Project financing

Project financing
Raising of funds to finance an economically
separable legal entity
Sources of funds - lenders, equity investors/
sponsors, subsidies and aids
Project cash flows service debt and provide
returns to equity investors
Government and other agencies providing
subsidies and aids look forward to the projects
economic, social and environmental benefits


Government subsidies and assistance
Capital subsidy
Tax break / Tax holiday
Exemption or reduction of import duty
Export credit financing direct loan, loan guarantee and
insurance
Grant of land free of cost or at a nominal price
Assurance of availability of raw materials, power etc.
Assurance of output off-take for a guaranteed price and
duration
Infrastructural support at no or nominal cost
Arranging finance at concessional rates
Accelerated depreciation for tax benefits
Basic elements of project financing
Project entity
Lenders
Debt
repayment
Debt
funds
Equity
investors
Returns to
investors
Equity
funds
Suppliers Purchasers
Output
Purchase
contracts
Supply
contracts
Raw
materials
Project financing vs. direct financing
In direct financing
project assets and liabilities are integrated into the
sponsors balance sheet
lenders look to the firms entire asset portfolio to
generate the cash flow to service their debt
loans are often unsecured
In project financing
project assets, liabilities and cash flows are
segregated from the sponsoring entity
project assets are pledged to secure loans
lenders have no recourse or limited recourse to cash
flows from the sponsors other assets not part of the
project
Special Purpose Vehicle (SPV)
A separate legal entity
It has a finite life since a projects life is finite
Project cash flows are distributed to lenders and
equity investors
Equity investors make reinvestment decisions
unlike in direct financing where corporate
managers may retain cash flows from profitable
projects and/or reinvest in other projects of their
own choice at the expense of lenders and
shareholders interests

Advantages of project financing
More efficient in terms of allocation of
financial risks and returns
Project ownership and better management
control and monitoring
Performance-linked compensation
Reduction of the underinvestment problem
Reduction of information asymmetry and
signaling cost
Reduction of agency cost
Advantages of project financing
Enhancement of shareholder value
Highly leveraged capital structure
Lower overall cost of funds
Ability of the project sponsor to negotiate
with equity investors to invest free cash
flows in other seemingly profitable projects
so that the dividend requirement can be
waived
Reduction of dispute resolution and legal
or regulatory costs
Disadvantages of project financing
Complex structure of financing
requires negotiations by all parties
generally involves more cost and time
Lenders have no or limited recourse to the
sponsors other assets
Project-related information has to be
shared with lenders and investors for
arranging finance that may reduce the
sponsors competitive advantage

Project appraisal
Project feasibility
Technical
Commercial
Economic
Financial
Managerial
Risk assessment
Completion
Technological
Supply of raw
materials
Economic
Financial
Currency
Political
Force majeure
Technical feasibility
Product, process, technology, technical
specifications
Detailed engineering work, capacity and
possibility of expansion
Details of cost projections and escalation
factors
Project time schedule and milestones
Land acquisition, infrastructure development,
approvals from government departments etc.
Technical feasibility
Supply of raw materials, power, water etc.
Details of plant, machinery, equipment etc.
Transport and communication facilities
Housing, education, healthcare, recreation
etc., if applicable
Pollution control, effluent / waste disposal
Requirement and availability of manpower
Consultation with external specialists
Commercial feasibility
Projection of demand for projects output
Market survey for projects output
Demand forecasts of industry associations
Evaluation of the project firms advertising,
sales promotion, warehousing, distribution
and other marketing aspects
Incorporation of forecast information into
project time, cost and other parameters
Economic feasibility
Break-Even Analysis
Net Present Value
Internal Rate of Return

Break-Even Analysis
Break-even volume is given by
Unit contribution Break-even volume = Total
fixed costs
Margin of safety = Installed capacity Break-
even volume
Economic feasibility
Net Present Value (NPV)
NPV is given by the present value of all future
cash flows minus the initial investment

( )
I
r
CF
NPV
n
t
t
t

+
=

=1
1
Where CF = After tax operating cash flows or
PAT + Non-cash expenses + Interest
r = Weighted Average Cost of Capital
I = Initial investment
n = Useful life of project
Economic feasibility
Weighted Average Cost of Capital (WACC)
= u(1-T)r
d
+ (1- u)r
e

Where
u = Debt as a fraction of investment
T = Tax rate
r
d
= Cost of debt
r
e
= Cost of equity
Economic feasibility
Cost of debt, r
d
, can be obtained by solving the
following equation:
( )

=
+
=
L
t
t
d
t
r
C
NP
1
1
Where
NP = Net proceeds, i.e. gross proceeds minus
floatation expenses such as underwriting fees,
legal fees etc.
C = Interest + principal payment
L = Length of the loan period
Economic feasibility
Cost of equity, r
e
, can be obtained by using
the Capital Asset Pricing Model (CAPM):
r
e
= r
f
+ |(r
m
- r
f
)
Where
r
f
= Risk-free rate of return
r
m
= Return on market portfolio
| = Riskiness of asset
r
m
-r
f
is called the market risk premium
Economic feasibility
Example
Investment = 100, Debt : Equity = 60:40
Useful life = 2 years, C
1
= C
2
= 34.48
CF
1
= 48, CF
2
= 74, Tax rate = 0.30
r
f
= 0.08, r
m
= 0.2, | = 1
Cost of debt:
( )
% 10 1 . 0
1
48 . 34
) 1 (
48 . 34
60
2
or r
r
r
d
d
d
=
+
+
+
=
Cost of equity: r
e
= 0.08 + 1(0.2 0.08) = 0.2 or 20%
Economic feasibility
WACC = 0.6(1-0.3)0.1+0.40.2 = 0.122
or 12.2%
( )
( )
0 56 . 1 100 56 . 101
100
122 . 0 1
74
122 . 0 1
48
% 2 . 12 @
2
> = =

+
+
+
= NPV
Theref ore
Since NPV > 0, the project is economically viable
Economic feasibility
Internal Rate of Return (IRR)
IRR is the rate of return that makes NPV zero.
IRR can be obtained by solving the following
equation:
( )
0
1
1
=
+

=
I
IRR
CF
n
t
t
t
Considering the previous example, IRR = 13.3%
Since IRR > WACC, the project is viable
Economic feasibility
NPV and IRR may lead to contradictory
decisions depending on the size and cash
flows of projects
Considering the previous example, if CF
1

= 113.5 and CF
2
= 0 for an alternative way
of operation, NPV = 1.16 and IRR = 13.5%
For size differential, NPV is a better rule
since it adds more wealth
For cash flow differential also, NPV makes
more realistic reinvestment assumptions
Economic feasibility
Social rate of discount and Economic Rate
of Return (ERR)
ERR is the rate of return when the present
value (PV) of all social benefits equals the
PV of all social costs
Discrepancies between social valuations
and market valuations occur due to
Price distortions
Administered/regulated pricing
Economic feasibility
Taxes and duties
Foreign exchange regulations
Monopolistic status of the company, etc.
Social valuations should reflect opportunity
costs of resources, i.e., the valuations of
foregone economic outputs
Taxes and duties are passed on to the
government. Since they do not consume
resources, they cost nothing to the society.
Hence their inclusions give rise to price
aberrations
Economic feasibility
Consider the previous example
Year
0 1 2
Capital cost
Land 8 - -
Plant & M/C 80 10 -
Duties/Taxes 6 4 -
Others 6 6 -
Total 100 20 -
Operating cost - 82 126
Total cost 100 102 126
Revenue - 150 200
Cash flow -100 48 74
Economic feasibility
Considering social valuations
Agricultural land. The present value (PV) of
the agricultural outputs during the projects
useful life is, say, 5
Plant & M/C are imported. Say about 20% of
their costs is accounted for by import duties,
which must be deducted
Duties/Taxes should be removed
The following table shows social costs, social
benefits and resultant cash flows
Economic feasibility
Year
0 1 2
Capital cost
Land 5 - -
Plant & M/C 64 8 -
Duties/Taxes - - -
Others 6 6 -
Total 75 14 -
Operating cost - 82 126
Total cost 75 96 126
Revenue - 150 200
Cash flow -75 54 74
Economic feasibility
Considering a social rate of discount, 12%
NPV@12% = 54/1.12 + 74/(1.12)
2
75 = 32.2
Economic Rate of Return (ERR) = 40.5%
Since NPV > 0 and ERR > Social rate of
discount, the project is socially desirable
If it is an import substitution project and
the imported output would have cost more
to the society, the project would be more
socially desirable
Economic feasibility
Suppose now that the project company is
a monopolist, charging 15% more than the
economic worth of the output
Then social benefits in year 1 and year 2
should be 150/1.15 and 200/1.15 or 130
and 174, respectively
Also cash flows in year 1 and year 2 would
become 34 and 48, respectively
Economic feasibility
Therefore, NPV@12%
= 34/1.12 + 48/(1.12)
2
75 = - 6.4
Economic Rate of Return (ERR) = 5.8%
Since NPV < 0 and ERR < Social rate of
discount, the project is not socially viable
Hence, a project which is otherwise viable
may not be desirable from the social point
of view
Financial feasibility
Inherent value of project assets
Marketability of assets in case the project fails
Borrowing capacity/Maximum loan amount
PV/o where PV represents the present value
(PV) of future cash flows and o is the target
cash flow coverage ratio
Debt-Equity ratio
Norms stipulated by financial institutions
Different for different categories, areas and
sectors
Financial feasibility
Promoters contribution
Higher contribution means higher stake and
involvement, and lower debt-equity ratio
Lower risk to lenders
Norms may be different for different areas, type of
company (private or public limited)
Security margin
Loan is sanctioned against tangible assets
Financing of intangible assets is promoters sole
responsibility
Security margin - % of tangible assets financed with
promoters contribution
Financial feasibility
Debt Service Coverage Ratio (DSCR)
(Operating cash flows Tax) / (Interest +
principal payments)
(PAT + Non-cash expenses + Interest) /
(Interest + principal payments)
DSCR ~ 1.5 2 is considered healthy
If DSCR is too high, loan repayment can be
effected quickly forcing financial institutions to
charge higher rates of interest
Assumptions should be realistic to keep DSCR
within acceptable limits
Financial feasibility
Loan repayment schedule
Moratorium of, say, 2 years
Period and instalments depend on cash flow
projections and DSCR
Syndication
Group of financial institutions extending loan
Conversion of debt
Convertible debenture
Conversion period and cap on equity holding
Financial feasibility
Some examples
Project cost 100; Debt-equity ratio 3:1
For a private limited company with no capital
subsidy, promoters contribution (equity)= 25
and debt = 75. Promoters contribution = 25%
If capital subsidy is 10, promoters equity is 15
Equity
Promoters contribution 15
Capital subsidy 10
Total 25
Debt 75
Project cost 100

Financial feasibility
Promoters contribution drops to 15%
If debt-equity ratio falls or capital subsidy is
reduced, promoters contribution increases
which may necessitate public issues
Public issue = 60%, promoters equity = 40%
Equity
promoters contribution 10
Public issue 15
Total equity 25
Debt 75
Project cost 100
Financial feasibility
Promoters contribution drops to 10%
Minimum promoters contribution = 15%
Equity
Promoters contribution 10
Public issue 15
Total equity 25
Debt
Unsecured loan
arranged by promoter 5
Term loan 70
Total debt 75
Project cost 100
Financial feasibility
Promoters contribution = promoters equity +
unsecured loan arranged by promoter = 10 +
5 = 15; promoters contribution = 15%
Debt-equity ratio = 70:30 = 2.33:1 < 3:1
Public issue = 40%, promoters equity = 60%
Equity
Promoters contribution 10
FIs contribution 5
Public issue 10
Total equity 25
Debt 75
Project cost 100
Managerial feasibility
Experience and track record in previous
similar projects
Seriousness and financial soundness
Technical background and competence
Capabilities of key management personnel
Review of staff assigned to the project
Site visits and joint study with the project
teams of financial institutions and experts
Financial institutions nominees on Board
Risk assessment
Completion risk
Inaccurate cash flow projections
Technical infeasibility / Environmental issues
Technological risk
New / unproven technology
Technological obsolescence
Raw material supply risk
Price and availability of raw materials during
the loan repayment period
Risk assessment
Economic risk
Demand may not pick up as expected
Price realization may not match expectation
Operating cost may shoot up due to inflation
Volatility in foreign exchange rates may have
adverse impacts on operations
Servicing debt and providing returns to equity
investors may be difficult after meeting costs
Can be hedged by entering into forwards and
futures contracts with suppliers and buyers
Risk assessment
Financial risk
Floating rate of interest
Interest rate cap contract
Interest rate swap agreement
Bank Project
Swap
counterp
arty
Loan Pay 8%
Pay LIBOR + 1% Receive LIBOR
Risk assessment
Currency risk
If revenue realization and debt servicing are
denominated in different currencies, varying
exchange rates may affect cash flows
Remedies (i) revenue, cost and debt are in
the same currency, (ii) hedging with currency
forwards or futures, and (iii) currency swap

Bank Project
Swap
counterp
arty
Loan in Rs Pay 10% ($)
Pay 8% (Rs) Receive 8% (Rs)
Risk assessment
Political risk
New policies, taxes, legal restrictions
Change of government
Force majeure
Acts of God
Earthquake, fire, flood, cyclone, strike etc.
Some of the above may get insurance cover
In case of force majeure, lenders require
sponsors to pledge insurance payments
Public-Private Partnership (PPP)
Private participation in infrastructure
projects is sought for
financing and efficiency
Issues ownership, management and
operations, financing, responsibility,
sharing of risks and rewards
Private ownership
Govt. control on safety,
quality, fees charged etc.
Government ownership
Private leasing, management
and operations
Public-Private Partnership (PPP)
Build-Operate-Transfer (BOT)
Private party builds and operates the facility
for a fixed term (concession period) after
which ownership is transferred to the govt.
Period should be such that capital invested is
recovered and adequate return on capital is
received
Govt. may have to pay the private party an
amount equal to the remaining value of the
facility upon transfer of ownership
Public-Private Partnership (PPP)
Build-Transfer-Operate (BTO)
Ownership is transferred to the govt. as soon as the
project is completed
The facility is leased by the private party from the
govt. for a fixed period
After that the govt. can run the facility itself or again
lease it to a private party
Buy-Build-Operate (BBO)
A loss-making govt.-owned unit or a unit in urgent
need of repair or expansion may be bought (with
ownership) by a private party, developed and run as a
profit-making public-use facility
Public-Private Partnership (PPP)
Lease-Develop-Operate (LDO)
The private party leases a govt. facility/land,
develops and operates for a fixed period
There is a revenue sharing arrangement
between the private party and the govt.
This is a useful model when the govt. would
not sell the facility or the private party cannot
arrange adequate finance to buy the facility
This is also a useful model when the facility is
currently losing money
Advantages of PPP
Private financing arrangement. Scope for
raising funds through multi-lateral lending
agencies
Efficient project execution, management
and operations
Expertise and experience of private party
Adoption of state-of-the-art technology
Sharing of risks and rewards between the
govt. and the private party
Advantages of PPP
Govt. assistance in acquisition of land,
getting permits and approvals, financing,
assured supply of raw materials, tax/duty
concessions, infrastructural support etc.
Commercial development of the property
(mall, shopping complex, multiplex etc.)
Allowing private investments will indicate
govt.s willingness to attract more private
and foreign investments
Disadvantages of PPP
Govt. regulations on fees to be charged.
Returns may not be commensurate with
those of alternative projects
Uncertainty in demand for/usage of the
facility and hence uncertainty in toll/fee
collection and revenue streams
Possible competition from comparable
govt. projects
Disadvantages of PPP
Political problem If the govt. introduces
new policies or the govt. is changed, the
project may be scrapped or may have to
be reworked exposing the private party to
a considerable financial risk
Govt. control on various matters reduces
efficiency. For example, resorting to govt.
process of tendering might not be in true
interest of the private party