Modelling Interest During Construction (IDC) in Project Finance

In project finance, understanding and accurately modelling Interest During Construction (IDC) is crucial for project viability and financial planning. This post will delve into the concept of IDC, its importance, and how to model it effectively in your financial projections.

What is Interest During Construction (IDC)?

Interest During Construction refers to the interest costs incurred on borrowed funds used to finance a project during its construction phase before it starts generating revenue. In project finance, these interest costs are typically capitalised (added to the project's cost) rather than expensed immediately.

Why is IDC Important?

1. Cost Impact: IDC can significantly increase the total project cost, sometimes by 10–15% or more, depending on the project's size, duration, andinterest rate.
2. Funding Requirements: Accurate IDC projections help determine the total funding needed for the project, as this needs to be taken into account.
3. Financial Viability: IDC affects the project's overall returns and debt service capacity as capitalised interest needs to not only be paid but also increases the debt balance.

Key Factors Affecting IDC

1. Construction period duration — the longer the period, the more interest will be capitalised.
2. Debt drawdown schedule — debt drawn down towards the end of construction will result in lower interest capitalised, while debt drawn with equity will result in higher interest capitalised.
3. Interest rates — the higher the rate, the higher the interest.
4. Capitalisation policy (i.e. is interest capitalised during construction or paid for from debt drawn during construction).

Steps to Model IDC in Project Finance

1. Define the Construction Period

• Clearly outline the start and end dates of the construction phase.
• Break down the period into monthly or quarterly intervals for detailed modelling.

2. Project the Debt Drawdown Schedule

• Estimate how much debt will be drawn and when during construction.
• This often aligns with the project's capital expenditure (CAPEX) schedule.

3. Determine the Interest Rate

• Use the agreed interest rate for the construction facility.
• If it's a floating rate, you may need to forecast the base rate and add the margin.

4. Calculate IDC

• For each period:

1. Calculate the average debt balance.
2. Multiply by the interest rate and the time fraction (e.g., 1/12 for monthly periods).
3. Sum up the interest for all periods.

5. Capitalise IDC

• Add the calculated IDC to the project's total cost.
• Ensure this aligns with the project's capitalisation policy and accounting standards.

Example IDC Calculation

Let's walk through a simplified example:

1. Construction period: 2 years
2. Total debt: $100 million
3. Interest rate: 5% per annum
4. Drawdown schedule: — Year 1: $40 million (evenly throughout the year) — Year 2: $60 million (evenly throughout the year)

Calculation:

• Year 1 average balance: $20 million IDC Year 1 = $20 million * 5% = $1 million
• Year 2 average balance: $70 million IDC Year 2 = $70 million * 5% = $3.5 million

Total IDC = $1 million + $3.5 million = $4.5 million

Best Practices for IDC Modelling

1. Use Dynamic Formulas: Link your IDC calculations to your debt drawdown and CAPEX schedules for flexibility.
2. Consider Interest Rate Scenarios: Model different interest rate scenarios to understand the potential impact on total project cost.
3. Align with Lender Agreements: Ensure your IDC modelling aligns with any specific terms in your financing agreements.
4. Monitor Capitalisation Limits: Be aware of any limits on IDC capitalisation imposed by accounting standards or project agreements.
5. Create Clear Documentation: Document your IDC assumptions and calculations for stakeholders and auditors.

Conclusion

Accurately modelling Interest During Construction is a critical component of project finance. It impacts the total project cost and influences funding requirements and overall project viability. By following the steps and best practices outlined in this post, you can create more accurate and robust financial models for your projects.

Remember, while IDC modelling can be complex, it's an essential skill for any project finance professional. As with all aspects of financial modelling, accuracy, clarity, and attention to detail are key to success.