Traditionally loan amortization methods had two forms. Either they had a constant principle, so there is a constant principle repayment each year, and as time goes on, the interest will fall. So in total, the payment will fall because the interest will be falling as the loan gets completely repaid. However, the problem with this is that in the early years of the cashflow forecast, that is when the cash flows are under most strain, there is the least cash to service the debt. That is when under a constant principle mechanism, the interest and repayments are largest.

So this method isn't very suitable for project finance or in fact, for any highly leveraged transactions.

Another method is a constant installment, and this is rather like a fixed rate mortgage. You have a constant payment, and in the early years, most of that payment is made up of interest with a small amount of principal repay. And then as time goes on, because the loan is being repaid, the interest element will fall and the loan repayment will rise. The problem here is that this requires a fixed payment for every year of the forecast, and that can be a problem if you're expecting your cash flows to grow. And also it is difficult to deal with any unpredictability. So in project finance with loan amortization, it'll typically structure the repayments around the cash flows of the business, and that generates more flexibility because it reflects the ability of the project to make the payments. And there are two main methods. One is the tailor made method where we take the cash flows and then the repayments are designed around them.

You can see here you have a forecast of cash flows from years 4 through year 9, which is the operational period. We are assuming years 1 through 3 is the construction period when obviously you can pay any debt because there is no positive cash flows.

In this case, the sponsor forecast is higher than the bank forecast because it is more optimistic. Also, the bank has taken a haircut against the forecast of 20%, so there are assuming only 80% of their forecast cash flows will be available to pay off debt, and that just adds a level of conservatism. Now that payment, as you can see below, Is applied to the entire loan. In year 4 we are repaying 19.2, and that 19.2 is partly interest of 5 and the remaining amount. The 14.2 is the repayment of the loan. So this means the beginning balance is repaid down to 85.8, and that continues until the loan is completely paid off. Another probably more common method is the cash sweep mechanism. Here we have the same forecast, the same sponsor cash flows, but in this case we have an assumed debt service coverage ratio of 1.6 times. And what that means is that the interest and repayment of the loan has to be covered 1.6 times by the available cashflow. So here we've taken in year four, the 30 million sponsor forecast divided by 1.6 to give us the cash flows available to repay the loan of 18.8. And again, of that 18.85 million is paid in interest with the remaining amount applied to the repayment of the loan. So there is two mechanisms that are used in project finance modeling, either the tailor made method or a likely more commonly used cash sweep method.