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Project Appraisal and Finance Notes For Module 1 Introduction and Overview
Project Appraisal and Finance Notes For Module 1 Introduction and Overview
Project Appraisal and Finance Notes For Module 1 Introduction and Overview
Learning outcome: Able to understand the basics of Project finance and associated risks
Core concepts
• Project
• Types of Projects
• Project characteristics
• Project finance
• Differences between Corporate finance and Project finance
• Evolution of Project finance
• Project risks
• Project rating index
• Facets of Project analysis
• Drivers of project finance/Factors affecting the quantum of Project finance
Assessment
• Questions
• Quiz
• Case 1 – Who is the project manager?
• Submission on Market, technical and environmental analysis-Assessment 1
1.1. Definition of project
A Project is a one-shot, time limited, goal directed, major undertaking, requiring the
commitment of varied skills and resources. It has also been described as a combination of
human and non-human resources pooled together in a temporary organization to achieve a
specific purpose. The purpose and the set of activities which can achieve that purpose
distinguish one project form another. -Project Management Institute, U.S,A
“A specific activity with a specific starting point and a specific ending point intended to
accomplish a specific objective. It is something you draw a boundary around at least a
conceptual boundary and say this is the Project”. -J. Price Gettinger.
Normal Projects
Disaster Projects
Anything needed to gain time is allowed in these projects.
Around the clock work is done at the construction site.
Capital cost will go will go up very high.
Project time will get drastically reduced.
Example-A COVID 19 hospital construction
Besides that, projects in general are classified on several basis as given in the following
illustrative list by the United Nations Asian and Pacific Development Institute.
TYPES OF
PROJECTS
National International
Non
Conventional
conventional R High technology Low technology
technology
&D
• Industrial project
• Agricultural project
• Educational project
• Health project
• Social project
• Quantifiable project
• Non-quantifiable project
• Independent project
• Dependent project
• Pilot project
• Demonstration project
• Normal project
• Crash project
• Disaster project
(2) Life cycle: A project has a life cycle. The life cycle consists of five stages i.e. conception
stage, definition stage, planning & organising stage, implementation stage and commissioning
stage.
(3) Uniqueness: Every project is unique and no two projects are similar. Setting up a cement
plant and construction of a highway are two different projects having unique features.
(4) Team Work: Project is a team work and it normally consists of diverse areas. There will be
personnel specialized in their respective areas and co-ordination among the diverse areas calls
for team work.
(6) Risk and uncertainty: Risk and uncertainty go hand in hand with project. A risk-free project
only means that the element is not apparently visible on the surface and it will be hidden
underneath.
(7) Customer specific nature: A project is always customer specific. It is the customer who
decides upon the product to be produced or services to be offered and hence it is the
responsibility of any organization to go for projects/services that are suited to customer needs.
(8) Change: Changes occur throughout the life span of a project as a natural outcome of many
environmental factors. The changes may vary from minor changes, which may have very little
impact on the project, to major changes which may have a big impact or even may change the
very nature of the project.
(9) Optimality: A project is always aimed at optimum utilization of resources for the overall
development of the economy.
(10) Sub-contracting: A high level of work in a project is done through contractors. The more
the complexity of the project, the more will be the extent of contracting.
(11) Unity in diversity: A project is a complex set of thousands of varieties. The varieties are
in terms of technology, equipment and materials, machinery and people, work, culture and
others.
• Offices
• Schools (classrooms)
• Banks
• Research and laboratory facilities
• Medical facilities
• Stores and shopping centers
• Institutional buildings
• Apartments
• Dormitories
• Parking structures
• Hotels and motels
• Light assembly and manufacturing
• Warehouses
• Airport terminals
• Recreational and athletic facilities
• Public assembly and performance halls
• Industrial control buildings
The parties involved and transaction flow in project finance are depicted in the diagram
below:
SPONSORS
Sponsors are usually the equity share capital holders of the parent company who wish to seek
project finance.
BANKS/FINANCIAL INSTITUTIONS
It may be a single lender or a consortium of financial institutions. They are the providers of
senior debt and hold precedence over debt extended (if any) by the sponsors. The loan is
secured strictly against the cash flows and assets of the SPV only. Therefore, sufficient due
diligence is performed before the grant of any credit.
It is a separate legal entity floated by the sponsors of the project. The project finance obtained
is directed exclusively only towards this SPV. The SPV acts as a corporate veil between the
lenders and the parent company preventing seepage of credit and attachment of property
between the two parties.
HOST GOVERNMENT
Refers to the government of the home country where the SPV is located. The SPV must be
incorporated in accordance with the government’s rules and regulations. It also often acts as a
guardian angel in providing various tax concessions, subsidies, and rebates.
OFF TAKERS
Off-takers are bound via an off-take agreement to mandatorily purchase a certain minimum
quantity of produce from the selling party. An off-take agreement is a frequently resorted to in
mining, construction and other industries of mass significance. The vendor (SPV) incurs a huge
amount of capital expenditure. An off-take agreement ensures the seller of the existence of a
market upon completion.
As in any construction job, suppliers and contractors are necessary for the execution of a
contract. They are the key suppliers of raw material. They also perform crucial functions such
as design and build (D&B), operations and maintenance (O&M), etc
The following five points are, in essence, the distinctive features of a project finance deal.
1. The debtor is a project company set up on an ad hoc basis that is financially and legally
independent from the sponsors.
2. Lenders have only limited recourse (or in some cases no recourse at all) to the sponsors after
the project is completed. The sponsors’ involvement in the deal is, in fact, limited in terms of
time (generally during the setup to start-up period), amount (they can be called on for equity
injections if certain economic-financial tests prove unsatisfactory), and quality (managing the
system efficiently and ensuring certain performance levels). This means that risks associated
with the deal must be assessed in a different way than risks concerning companies already in
operation.
3. Project risks are allocated equitably between all parties involved in the transaction, with the
objective of assigning risks to the contractual counterparties best able to control and manage
them.
4. Cash flows generated by the SPV must be sufficient to cover payments for operating costs
and to service the debt in terms of capital repayment and interest. Because the priority use of
cash flow is to fund operating costs and to service the debt, only residual funds after the latter
are covered can be used to pay dividends to sponsors.
5. Collateral is given by the sponsors to lenders as security for receipts and assets tied up in
managing the project.
Funding was provided on the basis of the ability of producers to repay principal and interest
through revenues from the sale of crude oil, often with long-term supply contracts serving as
counter guarantees.
In the 1970s, project finance spread to Europe as well, again in the petroleum sector. It became
the financing method used for extracting crude on the English coast. Moreover, in the same
decade, power production regulations were passed in the United States (PURPA—the Public
Utility Regulatory Policy Act of 1978). In doing so, Congress promoted energy production
from alternative sources and required utilities to buy all electric output from qualified producers
(IPPs, or independent power producers). From that point on, project finance began to see even
wider application in the construction of power plants for traditional as well as alternative or
renewable sources.
From a historical perspective, then, project finance came into use in well-defined sectors having
two particular characteristics:
1. A captive market, created by means of long-term contracts at pre-set prices signed by big,
financially solid buyers (off takers)
Environment risk
Regulatory risk
Legal risk
The risks to allocate and to cover are: Pre-completion phase risks, Post-completion phase risks,
and risks common to both phases
The phase leading up to the start of operations involves building the project facilities. This
stage is characterized by a concentration of industrial risks, for the most part. These risks should
be very carefully assessed because they emerge at the outset of the project, before the initiative
actually begins to generate positive cash flows.
• Activity planning risk- This involves delineating the timing and resources for various
activities that are linked in a process that leads to a certain result within a pre-set time frame.
The logical links among various activities are vital in order to arrive at the construction deadline
with a plant that is actually capable of functioning. Delays in completing one activity can have
major repercussions on subsequent activities. Additional effects of bad planning are possible
repercussions on the SPV’s other key contracts. For example, a delay in the completion of a
facility could result in penalties to be paid to the product purchaser. As a worst-case scenario,
the contract might even be cancelled.
• Technological Risk- the risk arises when a specific license, valid in theory, proves
inapplicable in a working plant. Examples of technological risk arise in projects involving
innovative technologies that have not been adequately consolidated in the past.
• Construction Risk or Completion Risk- occurs when the project may not be completed
or that construction might be delayed. Some examples of construction risk pertain to:
The major risks in the post-completion phase involve the supply of input, the performance of
the plant as compared to project standards, and the sale of the product or service.
• Supply risk arises when the SPV is not able to obtain the needed production input for
operations or when input is supplied in suboptimal quantity or quality as that needed for the
efficient utilization of the structure.
• The operating risk (or performance risk) arises when the plant functions but
technically underperforms in post-completion testing.
• Demand risk (or market risk) is the risk that revenue generated by the SPV is less than
anticipated. This negative differential may be a result of overly optimistic projections in terms
of quantity of output sold, sales price, or a combination of the two.
Many risks common to both phases pertain to key macroeconomic and financial variables
(inflation, exchange rate, interest rate); consequently, any division between the categories of
industrial and financial risk is actually somewhat arbitrary.
Interest Rate Risk: This cost item represents a significant percentage of total costs; in fact,
the more intense the recourse to borrowed capital, the greater the weight of the interest
component.
Exchange Rate Risk: Essentially this risk emerges when some financial flows from the project
are stated in a different currency than that of the SPV. This often occurs in international projects
where costs and revenues are computed in different currencies. When possible, the best risk
coverage strategy is currency matching.
• Forward agreements for buying or selling (In a forward contract, the buyer
and seller agree to buy or sell an underlying asset at a price they both agree on at an
established future date. This price is called the forward price.)
• Futures on exchange rates (Currency futures are futures contracts for currencies that
specify the price of exchanging one currency for another at a future date.
The rate for currency futures contracts is derived from spot rates of
the currency pair. Currency futures are used to hedge the risk of receiving payments
in a foreign currency)
• Options on exchange rates (a foreign exchange option (commonly shortened to
just FX option or currency option) is a derivative financial instrument that gives the
right but not the obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date.)
• Currency swaps (A currency swap is a transaction in which two parties exchange an
equivalent amount of money with each other but in different currencies. ... The purpose
could be to hedge exposure to exchange-rate risk, to speculate on the direction of
a currency, or to reduce the cost of borrowing in a foreign currency.)
Inflation Risk: Inflation risk arises when the cost dynamic is subject to a sudden acceleration
that cannot be transferred to a corresponding increase in revenues.
Environmental Risk: This risk has to do with any potential negative impact the building
project could have on the surrounding environment. Such risk can be caused by a variety of
factors, some of which are also linked to political risk. Examples are: Building or operating the
plant can damage the surrounding environment, create noise pollution, etc., Change in law can
result in building variants and an increase in investment costs.
Regulatory Risk: There are various facets to regulatory risk; the most common are the
following.
Legal Risk: Legal risk centres primarily on the project’s lenders, whose lawyers analyze and
manage this risk (see Section 4.1). Their job is to ascertain whether the commercial law of the
host country offers contract enforceability should problems emerge during the construction or
post-completion phases.
Credit Risk or Counterparty Risk: This risk relates to the parties who enter into contracts
with the SPV for various intents and purposes. The creditworthiness of the contractor, the
product buyer, the input supplier, and the plant operator is carefully assessed by lenders through
an exhaustive due diligence process.
The PDRI is quick and easy to use. It is a “best practice” tool that will provide numerous
benefits to the building industry. A few of these include:
1. A checklist that a project team can use for determining the necessary steps to follow in
defining the project scope
2. A listing of standardized scope definition terminology throughout the building industry
3. An industry standard for rating the completeness of the project scope definition package to
facilitate risk assessment and prediction of escalation, potential for disputes, etc.
4. A means to monitor progress at various stages during the front-end planning effort
5. A tool that aids in communication and promotes alignment between owners and design
contractors by highlighting poorly defined areas in a scope definition package
6. A means for project team participants to reconcile differences using a common basis for
project evaluation
7. A training tool for organizations and individuals throughout the industry
• Market analysis
• Technical analysis
• Financial analysis
• Economic analysis
• Ecological analysis
Market Analysis: Market analysis is concerned primarily with two questions: ■ What would
be the aggregate demand for the proposed product/service in the future? ■ What would be the
market share of the project under appraisal?
Technical Analysis: Analysis of the technical and engineering aspects of a project needs to be
done continually when a project is formulated. Technical analysis seeks to determine whether
the prerequisites for the successful commissioning of the project have been considered and
reasonably good choices have been made with respect to location, size, process, etc.
Financial Analysis: Financial analysis seeks to ascertain whether the proposed project will be
financially viable in the sense of being able to meet the burden of servicing debt and whether
the proposed project will satisfy the return expectations of those who provide the capital.
Economic Analysis: Economic analysis, also referred to as social cost benefit analysis, is
concerned with judging a project from the larger social point of view. In such an evaluation the
focus is on the social costs and benefits of a project which may often be different from its
monetary costs and benefits.
Ecological Analysis: In recent years, environmental concerns have assumed a great deal of
significance — and rightly so. Ecological analysis should be done particularly for major
projects which have significant ecological implications (like power plants and irrigation
schemes) and environment-polluting industries (like bulk drugs, chemicals, and leather
processing).
Assessment 1
To explain to the Steering Group, other stakeholders, the project manager and BCM how
the responsibilities are split over the project manager and BCM, we have also developed a
RACI matrix and a standard role description. These are then discussed by the project
manager and BCM, and if necessary, the sponsor, at the start of the project. They are then
tailored for the specific project, but have proven to be an 80-90% fit at the start.
Does This Work?
We have now started a number of projects this way, and the project manager finds that it
gives clarity on the main roles at the start of the project. Also, there is little chance that the
BCM will try and run the project, normally they have their hands full with the business
change anyway! So, the BCM is happy to know that there is someone else responsible for
the day-to-day running of the project. A number of projects that started with this structure
have completed, and the feedback from the customers has been good. On review the project
managers feel that this approach works well, and also gives enough room for tailoring to the
needs of the individual project.
In Summary
This problem only occurs in projects that are not part of a programme, but in my team, we
have a large number of these. Having a project manager and a BCM, with clear
responsibilities and the capabilities to match, greatly increases the chance of success in the
project team. I am aware that this is probably not the only way to solve this dilemma, and
would like to hear from people who have other ideas and experiences, even if they are
contradictory to mine!
Question:
Analyse the case and discuss the case facts.
Source: http://www.projectsmart.co.uk/who-is-the-project-manager.html (Taken from the
study material of LPU)