Q3. AS CURRENTLY ENVISIONED, DEBT WILL COMPROMISE OF 60% OF THE FUNDS NEEDED FORTHE PROJECT. WOULD YOU RECOMMEND A HIGHER OR A LOWER LEVERAGE RATIO? WHATHAPPENS TO THE MINIMUM DSCR AND IRR ON EQUITY AS THE PROJECT LEVERAGE INCREASESTO 70% OF THE PROJECT FUNDS? DECREASES BY 50%?Soln. We would recommend that the debt should compromise of the already decided 60% level of thetotal funds. This recommendation I based on the following findings and reasons: 1. At 60% leverage the firm earns an IRR of 26% which gives it measurable gains when compared to the cost of equity of 21%. Hence giving a definite 5% benefits over equity investment.
2. At 60% leverage the DSCR for the initial years is around 2.06X and thereby increasing givingit enough margins to easily get an investment grade rating. 3. Also, at 60% leverage the DSCR is sufficient enough to cover the interest debt expenses incase of any price fluctuations, thereby covering the risk of price volatility and exchange ratevolatility. 4. At a higher leverage of 70%, the DSCR in the initial years comes down to 1.45X, making itvery close to the minimum required DSCR of 1.35X. Hence the risk associated with price fluctuations is very high, and there are low chances of getting an investment grade rating for the project. Hence a higher leverage is not recommended.
5. At lower leverage of 50%, the net IRR is 22% which is comparable to the cost of equity of 21%. Hence, at a lower leverage, the company has no benefits of going for project financing. Therefore a lower leverage is not recommended. When project leverage is 70%:
When the project leverage is 70%, the IRR increases to 32%giving it substantial returns. But at the same time its DSCR suffers and comes down to 1.45X in the initial years, thereby increasing its default risk and hence making it sub-investment grade project. But it still remains above the minimum required DSCR of 1.35X and hence the minimum DSCR is not affected. When project leverage is 50%: