MIZAN TEPI UNIVERSITY

COLLEGE OF ENGINEERIG AND TECHNOLOGY

DEPARTMENT OF CONSTRUCTION TECHNOLOGY AND MANAGEMENT
The Commercial banks are important financial intermediaries serving the general
public in any society. In most cases, commercial banks hold more assets than
any other financial institution. In some cases even more than central bank. Apart
from their many functions, commercial banks facilitate growth and development.
Banks lends in many areas or sectors of the economy. Viewed from the building
and construction sector, they contribute to investment, employment creation,
and by extension, the process of infrastructure and economic growth.

Explain the various loan arrangements and financial products offered by banks to
construction companies

What Is Project Finance?

Project finance is the funding of long-term infrastructure, industrial projects,
and public services using a non-recourse or limited recourse financial
structure. The debt and equity used to finance the project are paid back from
the cash flow generated by the project.

Project financing is a loan structure that relies primarily on the project's cash
flow for repayment, with the project's assets, rights, and interests held as
secondary collateral. Project finance is especially attractive to the private
sector because companies can fund major projects off-balance sheet (OBS).

KEY TAKEAWAYS

 Project finance involves the public funding of infrastructure and other

long-term, capital-intensive projects.
 Project financing often utilizes a non-recourse or limited recourse
financial structure.
 A debtor with a non-recourse loan cannot be pursued for any additional
payment beyond the seizure of the asset.
 Project debt is typically held in a sufficient minority subsidiary that is not
consolidated on the balance sheet of the respective shareholders,
which makes it an off-balance sheet item.

How Project Finance Works

As noted above, the term project finance refers to the financing of long-term
projects industrial and/or infrastructure projects—most commonly for oil and
gas companies and the power sector. It is also used to finance certain
economic bodies like special purpose vehicles (SPVs) . The funding required
for these projects is based entirely on the projected cash flows.

Some of the common sponsors of project finance include the following

entities:

 Contractor Sponsors: These sponsors provide subordinated or

unsecured debt and/or equity. They are key to the establishment and
operation of business units.
 Financial Sponsors: These sponsors include investors and are usually
in the pursuit of a big return on their investment.
 Industrial Sponsors: These sponsors generally believe that the
project is related to their own businesses.
 Public Sponsors: These sponsors include governments from various
levels.

The project finance structure for a build, operate, and transfer (BOT) project
includes multiple key elements. Project finance for BOT projects generally
includes an SPV. The company’s sole activity is carrying out the project by
subcontracting most aspects through construction and operations contracts.
Because there is no revenue stream during the construction phase of new-
build projects, debt service only occurs during the operations phase.

For this reason, parties take significant risks during the construction phase.
The sole revenue stream during this phase is generally under an offtake
agreement or power purchase agreement. Because there is limited or no
recourse to the project’s sponsors, company shareholders are typically liable
up to the extent of their shareholdings. The project remains off-balance-sheet
for the sponsors and for the government.

Not all infrastructure investments are funded with project finance. Many
companies issue traditional debt or equity in order to undertake such projects.

Off-Balance Sheet Projects

Project debt is typically held in a sufficient minority subsidiary and is not
consolidated on the balance sheet of the respective shareholders. This
reduces the project’s impact on the cost of the shareholders’ existing debt
and debt capacity. The shareholders are free to use their debt capacity for
other investments.
To some extent, the government may use project financing to keep project
debt and liabilities off-balance sheet so they take up less fiscal space. Fiscal
space is the amount of money the government may spend beyond what it is
already investing in public services such as health, welfare, and education.
The theory is that strong economic growth will bring the government more
money through extra tax revenue from more people working and paying more
taxes, allowing the government to increase spending on public services.

Non-Recourse Project Financing

When a company defaults on a loan, recourse financing gives lenders full
claim to shareholders’ assets or cash flow. In contrast, project financing
designates the project company as a limited liability SPV. The lenders’
recourse is thus limited primarily or entirely to the project’s assets, including
completion and performance guarantees and bonds, in case the project
company defaults.

A key issue in non-recourse financing is whether circumstances may arise in

which the lenders have recourse to some or all of the shareholders’ assets. A
deliberate breach on the part of the shareholders may give the lender
recourse to assets.

Applicable law may restrict the extent to which shareholder liability may be
limited. For example, liability for personal injury or death is typically not
subject to elimination. Non-recourse debt is characterized by high capital
expenditures (CapEx), long loan periods, and uncertain revenue streams.
Underwriting these loans requires financial modeling skills and sound
knowledge of the underlying technical domain.

To preempt deficiency balances, loan-to-value (LTV) ratios are usually limited

to 60% in non-recourse loans. Lenders impose higher credit standards on
borrowers to minimize the chance of default. Non-recourse loans, on account
of their greater risk, carry higher interest rates than recourse loans.

Recourse Loans vs. Non-Recourse Loans

If two people are looking to purchase large assets, such as a home, and one
receives a recourse loan and the other a non-recourse loan, the actions the
financial institution can take against each borrower are different.
In both cases, the homes may be used as collateral, meaning they can be
seized should either borrower default. To recoup costs when the borrowers
default, the financial institutions can attempt to sell the homes and use the
sale price to pay down the associated debt. If the properties sell for less than
the amount owed, the financial institution can pursue only the debtor with the
recourse loan. The debtor with the non-recourse loan cannot be pursued for
any additional payment beyond the seizure of the asset.

Project Finance vs. Corporate Finance

Project and corporate finance are very important concepts in the world of
financing. Both of these funding methods rely on debt and equity in order to
help businesses reach their financing goals. Having said that, they are very
distinct.

Project finance can be very capital-intensive and risky and relies on the
project's cash flow for repayment in the future. Corporate finance, on the
other hand, is focused on boosting shareholder value through various
strategies like the investment of capital and taxation. Unlike project financing,
shareholders receive an ownership stake in the company with corporate
financing.

Some of the key features of corporate financing include:

 A company's capital structure, which is a company's funding of its

operations and growth.
 The distribution of dividends. Dividends represent a portion of the
profits generated by a company and are paid to shareholders.
 The management of working capital, which is money used to fund a
company's day-to-day operations.

What Is the Role of Project Finance?

Project finance is a way for companies to raise money to realize opportunities
for growth. This type of funding is generally meant for large, long-term
projects. It relies on the project's cash flows to repay sponsors or investors.

What Are the Risks Associated With Project Finance?

Some of the risks associated with project finance include volume, financial,
and operational risk. Volume risk can be attributed to supply or consumption
changes, competition, or changes in output prices. Inflation, foreign
exchange, and interest rates often lead to financial risk. Operational risk is
often defined by a company's operating performance, the cost of raw
materials, and the cost of maintenance, among others.

Why Do Firms Use Project Finance?

Project finance is a way for companies to fund long-term projects. This form
of financing uses a non- or limited recourse financial structure. Firms with
weak balance sheets are more apt to use project finance to meet their
funding needs rather than trying to raise capital on their own. This is
especially true for smaller companies and startups that have large-scale
projects on the horizon.

The Bottom Line

Companies need capital in order to begin and grow their operations. One of
the ways that certain companies can do so is through project financing. This
form of funding allows businesses that may not have a strong financial history
to raise capital for larger, long-term projects. Sponsors, which invest in these
projects, are paid using cash flows from the project. This is unlike corporate
finance, which is less risky and concentrates on maximizing shareholder
value.

Provide examples of real case scenarios where construction companies in Ethiopia have
successfully obtained loans from banks for their projects.

THE BASICS OF CONSTRUCTION FINANCE In this section, we cover the way construction loans work,
project costs and the key numbers that lenders evaluate. HOW CONSTRUCTION FINANCING WORKS The
first thing to know about construction finance is you actually need to fund two different loan periods,
each with different risk levels. Most owners secure two loans, one for each period. The first is the period
during construction, funded with a construction loan. The second is the period after construction,
funded with a permanent loan, AKA a takeout loan. Typically, owners structure financing through a real
estate holding company, which holds the construction property and the loans to limit risk for owners
and their businesses. CONSTRUCTION LOANS A construction loan pays for up-front project costs. In most
cases, you’ll make interest-only payments during construction, meaning once construction is complete,
you’ll still have to pay the full principal amount of the loan plus interest. The faster you complete
construction, the less interest you’ll have to pay, or the lower your cost of capital. STABILIZATION Once
construction is complete, you need your facility to reach what’s called stabilization, which happens
when your facility is worth more than the initial cost of construction. Lenders consider your finished
property quality collateral, so lending to you is less risky. Depending on the type of property you build, it
may not achieve stabilization until it’s reached a specified level of occupancy or rental income. 6 | THE
KORTE COMPANY PERMANENT LOANS Once your property has achieved stabilization, you’ll get a
permanent loan with a lower interest rate to pay off the construction loan. Then, you’ll pay back the
permanent loan, which typically has a set repayment structure and schedule. In some cases, you can
take out a combination loan, which covers both the construction period and the post-construction
period. In combination loans, conditions for stabilization are defined up-front, and a pre-negotiated
interest rate and payment plan kick in once stabilization is achieved. The most favorable option would
usually be a low-interest balloon loan, in which owners make low monthly payments (possibly interest-
only) for a specified time period and make a large final payment. But because of today’s tight financial
markets, balloon loans are difficult to attain. FINANCING BASICS: RISK, COLLATERAL AND VALUE Lending
money for construction, particularly new construction, is riskier than many other types of lending. For
starters, construction is a complex undertaking with many potential pitfalls. It requires a strong
ownership group with a defined plan for finished facilities. And it demands a skilled project team to
deliver your build on-time, on-budget and to high quality standards. Lenders want to know your project
will succeed, so they’ll take measures to evaluate your project’s viability and their risk. STABILIZATION
property value > initial cost of construction 7 | THE KORTE COMPANY PASSING THE PROFIT TEST TO GET
A CONSTRUCTION LOAN When evaluating potential borrowers for a construction loan, lenders start with
the profit test, which determines whether or not your finished facility will be worth more than cost of
your project — particularly if you plan to use your facility as loan collateral. Lenders will evaluate how
much relevant experience your ownership group has and the experience of your project team. And
they’ll consider how invested you are in your project using two measures: 1.The loan-to-value ratio
2.The loan-to-cost ratio LOAN-TO-VALUE RATIO = amount of money borrowed vs. estimated value of
facility LOAN-TO-COST RATIO = amount of money borrowed vs. cost of project 8 | THE KORTE COMPANY
Today, most lenders don’t usually finance more than 75 percent of a project’s value. Depending on the
job, the threshold may be lower than 75 percent. The lower the loan-to-value and loan-to-cost ratios,
the less risk your lender is taking and the less need you have for additional collateral or personal
guarantees. COLLATERAL AND GUARANTEES In almost every construction loan, owners use their facility
as collateral. If owners default on the loan, the lender gets the facility. Collateral may also be land.
Depending on the project, land may be a bigger portion of collateral. The reason? Some properties are
easier for a lender to sell or lease than others — e.g. an office space can be rented to many tenants,
while a gas station has limited use. Almost always — particularly given today’s tight credit environment
— lenders will require your ownership group to provide personal guarantees, wherein your investors
agree to personally pay back the loan if the project fails. Lenders will evaluate the net worth of your
ownership group and want to see that it’s at least equal to the amount of the loan. The official term for
this is the “loan-size ratio.” Today, borrowers usually must show ALL of their assets and liabilities,
providing an annual update to lenders. Personal guarantees can be joint and several. And they can be
capped at a certain amount.