are correct;
(3) The model has the ability to calculate a reasonable range of sensitivities, as discussed above.
The public authority should also be a beneficiary of this audit if its own financial advisers do not audit and
certify the model (which it is preferable they should do, because of various ways in which it may be used).
The Base Case
Once the public authority, sponsors and lenders agreed that the financial models structure and calculation
formula reflect the project and the project contracts correctly, the basic input assumptions were settled, and the
financial structure and terms discussed below were agreed and also incorporated in the model, the final run of
the model which was known as the base case (or banking case) usually took place at or just before financial
close (HM Treasury, 2000):
(1) To enable the lenders to check that, by using fully up-to-date assumptions and the final versions of the
project contracts, the project still provides them with adequate coverage for their loan;
(2) In some cases, to fix the level of the service fees to reflect interests rates at the financial close.

Financing Costs
Apart from the lenders advisory fees, the main financing costs paid by the project company for
commercial bank loans have been (Guidance Material, 2005):
(1) The lenders own cost of funds in the wholesale money market, most probably on a floating-rate
basis, and costs relating to financial hedging, if any;
(2) The lenders credit margin;
(3) A cost-of-capital charge and other additional costs;
(4) Advisory, arranging, and underwriting fees;
(5) Commitment fees;
(6) Agency and security trustee fees.
The pricing for bonds is similar to this.
Credit Margin
Project-finance loans for PPP projects typically had credit margins in the range of 0.75%-1.5% over the
lenders cost of funds (Guidance Material, 2005). The top end of this range will relate to high-risk projects such
as concession roads, while the bottom end will relate to low-risk projects such as PFI-Model accommodation
projects. Pricing is usually higher until completion of construction, which reflects the higher risk of this stage
of the project, then drops down, and then may gradually climb back again over time. Thus an accommodation
project with a loan covering a two-year construction and 25-year operation period may have a credit margin of
1% for 1-2 years, 0.85% for 3-5 years, and 1% thereafter. The increase in the margin is partly intended to
encourage refinancing.
Additional Costs
Bank lenders are also exposed to the possibility of additional funding costs, which would erode their credit
margin arose from (Eurostat, 2002):
Liquidity or capital costs. Banks may face an increased requirement from their central bank for liquidity
982 FINANCIAL MODEL OF A PPP PROJECT

reserves against long-term lending, or for increased capital to support such lending which is known as
minimum liquidity requirements (MLRs), or minimum liquid asset requirements (MLAs). If these costs are of
any significance (usually the effect is minimal), they are borne by the borrower. Banks may also be required to
raise the ratio of capital which they have to hold against different classes of assets (as a protection for their
depositors). The cost of their loans will have to be increased to preserve their return on capital. Capital
requirements for project-finance loans have been a matter of great debate in the context of the introduction of
the Basel II capital requirements.
Taxes. In the minority of cases where loans are made outside the project companys country, lenders may
not be able to offset withholding taxes on interests payments from the project company against their other taxes
liabilities, but apart from such cases, lenders should not be able to charge any of their tax abilities onto the
project company.
Where withholding taxes do apply, the project company usually has to gross up its interests payments
(i.e., increase them by a sufficient amount to produce the amount of net interests payment to the lenders after
deduction of tax). A lender may agree that if this amount of tax can be offset against its other tax liabilities in
due course, the withholding will be refunded to the borrower. However, lenders are not prepared to get into
debates about how they manage their tax affairs, and therefore all refunds rely entirely on a lenders good faith.
Market disruption. The project company also takes the risk, where the bank funding is on a short-term
floating-rate basis, the banks may not be able to roll over their funding due to the disruption in the market. This
could change the market-interest pricing basis if the banks cannot fund or prepay the loan at all. If one or two
banks get into trouble because of themselves rather than of general market problems, these provisions will not
be applied.
These provisions are not peculiar to the project-finance market, but should only be increased to cover the
banks that are actually affected, not the whole syndicate. In practice, these provisions (other than those related
to liquidity costs and withholding tax) do not have to be applied in recent years.

References
Dewatripont, M., & Legros, P. (2005). Public-private partnerships: Contract design and risk transfer. EIB papers, 10(1), 120.
European Investment Bank. (2005). Evaluation of PPP projects financed by the EIB. Europe: Campbell Thomson and Judith
Goodwin.
Eurostat. (2002). Manual on government deficit and debt. Office for Official Publications of the European Communities,
Luxemburg.
Guidance Material. (2005). Managing interest rate risk. Melbourne: Department of Treasury and Finance.
HM Treasury. (2000). Public private partnerships: The governments approach. London: HM Stationery Office.
International Organization of Supreme Audit Institutions. (2004). Guidelines on best practice for the audit of risk in
Public-Private Partnership (PPP).
Klein, M. (1996). Risk, taxpayers, and the role of government in project finance. Washington DC: World Bank.
National Treasury. (2001). Introductory manual on project finance for manager of PPP projects.
Sorge, M. (2004). The nature of credit risk in project finance. Review of the BIS Quarterly from the Bank for International
Settlements, 91.
UNICITRAL. (2001). Model legislative provisions on privately financed infrastructure projects. New York: United Nations.
Valila, T. (2005). How expensive are cost savings? On the economics of public-private partnership. EIB paper, 10(1), 94.