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One area that has been overlooked in project finance is the assessment of profitability. Although project finance has attracted a lot of attention in the banking community in recent years, project finance professionals have not been provided with the proper tools to calculate the returns of the deals. Due to the non-recourse nature, the large size, and the long terms of these loans, it is often vital for the decision-maker to have a good estimate of the return on equity (ROE) and riskadjusted return on capital (RAROC) when committing or pricing the loans.
Traditional corporate RAROC models, however, are often overly simplified and are becoming inadequate to address the complexity of the project deals, which typically include part or all of the following:
Gradual drawdown.
Irregular repayment schedule.
Varying margins.
Changing project risk rating due to completion guarantee or political insurance and credit migration.
Multiple tranches with different terms. Forward commitment.
Underwriting risk and return.
Traditionally, RAROC are calculated using a quotient form [see Equation (1)]. This calculation typically results in different ratios for different years during the loan life. One does not have a single RAROC for a deal without further approximation. where NIAT stands for net income after tax.
This article presents a different methodology, a conceptual framework that can be developed into a computer model to help calculate the economic return of a project deal.
We take the cash flow approach to derive a single RAROC number over the entire life of a loan. Specifically, we view the risk capital that is allocated to underpin the unexpected loss of the loan as the investment outlay. Future cash flows are NIAT, net of capital outlays. Then the discount rate that equates the NPV to 0, or the internal rate of return (IRR), is the rate of return of the deal, i.e., the RAROC of the loan.
A decision can then be made consistently with the basic capital budgeting principle: Commit a loan if and only if the RAROC exceeds the shareholders' required rate of return (the hurdle rate) or, equivalently, if and only if the loan generates a positive NPV at the hurdle rate. As we see, the model has the flexibility to handle loans with irregular drawdown and repayment profiles as...