FACULTY OF THE BUILT ENVIRONMENT

DEPARTMENT OF QUANTITY SURVEYING

CONSTRUCTION FINANCE (AQS4203)
ASSIGNMENT 1

AMOS MUNDIRO B. N01521451B

1|Page
Question 1

With the aid of examples, examine the differences between corporate finance and project
finance.

Project finance refers to a method of long term financing for infrastructure and industrial projects.
Project finance has been used in mining, transportation, telecommunication and public utility
industries. It has also been seen frequently in international economic development, to enable the
transactional economies to modernise. The need for project finance has remained high throughout
the world as more countries require increasing supplies of public utilities and infrastructure.

Corporate finance exists where the primary source of repayment for investors and creditors is the
sponsoring company backed by the entire balance sheet, not the project alone. Creditors will still
seek to assure themselves of the economic viability of the project being financed, so that it is not
a drain of the corporate sponsor’s pool of assets, an important influence on their credit decision is
the overall strength of the sponsor’s balance sheet as well as business reputation.

Project financing (non- resource debt) differs from corporate financing in two main ways:

1. The creditors do not have a claim on the profit from other projects if the project fails, while
corporate financing gives this right to the investors.
2. And it typically has priority on the cash flows from the project over any corporate claims.

In traditional or corporate finance, the sponsoring company (the company building the project)
typically procures capital by demonstrating to lenders that it has sufficient assets on its balance
sheets, to use as collateral in the case of default. The lender will be able to foreclose on the sponsor
company’s assets, sell them, and use the proceeds to recover its investment. In project finance, the
repayment of debt is not based on the assets reflected on the sponsoring company’s balance sheet,
but on the revenues that the project will generate once it is completed.

Financing through a creation of an independent company, or financing by non-resource debt, has

become an important part of corporate financing decision. Shah and Thakor (1987) analysed
optimal financing in the presence of corporate taxation. In their model, projects have the same
mean of return furthermore the owners have private information about risks and investors may

2|Page
acquire (costly) information about the parameters of firm’s risks. They further stated that if the
benefits from the information production are relatively high, project financing is optimal because
the cost of screening a separately incorporatal project is low. Alternatively, project financing can
result in higher leverage and provide greater tax benefits. This is because under corporate
financing, leverage is below the optimal level.

Since projects are or may be located in different states or countries, they are very long term, the
corporate tax rates and their dynamics may differ across the projects, and the uncertainty
surrounding the real tax advantage of project financing is therefore large.

Project finance greatly minimizes risk to the sponsoring company, as compared to traditional
corporate finance, because the lender relies only on the project revenue to repay the loan and
cannot pursue the sponsoring company’s assets in the case of default. However, a sponsoring
company can only use project finance where it can demonstrate that revenue streams from the
completed project will be sufficient to repay the loan.

Raising capital through project finance is generally more costly than through corporate finance
avenues. The greater need for information, monitoring and contractual agreements increases the
transaction costs. In addition, the highly-specific nature of the financial structures also entails
higher costs and can reduce the liquidity of the project’s debt. Margins for project financings also
often include premiums for country and political risks since so many of the projects are in relatively
high risk countries. Or the cost of political risk insurance is factored into overall costs.
The following table summarizes the key differences between the two types of financing method:

Dimension Corporate finance Project finance

Financing vehicle
Type of capital
Dividend policy and
reinvestment decisions
Capital investment
Multi-purpose organization
Permanent - an indefinite
time horizon for equity
Corporate management
makes decisions
autonomous from investors
and creditors
Opaque to creditors
Single-purpose entity
Finite - time horizon
matches life of project
Fixed dividend policy -
immediate payout; no
reinvestment allowed
Highly transparent to

3|Page
 decisions
Financial structures
Transaction costs for
financing
Size of financings
Basis for credit evaluation
Cost of capital
Investor/lender base
Easily duplicated; common
forms
Low costs due to
competition from
providers, routinized
mechanisms and short
turnaround time
Flexible
Overall financial health of
corporate entity; focus on
balance sheet and cash flow
Relatively lower
Typically broader
participation; deep
secondary markets
creditors
Highly-tailored structures
which cannot generally be
re-used
Relatively higher costs due
to documentation and
longer gestation period
Might require critical mass
to cover high transaction
costs
Technical and economic
feasibility; focus on
project’s assets, cash flow
and contractual
arrangements
Relatively higher
Typically smaller group;
limited secondary markets

In summary, when a corporation chooses to undertake an investment project, cash flows from
existing activities fund the newcomer; and management has the option to roll over the project’s
capital into still newer ventures within the company later on -- without submitting them to the
discipline of the capital market.
However With project financing, by contrast, the assets and cash flows associated with each
project are accounted for separately. Funding for the new project is negotiated from outside
sources, and creditors have recourse only to the assets and cash flows of a specific project. As the

4|Page
project runs its course, furthermore, the capital is returned to the investors, and they decide how to
reinvest it.

5|Page
Question 2
With the aid of examples discuss the characteristics of infrastructure assets that differentiate
them from other assets.
Infrastructure refers to physical assets that provides essential services to society. Infrastructure
based services such as water supply, electricity supply, sanitation, waste disposal,
telecommunication, public transport or road infrastructure are of crucial importance for almost any
economic and social activity. In most industrialized countries, it is a matter of course that the
provision of these services is reliable and affordable, at almost any place.

Infrastructure assets, services & markets have different attributes: ‘economic’ infrastructure
market sectors and distribution networks: transport: road, rail, ports and airports; water:
waste/water; power & telecommunications.

The following are characteristics of infrastructure assets that differentiate them from other assets:

Pricing power

Infrastructure assets are usually able to raise the price of their services steadily over time. This can
be due to toll increase linked to inflation, regulated real returns, or high barriers to entry making
competition difficult.

Monopolistic Market Position

Usually, infrastructure assets and businesses are innate monopolies. The causes of this
monopolistic power can be attributed to high barriers to entry caused by capital, legal or political
considerations.

Predictable cash flows

Infrastructure assets have the potential to generate stable and highly predictable cash flows over
long time frames, although there is no guarantee. This predictability is underpinned by
infrastructure’s essential service nature, regulated returns, long term contracts and limited
economic sensitivity.

6|Page
Regulated Entities

The monopolistic nature of infrastructure assets lends itself to price gouging or extra-market
returns to the private investors, and to the detriment of consumers. To prevent price abuse,
governments or their agencies often regulate such enterprises. Private investors (lessees) are often
allowed to charge tariffs that compensate them for operating costs plus a specified return on capital.
In a large number of privatization cases, for example, the Chicago Skyway, the investors have
been allowed to recapture their initial investment in a fraction of the lease life. After that, it is pure
gravy for the lessees. In spite of these regulations and constraints, privatization offers low risk and
dependable returns to investors.

Inelastic Demand and Resilience to Economic Downturns

Infrastructure assets supply essential services for the functioning of society. They include airports,
roads, power, and water. Since these goods and services are indispensable in daily life, they are
relatively immune to economic downturns and price changes. They are expected to fare better and
have a lower probability of suffering from a permanent decline in revenues. This characteristic
also assures steady, low risk returns to private owners. Their long-term growth is caused by
demographic changes and overall economic growth.

Capital Intensive, Low Operating Costs

Infrastructure assets require high levels of capital investment. But, once built or created, they
generally demand low operating costs, and provide high operating margins. The higher margins
and long lives are conducive to obtaining high leverage debt for private parties seeking ownership
or leasing of these assets.

Low volatile of operating cash flows

There are various factors that contribute to the low volatility of the operating cash flows of
infrastructure assets. Usually, this occurs due to a captive customer base, regulated pricing
schedules, limited competition or licensing, or from long-term contracts. Basically, the private
parties are guaranteed an effective inflation hedge.

7|Page
Stable Yield

Due to the low operating costs and stable cash flows, investors typically expect dividend yields in
the mid to high single digits, as well as some modest capital appreciation. During times like the
current economy, these are enviable returns compared to most other asset classes.

Low Correlation with Other Asset Classes

Investment in infrastructure assets can provide valuable portfolio diversification because they have
a low correlation with other asset classes. It was often assumed that infrastructure assets could be
regarded as real estate. Two studies, (Newell and Peng 2008; Moreland and Razaki (2008) have
provided some evidence to refute this assertion. Thus, infrastructure assets can be treated as a
separate asset class in some cases and may be useful in portfolio diversification.

Sustainable growth

Infrastructure assets generally have a growth profile supported by long term economic and
demographic trends. They tend to be relatively immune to economic cycles, and exhibit defensive
qualities in falling markets.

Life span of an asset

They have long asset duration for example power plants have over 30 years lifespan as compared to other
assets.

8|Page
Question 3
With the aid of examples state and explain the traditional and modern sources of project
finance in developing countries.
Project finance reflects the sources of funds in order to embark on a project and financing may
come from a variety of sources. The main sources include equity, debt and governments grants.
Financing from these alternative sources have important implications on project’s overall cost,
cash flow, ultimate liability and claims to project incomes and assets. The future cash flows of the
project plays a very impotant role in decision making, that either the project should be started or
not.

Traditional sources of project finance in developing countries.

Corporate Finance

A private company borrows funds to construct a new facility and guarantees to repay lenders
from its available operating income and its base of assets. The company may choose to give its
own equity as well. In performing credit analysis, lenders look at the company’s total income
from operations, its stock of assets, and its existing liabilities. The loan, of course, becomes a
liability on the company’s balance sheet.

Project Finance

A team or an association of private firms establishes a new project to build, own and operate an
explicit infrastructure project. Different sponsors gain profit from capitalizing the project company
with various equity contributions. The project company borrows funds from lenders. The lenders
look to the projected future revenue stream generated by the project and the project company’s
assets to repay all loans. When it comes to getting a project financed in a host country, the
government there won’t provide a financial guarantee to lender and sponsoring firms will only
provide limited guarantees.

BOT Financing (an example of project finance)

It is sometimes called BOOT. It is a form of project finance, typically used for infrastructure
building in developing economies. Examples other than in developing countries that have used
BOT financing include Taiwan, Israel, India, Iran and more. It has also been used in the

9|Page
industrialised nations such as Canada, Australia and New Zealand. An example is a project which
was executed in the US that is the construction of portions of interstate highway 69.

The term BOT or BOOT conveys that the private investor – sponsor of the infrastructure project
(typically a single company or a consortium of several companies from the private sector) will
need to transfer ownership and or operation of the infrastructure to the host government or local
entities at the end of the project’s term.

The host government or local entity will then own and operate the infrastructure, having obtained
the technological know-how and training from the private sector.

Export credit agency

Because infrastructure projects in developing countries so often require imported equipment from
the developed countries, the export credit agencies (ECAs) are routinely approached by contractors
to support these projects. Generally, the ECA will provide a loan guarantee or funding to projects
for an amount that does not exceed the value of exports that the project will generate for the ECA’s
home country. ECA participation has increased rapidly. According to research scholars, it was
asserted that in just four years, ECA involvement in project finance has risen from practically zero
to an estimated $10 billion a year. Again, ECA participation can bolster a project’s status and give
it a certain amount of de facto political insurance.

Multilateral agencies
The World Bank, International Finance Corporation and regional development banks often act as
lenders or co-financers to important infrastructure projects in developing countries. In addition,
these institutions often play a facilitating role for projects by implementing programs to improve
the regulatory frameworks for broader participation by foreign companies and the local private
sector. In many cases, the multilateral agencies are able to provide financing on concessional
terms. The additional benefit they bring to projects is further assurance to lenders that the local
government and state companies will not interfere detrimentally with the project.

10 | P a g e
Non Profit making Organisations (NGO’s)
These are organisations which facilitates infrastructure development in developing country as well
as giving assistance in other areas like food programs and health services. For example the UNDP,
which financed the renovations of MCAZ building recently in Harare.

Modern sources of project finance in developing countries.

There are some alternative types of long-term securities that a project may issue in raising funds.
Although some requires the highest level of return which implies high risk involved and some
requiring the lowest returns which also implies less or reasonable risk.

Common equity

Projects can be financed through the equity. The investors who take part in the equity financing
are called sponsors. The ownership of possession of the project is represented through the common
equity. The major part of the equity is held by the sponsors of the project.

Preferred equity

Also signifies the ownership of the project. However, in the event of liquidation, the preferred
equity sponsors have precedence over the common equity holders in getting dividends.

Convertible debt

Is convertible to equity under certain conditions, usually at the choice of the holder. This debt is
generally considered secondary and senior lenders regard it as pseudo-equity.

Unsecured debt

This debt is given preference over the equity and convertible debt when dividends are being
distributed or when the principal is being repaid. The unsecured debt, as clear from the name, is
not secured by any specific asset and can be for both short term of long term.

Secured debt

It is secured by specific assets or sources of revenues and can either be short or long term.

11 | P a g e
Lease financing

Varies in terms of structure and duration, and the rights of the assets which are leased are always
with the lesser. Its driving forces are issues and problems of taxes and the strength or power of the
collateral. Banks generally offer other short term funding options. These are best described by their
use of funds and they also carry specific conditions that will meet those necessities.

Construction financing

Is utilized for the reason of construction. The construction financing is generally flexible in nature.
When the construction is completed, it is generally replaced by one or more of the longer-term
securities. There is different level of securities which are required by the lenders. It also happens
that the lender of the construction financing can also be the long-term investor who can straighten
out the construction financing.

Bridging finance

The bridging finance is normally used during the initial phase of the project and is almost same
as the construction financing. It is also used for several other reasons or purposes. When longer
term funding is received, this type of financing is eliminated.

Direct equity investment funds.

Private infrastructure funds represent another source of equity capital for project financings.
Examples of these funds include Asian Infrastructure Fund (AIG), Peregrine’s Asian Infrastructure
Fund, Global Power Investments and the Scudder Latin America Infrastructure Fund These funds
raise capital from a limited number of large institutional investors. Then their advisory teams
screen a large number of infrastructure projects for potential investment opportunities. The funds
typically take minority stakes of the infrastructure projects in which they invest.

Pension Funds
Pension funds can also be used for project finance. Whereas these funds historically were invested
in stocks and bonds, the recent growth of pension funds has meant new outlets had to be found for

12 | P a g e
their investments. This growth, plus the favourable yield available through real estate investments,
has resulted in active participation in financing real estate projects. Besides making mortgage
loans, pension funds also own real estate. A very good example is the Gweru Megawat Mall which
was funded by the ZESA Pension Fund.

13 | P a g e
References

1. Fisher, W. B. (2011). Real Estate Finance and Investments fourteenth edition. In W. B.

Fisher, Real Estate Finance and Investments fourteenth edition. New York: McGraw-Hill
Companies Douglas Reiner
2. Bruce Comer (1996). Project finance teaching notes
3. Gil, N., Beckman, S., 2009. Infrastructure meets business: building new bridges,
mending old ones. California Management Review, 51 (2), 6-29.
4. Campbell, T.S., 1979, Optimal investment financing decisions and the value of
confidentiality,
5. Journal of Financial and Quantitative Analysis 14, 913-924.
6. Campbell, T.S. and W.A. Kracaw, 1980, Information production, market signalling, and
the theory of financial intermediation, Journal of Finance 35, 863-882.
7. Dann, L.Y. and W.H. Mikkelson, 1984, Convertible debt issuance, capital structure change
and financing-related information: Some new evidence, Journal of Financial Economics,
this issue.
8. Downes, D.H. and R. Heinkel, 1982, Signalling and the valuation of unseasoned new
issues,

14 | P a g e