There are only two books so far that I have been recommending to anyone asking me for references for learning project finance and project finance modeling:
- “Principles of Project Finance” by Professor Yescombe
- “Corporate and Project Finance Modeling” by Professor Edward Bodmer
However, I have recently come across another book that caught my attention. This book is:
One principle that captured my attention and is advocated in the book is “Think slow and act fast.” This concept is precisely what Professor Edward Bodmer reminds his students of, referring to an old saying that originates from Napoléon Bonaparte: “Dress me slowly; I am in a hurry.” But I couldn’t grasp the idea until I read this book, “How Big Things Get Done.”
This reading resonated with me because I witnessed many projects facing delays and cost overruns in the last couple of years. What was a mystery to me was how we define these base cases in our financial models, which should represent the most expected case; however, we still face issues like not providing enough contingency funds for construction completion and not having the proper contingent facilities in place to cover unexpected problems. So, something needs to be fixed with our base cases, which is what the book discusses. The book gives many examples of real projects that face cost overruns simply because the involved parties didn’t plan properly. The planning stage involves working with a financial model because project finance is all about projections. All the parties involved rely on projections. All the instruments are sized based on a set of assumptions called the base case. This principle of thinking slow and acting fast is helping us pay more attention to the planning stage and the base cases in our financial models. In this blog post, I will discuss why this book is essential for financial modelers and my takeaways.
Why do I recommend this book to anyone involved in financial modeling?
Because your role as a financial modeler is to build and review financial models. This process also requires you to plug in the inputs that will define a base case for the project. Of course, defining the inputs and scenarios in the financial model is teamwork. As a financial modeler, you get your inputs from either studies or contracts. Sometimes, especially in the early development stage, you must develop your estimations based on reliable justifications. As you will understand from this book and you might have experienced yourself, most of the parties involved in the project, especially in the development and planning stage, are, as the book says, thinking fast and acting slow.
They all have a vision to get the project to the finish line. Without their vision and passion, the project will get nowhere. Your role as a financial modeler is to show them what their vision looks like in the future (the base case) and also to show them what happens if things don’t go as planned.
Why is it crucial for financial modelers to understand this “Think Slow and Act Fast” concept?
During model build:
If you adopt this philosophy of “Think slow and act fast” before building a financial model, then you will be able to build a model that is Flexible, Appropriate, Transparent, and Structured (For those of you who are familiar with these 4 adjectives, they are the pillars of “FAST” financial modeling standards). I would also add sustainability in there, and this is what makes your planning for the financial model a crucial part of the building phase of the model. If you want your model to stand the test of time, you need to build a robust enough model that can be used and maintained effortlessly without complex restructuring. In that case, you need to pull out your pen and paper and define how you want the design of your financial model to be. Pay attention to this step, which is part of the slow process, to act fast later in any project’s appraisal and implementation stages.
Also, remember to explore my mini-course on Spreadsheet Design, where I guide you on designing structured, flexible, simple spreadsheets.
https://hedieh-s-school.thinkific.com/courses/Projectfinancespreadsheetdesign
Review of financial models:
When you adopt someone else’s financial model, would you take the base case scenario defined in the financial model you have received as a given and start populating project documents based on that inherited model? I am sure your answer is no. You take your time to understand the model mechanics, ensure there are no errors, review each input in the model, and ensure they conform with project documents.
Defining the Base Case and Scenarios:
Whether you have built the model or are using someone else’s financial model for your transaction, you need to define your base case. Depending on your and your institution’s points of view, you might have a different perspective on how things will turn out in the future, which is what project finance all depends on. So you might want to apply the principle of “think slow and act fast” in this process and understand the transaction and the macroeconomic view of the country where the project is situated. So, slow down in those steps, talk to advisors, read all project documents, and attend all conference calls and meetings on the project to understand better the correct inputs to consider in your base case.
Contingency is a real cost:
One last takeaway from the book is the dark fact that contingency is real and is not a provision. In our projects, we have a cost item called contingency, which is supposed to be a provision for unexpected events. When reading the book and through the different fascinating stories, you see that projects in practice mostly go sideways and have to tap into contingency accounts. In most cases, the overrun surpasses the initial contingency budgeted in the total project cost. So what is the implication of that? It is restructuring the project. And anyone who has dealt with restructuring a project knows that it takes a lot of time and resources and will blow up the budget in a snowball manner.
So as a financial modeler, your job is to be aware of that and ensure that the contingency level is sized correctly and is not “Ambitious.” If you work for the lender’s group, you already have a more conservative mindset than the sponsors. But still, in all the projects cited in the book, most prestigious banks were involved, so most probably, the level of contingency built into the project, even from lenders’ conservative perspective, is mostly not rightly sized. In most cases, there’s a 5% to 10% of total EPC that is considered as a contingency. In their base case, sponsors sometimes consider a case where things go exactly as planned without tapping into 100% of the contingency lenders require. They will have some unspent money in the contingency account by the end of the project’s construction. Depending on the contracts, sometimes these unspent contingencies are accounted for in the equity IRR calculation, which has proved to be wishful thinking.
So as a financial modeler, your role is to take note of that, and even if the advisors tell you to put 5% of EPC as a contingency, make sure that you always present scenario results (if analysis) for cases if things go wrong. Here are typical sensitivities that you should test with your model:
– Impact of delay in the development stage
– Impact of delay in the construction phase
– Impact of delay in the commercial operation date
– Impact of cost overrun on capital expenditure
– Impact of an increase in financing fees (increase in interest rates)
– If your project has different currencies, the impact of change in exchange rates
– If any project costs are indexed, you need to check the impact of the change in the inflation rate or any applicable escalation.
Then you also need to introduce measures to decrease the risk of a project requiring restructuring. Here are some measures just as examples:
– Incorporation of different hedging instruments
– Incorporation of liquidated damages
– Including contingent debt and equity facilities
– Making sure that different reserve accounts are put in place for various purposes: Debt service reserve account, major maintenance reserve account, pre-funding of working capital…
I would love to hear what you think about this topic, and I recommend you take this book with you when you go on your next vacation.
