Waterfall model :

This is a favourite interview question in bank promotions. Not many, even those
working in credit departments, are aware of this concept. Let us see what this is.

In the case of projects, there can be multiple parties involved. For example, there could
be an investor who invests in the project but he will not actually run the project in the
field. For running the project, he might seek the services of an operator who will actually
look after day to day running of the operations.

Let us assume that the project requires Rs. 100 crore. Though the investor has the ability
to fund this entire amount, he will insist that the operator bring in some of his funds. Let
us say that the investor will fund Rs. 90 crore and the operator will invest Rs. 10 crore.
By doing this, there will be operator’s interest in the project (just as we discussed earlier
the need for banks to insist on borrower margin).

The investor is not actually running the project. It is the operator who is running the
project on the field. Since the stake of the investor is huge (he has invested 90% of the
total funding), he has greater reason to worry about the success/ cash flows from the
project. But he is not running this project. So he wants to have a mechanism where the
operator feels motivated to make the project a success and generate good cashflows.
How can the investor do this?

If the investor says to the operator “Every year I will give you Rs. 1 crore and the balance
I will take” – this is a poor way of motivating the operator. If the operator is assured of
Rs. 1 crore (i.e. 10% on his investment of Rs. 10 crore) irrespective of the performance of
the project, he will have no reason to perform beyond this limit. Even if the project
generates Rs. 10 crore cashflow in a year, he will have only Rs. 1 crore while the investor
will take the balance Rs. 9 crore. So there is no incentive for the operator to perform
exceedingly well.

So what the investor does is to adopt a different method. He will say like this :
 Out of the operating income, I will first take my share let us say 5% return on my
Rs. 90 crore investment i.e. Rs. 4.50 crore
 If after taking the above, amount is left, then you take your share, let us say 5%
return on your Rs. 10 crore investment i.e. Rs. 0.50 crore
 If still amount is left after our shares as above i.e. if operating income exceeds
(4.50+ 0.50 = 5.00 crore), we can split that excess amount equally
Let us assume that the operating income is as follows for 6 years.

Year Year Year Year Year Year

1 2 3 4 5 6
Operating income 1.00 3.50 4.75 6.00 10.00 15.00
Share of investor 1.00 3.50 4.50 4.50 4.50 4.50
Balance left after investor took his 5% - - 0.25 1.50 5.50 10.50
return
Share of operator - - 0.25 0.50 0.50 0.50
Balance left after operator took his 5% - - - 1.00 5.00 10.00
return
50% share of investor - - - 0.50 2.50 5.00
50% share of operator - - - 0.50 2.50 5.00
Total share of investor 1.00 3.50 4.50 5.00 7.00 9.50
Total share of operator - - 0.25 1.00 3.00 5.50

In years 1 and 2, no amount is left for the operator. This is because as per the agreement,
first the investor will recover 5% of his investment i.e. 5% of Rs.90 crore = Rs. 4.50 crore.
Since the amount available in the first two years is less than Rs. 4.50 crore, the investor
will take the entire amount and nothing is left for the operator.

In year 3, after the investor recovers his Rs. 4.50 crore, an amount of Rs. 0.25 crore is left.
So this goes to the operator. Please note that the desired return i.e. 5% of operator’s
investment of Rs. 10 crore = Rs. 0.50 crore is not available. So the operator gets only Rs.
0.25 crore. From year 4 onwards, even after meeting the Rs. 4.50 crore return to investor
and Rs. 0.50 crore return to operator, some balance is left. So that balance will be shared
equally between the investor and the operator.

If you observe the above table carefully, you will observe that the investor is providing
an incentive to the operator to perform better and better. If the performance is low as is
the case in first two years, the operator gets nothing. Only if the project generates a
minimum operating income i.e. Rs.4.50 crore, money will start flowing to the operator.
In case the project does really well as is the case in year 6, the return to the operator is
huge.

Infact in year 6, the total operating income of Rs. 15 crore is shared in the ratio of Rs. 9.50
crore to Rs. 5.50 crore i.e. the operator is getting 36% share of the total income compared
to his investment of only 10% (Rs. 10 crore initial investment out of project cost of Rs. 100
crore works to 10%) So if the project does really well, the operator will get 36% return in
year 6 compared to investment of only 10% You can do the calculations and see that if
the operating income is Rs. 20 crore, the operator’s share will be 40%. His share will go
on increasing if the project performs better and better. So there is a clear incentive to the
operator to perform better.
The above concept is referred to as waterflow model of cashflow. The name “waterfall” has
come because as we saw in the example there are three stages – first investor will get Rs. 4.50
crore, only then operator will get Rs.0.50 crore, only then balance if any is shared equally. So
we can imagine this scenarios as three containers placed one below the other. We can think
of operating income as water. If we start pouring water into the top container i.e. investor,
the water will keep filling his container. If the water is less than Rs. 4.50 crore, there will be
no overflow to the below container i.e. operator. If the water exceeds Rs. 4.50 crore, say Rs.
4.75 crore, the top container gets filled and the excess of Rs. 0.25 crore will overflow to the
below container i.e. the operator. But the operator’s container is not filled completely. The
capacity of his container is Rs. 0.50 crore whereas only Rs.0.25 crore has overflown from the
top container. However if the water is Rs. 10 crore, not only are the top two containers filled
completely but the excess of Rs. 5 crore flows into the bottom container which is shared 50%-
50% between the investor and the operator. So this flow of water from one container to
another is like a waterfall and hence this is referred to as waterflow model of cashflows.