DSCR, debt sizing and sculpting

0:00 How much can this project borrow?

Every project finance negotiation eventually arrives at one question: how much can this project borrow? Sponsors want as much debt as possible, because it lifts equity returns. Lenders want enough cover that debt is repaid even if things go somewhat wrong. The number they agree on comes from a single ratio: the debt service coverage ratio. In this lecture you'll learn how DSCR is defined, how lenders size debt as the lower of a coverage test and a gearing cap, how to calculate debt capacity step by step, why sculpting maximises debt, and how tenor, tail and grace periods affect the answer. By the end, you'll be able to size and sculpt debt yourself and check that the balance reaches zero at maturity.

0:53 Why it matters

Why does this matter? Because debt size drives everything else. It sets how much equity sponsors must find, which drives equity returns and sometimes whether the project goes ahead at all. The assumptions behind sizing, which CFADS case, which interest rate, what target DSCR, decide how resilient the project is later. And the numbers are sensitive. A few per cent change in CFADS, or a change in the interest rate, can move debt capacity by millions. So understanding the mechanics isn't optional for anyone negotiating a deal, reviewing a model or advising a board.

1:34 The concept: DSCR and the two sizing tests

The DSCR for a period is CFADS divided by senior interest plus senior principal. A DSCR of one point three times means CFADS is thirty per cent more than the debt service due. Lenders set a target, or sizing, DSCR, and lower lock-up and default levels for ongoing covenants. The target reflects risk: projects with highly contracted, creditworthy revenue can often be sized at lower DSCRs than projects with volume or merchant risk, though exact levels depend on market, sector and lender. Then lenders typically size senior debt as the lower of two tests. The DSCR test: the maximum debt that CFADS can support at the target DSCR. And the gearing test: a maximum percentage of total project cost. Think of it like a mortgage: the bank checks both your income and the loan-to-value, and lends the lower amount.

2:34 Worked example one: flat CFADS

Let's size debt from the lesson, illustratively. CFADS is ten million a year for five years of repayment. Target DSCR, one point three. All-in interest rate, seven per cent. Total project cost, forty-five million, and a gearing cap of seventy-five per cent. Step one: maximum debt service is ten divided by one point three, about seven point six nine million a year. Step two: the present value of five years of that at seven per cent. The annuity factor is four point one zero zero two, so debt capacity is about thirty-one point five four million. Step three: the gearing cap is seventy-five per cent of forty-five, thirty-three point seven five million. Step four: take the lower. Debt is thirty-one point five four million, so the DSCR test binds. Equity is forty-five minus thirty-one point five four, about thirteen point four six million, and actual gearing is about seventy per cent.

3:40 Worked example two: sculpting

Real CFADS isn't flat. Suppose it's ten, eleven, twelve, twelve and thirteen million in years one to five. If you repaid in equal annuity instalments, DSCR would vary, and the lowest year, year one, would limit the whole debt. Sculpting fixes that. You set each year's debt service equal to that year's CFADS divided by the target DSCR. So debt service is seven point six nine, eight point four six, nine point two three, nine point two three and ten million. Discount those at seven per cent and add them up: debt capacity is about thirty-six point three million, compared with the thirty-one point five of the flat case. Each year's DSCR is exactly one point three. Each year's debt service splits into interest, the rate times the opening balance, and principal, the remainder, and the balance reaches zero at the end. Sculpting matches repayments to the shape of the cash.

4:46 Watch me do it: sculpting in a spreadsheet

Let me build it in a spreadsheet. Row one: CFADS by year. Row two: target debt service, equal to CFADS divided by the target DSCR, times the repayment flag. Now debt capacity: NPV at the debt rate of the target debt service row. Here, Excel's NPV is exactly right, because the first repayment falls one period after the sizing date. Then the schedule. Opening balance in year one equals the debt. Interest equals opening balance times the rate. Principal equals target debt service minus interest. Closing balance equals opening minus principal, and it becomes next year's opening. Finally two checks: DSCR in every repayment year equals the target, and the closing balance at final maturity is zero. If the balance doesn't reach zero, the periods, rates or discounting don't line up, and that's exactly what the check exists to catch.

5:47 Tenor, tail, grace and minimum DSCR

A few structural levers. Tenor: longer tenors increase debt capacity but raise risk, so lenders keep the final maturity inside the offtake contract with a tail, a buffer period of contracted revenue after the last repayment. Grace period: repayments usually start some months after commercial operation to allow for ramp-up. Balloon or bullet repayments leave a large amount due at maturity, which creates refinancing risk. Lenders also look at minimum DSCR, the worst period, which drives risk, and average DSCR, the overall comfort. In a sculpted base case, DSCRs are flat, but under sensitivities they diverge, and the minimum becomes crucial. And debt capacity is highly sensitive to interest rates and CFADS, so lenders size on a conservative CFADS case, often P90 yield, and on hedged or fixed rates.

6:43 Interest rates and the sizing case

Let's look at the two inputs that move debt capacity the most. First, the interest rate. Debt capacity is the present value of the debt service CFADS can support, so a higher rate lowers the present value of exactly the same payments. In our sculpted example, moving from seven to eight per cent reduces capacity noticeably, even though CFADS hasn't changed at all. That's why rates are usually hedged at or just before financial close, and why bids sometimes include rate adjustment mechanisms. Second, the CFADS case. If lenders size on a P90 yield rather than P50, every year's CFADS is lower, so every year's maximum debt service is lower, and debt capacity falls. Sponsors don't love that. But as the Python lab later shows, debt sculpted on P50 cash flows will very often breach its lock-up in at least one year. Sizing on a conservative case is what buys resilience.

7:49 Common mistakes, recap and try this now

The common mistakes. Sizing on P50 CFADS when lenders require a downside case. Forgetting that fees and DSRA funding increase total uses as debt increases, which is a circularity. Confusing DSCR, a period test, with LLCR, a present value test. And sculpting on CFADS that includes items the loan agreement excludes. So, to recap. DSCR is CFADS over senior debt service. Debt is the lower of the DSCR-based capacity and the gearing cap. Sculpting sets debt service to CFADS over the target DSCR, maximising debt with a flat DSCR profile. Then check: DSCR equals target, the balance hits zero at maturity, the gearing cap is respected and the tail is preserved. Your try-this-now: in a spreadsheet, sculpt debt for a seven-year CFADS profile of your choice at a one point three five target DSCR and eight per cent interest, and check the balance reaches zero.