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Introduction To Project Finance
Introduction To Project Finance
PROJECT FINANCE
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap
What Is Project Finance?
• Definition
• Major characteristics
• Schematic example of a project
structure
• Major project contracts
Definition:
“Project Finance involves one or more corporate sponsors
investing in and owning a single purpose, industrial asset
through a legally independent project company
financed with limited or non-recourse debt.”
A “nexus
of
contracts”
that aids
the sharing
of risks,
returns,
and
control
Source: Esty, B., “An Overview of Project Finance – 2002 Update: Typical project structure for an independent power producer”
Major project contracts:
• The Offtake Contract: • Input Supply Contract:
Value Creation
Contractual Structure
How Does It Create Value?
• Drawbacks of using Project Finance
• Value creation by Project Finance
– Organizational structure
• Agency costs, debt overhang, risk contamination, risk
mitigation
– Contractual structure
• Structuring the project contracts to allocate risk, return,
and control
– Governance structure
• Benefits of debt-based governance
• Case examples to value creation
Value creation by organizational structure:
Agency Costs
Problems Structural Solutions:
• • Concentrated equity ownership and
Agency conflicts between single cash flow stream provides critical
sponsors (owners) and monitoring
management (control) • Strong debt covenants allow both
sponsors and creditors to better monitor
• High levels of free cash management
flow leading to • High debt service reduces the free cash
overinvestment in flow exposed to discretion
negative NPV projects • Extensive contracting reduces
managerial discretion
• Risk shifting/debt • “Cash Flow Waterfall” mechanism
shifting by managers to facilitates the management and allocation
invest in high risk, of cash flows, reducing managerial
negative NPV projects discretion. Covers capex, debt service,
to recoup past losses reserve accounts, and distribution of
residual income to shareholders
• Refusal to make • Given the projects are defined within
additional investment narrow boundaries with limited
investment opportunities, moral hazard
(risk shifting, debt shifting, reluctance to
invest) is minimized
Value creation by organizational structure:
Agency Costs
Problems Structural Solutions:
• Agency conflicts between • “Cash Flow Waterfall” mechanism
sponsors and creditors: reduces potential conflicts in distribution
and re-investment of project revenues
– Distribution of cash flows, re-
investment, and restructuring • Legally/economically separate project
during distress company eliminates potential for risk
shifting and debt shifting
– Moral hazard (such as risk
shifting and debt shifting)
encouraged by full recourse • Concentrated debt ownership is preferred
nature of debt to sponsor (i.e. bank loans vs. bonds) to facilitate the
restructuring and speedy resolutions
Risk Management:
• Sponsors bear the residual gains and losses, and make key investment decisions.
In simple terms,
Return to equity = Revenues – Material / service costs – Labor costs -
Depreciation – Interest expenses – Taxes
• Other earners of net income (or net value added) from investment can also share
risk:
Net Value added =
Return to equity + Interest expenses + Taxes + Labor costs
= Revenues – Material / service costs – Depreciation
Profit sharing mechanisms or tax incentives may change how variability in income is shared
among sponsors, lenders, government, and labor
• Output purchasers and input suppliers can also share the risks as they experience
variability in their markets
Value creation by contractual structure:
An Introduction to Risk Management
• Some risks can be reduced by spreading the burden across many participants; some
other risks cannot be spread, but can be shifted or reallocated
• Gains in economic efficiency can be achieved if overall cost of risk declines through
risk shifting and reallocating:
– The same risk will have a lower cost if born by parties better capable and willing
to do so
Value creation by contractual structure:
An Introduction to Risk Management
• Generally well developed capital, financial, and futures markets may not always be
available
• Special contractual arrangements are often required to manage risk to make projects
viable
• The aim of extensive contracting is to reduce cash flow volatility, increase firm value
and debt capacity in a cost-effective way
• Guarantees and insurance for those risks that cannot be handled through contracting
Elements of contracting:
• General form:
– Exchange risk (x) for return (y)
• Additional considerations:
– Participation or partial transfer of ownership
– Timing of x and y
– Contingency of x and y (under what circumstances)
– Penalties on non-performance
– Bonus on performance
Value creation by contractual structure:
Contracting and Project Finance to reduce cost of risk
Contracting criteria:
• Contract with lowest cost not necessarily best contract
• Effective contracts may provide:
– Better risk shifting: better distributions of cost
– Better incentives: higher project returns or lower total project risk as a result of
incentives
• Change the incentive structure to change the probabilities of different outcomes
stakeholders have incentives to increase probability of success and reduce probability
of failure in project
• “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives
– Cost focus is implicitly a zero sum perspective: one stakeholder gains and the
other stakeholder loses
– Integrative focus is explicitly a positive sum perspective: By crafting the right
contract, one stakeholder can gain without necessarily costing to the other one
(due to differences between perceived values, preferences, and risk bearing
capacity) contracts that create increased value through risk sharing and /or
improved incentives
Value creation by contractual structure:
Contracting and Project Finance to reduce cost of risk
–Is it also one of project’s sponsors? •Contract supervision by the project company’s other
(Conflict of interest) personnel not directly related to the contractor
–The contractor’s credit standing? If the •Careful review of contractor’s credit standing
contractor’s wider business gets into •Careful review of the project scale in relation to the
difficulty, the project is likely to suffer size of contractor’s overall business
•If project too big for the contractor to handle alone, a
joint venture approach with a larger contractor
•Guarantees of obligations by the contractor's parent
company
Value creation by contractual structure:
Pre-completion risks:
Risk Solution
•Construction cost overruns: reduce equity •Pre-agreed overrun funding (contingency finding)
returns, and DSCR •Fixed (real) price contract, as the EPC contract is
normally the largest cost item in budget (60-70%)
•Contractor takes junior debt and/or equity stake in
operations (BOT or BOO)
•Delay in completion: failure to meet the •Completion guarantees, date-certain EPC contract
milestones increase costs, reduce equity returns, •Performance bonds
and reduce DSCR •Completion bonuses/penalties
–Financing costs, especially as debt will be •Reputable contractor
outstanding longer
•Close monitoring / testing of project execution
–Revenues from operating the project will
(operational, financial, etc.) for early detection of
be lost or deferred (significant risk also
problems
especially if part of financing depends on
•Careful definition of “completion” in all the contracts
early revenues)
(EPC contract, input supplier contracts, off-taker
–Penalties may be payable under contract
contract, etc) so that it is acceptable and manageable
to input suppliers or off-taker by all parties involved
•Process failures •Process / Equipment warranties
•Tested technology
Value creation by contractual structure:
Pre-completion risks:
Risk Solution
•Nonperformance on completion: due to poor •Debt recourse to sponsors (from lenders’
design, inadequate technology perspective)
•Performance LDs (liquidated damages): Pre-agreed
level of loss to be born by the contractor. Covers the
NPV of loss due to nonperformance over the life of
the project
• The Project Company should be aware of the
uncertainty regarding the LDs and should allow a
margin when negotiating the calculations with the
contractor
•Natural resource risk •Independent reserve certification
Value creation by contractual structure:
Pre-completion risks:
Risk Solution
•Third party risks: •If the third party is not otherwise involved in the
–The contractor may be dependent on third project, incentive mechanisms to keep the timetable
parties such as suppliers of utilities to •If the third party is involved with a project contract,
complete the project the contract should include terms such that the third
party should be held responsible for the delay losses
•Contractor’s good relationships and experience with
the third parties may be a plus
–The project may be dependent on
completion of another project – worst type •Financing the projects as one package may be
of third party risk especially when the examined as a potential solution, as long as the
project financing is dependent on it. sponsors’ interests on both sides can be aligned
•Sponsor-related risks (Lenders’ perspective): •Require lower D/E ratio
–Sponsor commitment to the project •Starting with equity: eliminate risk shifting, debt
–Financially weak sponsor overhang and probability of distress (lenders’
requirement).
•Add insider debt (Quasi equity) before debt: reduces
cost of information asymmetry.
•Attain third party credit support for weak sponsor
(letter of credit)
•Cross default to other sponsors
Value creation by contractual structure:
Post-completion risks:
Risk Solution
•Market risk: Uncertainty regarding the future •Long term off-take contract with creditworthy buyers:
price and demand for the output –take and pay, take or pay, take if delivered contracts:
–Volume risk: cannot sell entire output •Price floors
•A fixed price growth path
–Price: cannot sell output at profit •An undertaking to pay a long-run average price
•Specific price escalator clauses that would maintain the
competitiveness of the product, such as indexing price to
the price of a close substitute or cost of major input
•Hedging contracts
•Operating cost risk: Uncertainty regarding the •Risk sharing contracts to increase correlation
changes in the operating cost throughout the life between revenue and some cost items:
of the project –If there is an off-take contract, linking input supply price
to it:
•Basing the product price under the off-take contract on the
cost of the input supplies (more likely if input supply is a
widely traded commodity like oil)
•Basing the input supply price to product price under the off-
take contract: (more likely if the input is a specialized
commodity, or if there is no off-take contract and risk is
passed to the input supplier)
–Price ceilings
–Profit sharing contract with labor
–Output or cost target related pay
Value creation by contractual structure:
Post-completion risks:
Risk Solution
•Input supply risk: Uncertainty regarding the •If there is an off-take contract, linking the terms of the
availability of the input supplies throughout the life output contract with input supply contracts such as
of the project the length of contract, volume, or force majeure
•If there is no off-take contract, making the input
supply contract run for at least the term of debt
•An input supply contract is off-take contract for the
supplier
•Organizational risks: Incentive problems relating •Profit sharing / stock options
to management or workers •Output or cost target related pay for workers
•Operating risk: operating difficulties due to •Performance warranties on equipment
technology (being degraded or obsolescent), •Expert evaluation and retention accounts
processes used, or incapacity of operator team •Proven technology
leads to inefficiencies and insufficient cash flow
•Experienced operator/management team
•Operating/maintenance contracts to ensure
operational efficiency
•Allowances for service / upgrade built into equipment
supply contracts
•Insurance to guarantee minimum operating cash
•Force majeure risk: Likelihood of occurrence of •Insurance for natural disasters
events like wars, labor strikes, terrorism, or
nonpolitical events such as earthquakes, etc.
Value creation by contractual structure:
Sovereign risks:
Risk Solution
•Exchange rate changes: Uncertainty regarding •Revenues, costs, and debt in same currency
the changes in the exchange rate throughout the (indexing if they are not in the same currency)
life of the project •Market-based hedging of currency risks (though not
•Implications of a sudden major local currency widely used)
devaluation in cases where the project revenue is •For protection from a sudden major devaluation, a
in local currency and debt in foreign currency revolving liquidity facility can be utilized to cover the
time lapse between the devaluation and the
subsequent increase in inflation that should
compensate the project company for debt payments
•Currency convertibility / transferability risk: As it •Government Support Agreement: Government
is often not possible to raise funding in local guarantee of foreign exchange availability: However,
currency in developing countries, revenues if the host country gets into financial difficulty and
earned in local currencies need to be converted runs out of foreign currency reserves, then the
into foreign currency amounts needed by offshore government may forbid either the conversion of local
investors/lenders, and then need to be transferred currency amounts to foreign currency, or the
outside the country to pay for them. Additionally, transmission of these amounts abroad The support
foreign currency may be needed to import agreement may become invalid
materials, equipment, etc. •Enclave projects: If the project revenues are paid
from a source outside the host country, the project
can be insulated from foreign exchange and transfer
risks (Example: sales of oil, gas across borders)
•Offshore debt service reserve accounts
Value creation by contractual structure:
Sovereign risks:
Risk Solution
•Hyperinflation risk: Relative changes in the price •Indexing the output price (in the long term sales
of inputs and output may adversely affect the contract) against the CPI and or industry price indices
project in the host country where the relevant costs are
incurred (Indexing means increasing over time
against agreed, published economic indices)
The lead sponsor, Telstra, has to structure the project company, selecting
an ownership, financial, and governance structure.
Case examples to value creation
Issues:
1. Selection of strategic sponsors who would bring the most value to the
project
2. Mitigation of market risk: Growing demand and capacity shortfall that
triggers competition, rapid improvements in cable technology and resulting
price decline necessitates moving very quickly
3. Completion risk: Potential delays due to environmental approvals and
other permits
4. Management of possible agency conflicts between:
1. sponsors and management
2. sponsors and other parties (capacity buyers (purchasers), suppliers,
etc.)
3. sponsors and creditors - decision of how many and which banks to
invite to participate
Case examples to value creation
How project structure may help:
1. Telstra partnered with Japan Telecom (who would bring its landing
station in Japan and was interested in buying capacity) and Teleglobe (a
major carrier who would bring significant volume) as sponsors
(reducing cash flow variability)
8. Bank debt with a small banking group was preferred rather than project
bonds to have flexibility
• The initial tranche of bank debt would be secured and repaid in 5
years with presale commitments
• The second tranche would also be repaid in 5 years, but from future
sales, acting as “trip wires” for the management team
Case examples to value creation
Calpine Corporation
Background:
Calpine, a small power generator with high leverage (~80%), sub-
investment grade rating, and little debt capacity, has to decide how to
finance its aggressive growth strategy, facing increasing pressure for
speed, efficiency, and flexibility in a soon-to-be competitive commodity
market.
The growth strategy includes building and operating a “power system”
consisting of multiple power plants. Project financing and corporate
financing alternatives are considered.
Case examples to value creation
Issues:
• Benefits:
– Opportunity to finance the growth strategy even if Calpine had low
investment ratings and limited debt capacity
• Costs:
– Time consuming and expensive to set-up and execute individual
deals
– Limited size and absorption capacity of the project finance market
– Possible restrictions to flexibly switch between the plants in the
power system if each plant would be collateralized separately
Case examples to value creation
How project structure may help:
2. Corporate Finance:
i. The structure gave Calpine flexibility to build the plants using equity,
and manage them flexibly as part of a power system (which would
be impossible with separately project financing the individual plants)
Case examples to value creation
BP Amoco
Background:
A large and well-capitalized company, BP Amoco tries to decide on the
best way to finance its share in the $8 billion development project of
Caspian oil fields, undertaken by a consortium of 11 companies.
Each of the partners had a choice in how to finance its share of the total
investment. Of these companies, 5 formed a Mutual Interest Group
(MIG) to obtain project loan with assistance of IFC and EBRD. The
alternatives BP Amoco considered for its share were corporate
financing, project financing, or a hybrid structure.
Case examples to value creation
Issues:
• Background
• Approaches to calculating the Cost of
Capital in Emerging Markets
• Country Risk Rating Model (Erb, Harvey and
Viskanta)
Background
• Projects are characterized by:
– unique risks
– high and rapidly changing leverage
– imbedded flexibility to respond to changing conditions (real options)
– changing tax rates
– early, certain and large negative cash flows followed by uncertain positive cash flows
2
0.3 R = 0.2976
0.2
0.1
0
-0.1 0 20 40 60 80 100
Rating
The Country Risk Rating Model
• Cost of Capital = risk free + intercept – (slope x Log(IICCR))
– Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating
– Gives the cost of capital of an average project in the country in $).
• If cash flows are in local currency, convert into $US:
– Calculate the difference between the multiyear forecasts of inflation in the host country and
those in US
– Use the difference to map out the expected exchange rates
– Use calculated expected exchange rates to convert cash flows into $
• Adjust for industry risk:
– Calculate the country risk premium from ICCRC:
Country risk premium =
Country cost of equity capital – US cost of equity capital
– Calculate US industry cost of capital by using industry beta
– Add the country risk premium to US industry cost of capital
• Adjust for project specific risks that deviate the project from the average level of risk in the
host country
– Risks incorporated in cash flows or industry adjustment:
• Pre-completion: technology, resource, completion.
• Post-completion: market, supply/input, throughput.
– Risks incorporated in discount rate:
• Sovereign risk: macroeconomic, legal, political, force majeure.
• Financial risk.
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project Valuation
4. Case analyses
5. Recap
Case analyses
• Chad-Cameroon Petroleum Development
and Pipeline Project
• Background
• Corporate finance vs. project finance
– Why is there a difference between financing of field and export
systems?
• The role of World Bank
• Assessment of project risks and returns
• Real options
• Project update
Background
• WB states in its web site that it “remains in dialogue with the Chadian
authorities, and is determined to safeguard the oil revenues intended for
poverty reduction programs included in its original agreement with Chad,
while recognizing the fiscal strains currently experienced by the government
of Chad”.
Petrozuata and Oil Field Development Project
• Background
• Why use project finance?
• Risk management
– Pre-completion risks
– Post-completion risks
– Sovereign risks
– Financial risks
• Real options
• Cost of capital calculation
• Project update
Background
The priority and challenge for the sponsors is to craft the project’s
operational and financial details so as for the project to achieve an
investment grade rating.
Why use Project Finance?
• Strategic reasons in the long run: $2.4B Petrozuata will be the first in a
series of projects planned which total as high as $65 B.
– PDVSA has low credit rating (long-term senior unsecured debt rating B from
S&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b)
– Under project financing, if the project can secure BBB investment grade rating,
lower cost of debt ~ 7.70%
– A gain of 2.47%
– However, huge transaction and contracting costs as well as the longer time
needed to structure a project financed deal should be weighed against the
potentially lower cost of debt to see if there is a net gain in terms of costs
Why use Project Finance?
– Cost focus would be a zero sum perspective for both PDVSA and Conoco (one
party gains and the other loses)
– Involvement of experienced Conoco and Du Pont in the deal may help increase
the aggregate net cash flows to the project, due to efficiency gains as well as risk
sharing/allocation benefits (positive-sum perspective)
– Under project finance, the project is subject to significantly lower income tax rates (34% as
opposed to 67.7%) and royalties.
– But losing the benefit of co-insurance which would come with corporate financing
Why use Project Finance?
– High leverage and dedicated cash flows via the “cash waterfall” structure helps
prevent opportunities for risk shifting, underinvestment, or cross-subsidization of
negative NPV projects
Operating
0.05 0.00 0.00 Resource risk
0.03 0.00 0.00 Technology risk
Financial
0.03 3.00 -0.17 Probability of Default
0.03 2.00 -0.09 Political Risk Insurance
• The project received ratings that exceeded the sovereign ratings by five
notches
• Completed a $1B bond issue, which was five times oversubscribed, and a
total of $450M bank financing (with 14 years maturity at 7.98%, 12 years
maturity at 7.86%)
• The project considered by analysts as “one of the best structured and best
executed project finance deals ever done”, 1997
• PDVSA continued to structure deals for the Orinoco Basin
• Venezuelan economy was hit hard by the decline in crude oil prices
• S&P revised its outlook for Petrozuata to negative, as a result of the cost
overruns, lower than expected early production revenues, falling prices, and
political uncertainty
• As economic situation worsened, Gov’t demanded and received
extraordinarily high dividends from PDVSA reaching up to 134% of
projected income in 1999
• Hugo Chavez won the 1998 elections and announced not to interfere with
foreign oil investments
Financing the Mozal Project
• Background
• Risk management
– Completion risks
– Operation risks
– Sovereign risks (Major risk group in this project and the reason
for project financing)
– Financial risks
– Real options
• The role of IFC
• Project update
Background
IFC’s concerns are the size of the project, as well as the political
risks of doing business in Mozambique.
Risk Management
Supply risk and operating costs: Availability, quality, and price of the
alumina, electricity, and labor
• Alumina accounted for 33% of production costs
+ The sponsors planned to link the price for alumina to LME aluminum
market prices
+ Alumina would be imported from a supplier of Alusaf’s affiliated
company Billiton under a 25 year supply contract
• Electricity accounted for 25% of production costs
+ The electricity price would also be a function of aluminum prices
+ Eskom and Mozambican Electric company would provide
inexpensive electricity under a 25 year contract whereby the price
will be fixed in the early years and then tied to aluminum prices
+ The majority of unskilled labor would come from Mozambique, decreasing
labor costs compared to industry averages
+ Other inputs would be supplied from the same contractors who supplied the
Hillside smelter under similar long-term contracts
Sovereign risks
Expropriation risks:
- Outright seizure of assets – very unlikely:
- The scale of the project relative to the size of the poor economy (9% of
GDP), combined with short-term survival concerns may be tempting for
a shortsighted Gov’t to expropriate
+ Gov’t wouldn't want to curb the investments, because they are
interested in development
+ Gov’t cannot afford an outright seizure, due to potential reactions from
WB/IFC, as this would jeopardize the much needed future development
funds
+ Following a direct seizure, international suppliers may not be willing to
work with the Gov’t, and Mozambique does not have local suppliers of
the raw materials to go on with the business alone
Sovereign risks
Expropriation risks:
- Seizure of cash flows (diversion) – low risk:
- Gov’t may divert the aluminum and sell it to others
+ However, the spot market for aluminum is very thin for Gov’t to divert
and easily sell the output
+ Potential reactions from WB/IFC
- Changing of taxation – creeping – moderate risk:
- Gov’t may remove the privileges that the smelter would be exempt from
customs duties and income taxes
- It is highly likely that the Gov’t may change the 1% sales tax, which is
more critical than the income tax
Sovereign risks
Political events:
– Political instability
– Risk of war: not completely eliminated
– Legal instability
– Bureaucratic hurdles
– Underdeveloped infrastructure
– Unskilled / untrained labor
Macroeconomic risks:
– Currency exposure:
+ Not a major risk as the major inputs and all the output would be
denominated in $.
– Convertibility risk:
+ Not a major risk since the proceeds will be kept at an overseas
trustee
Sovereign risks mitigation
Sovereign risk was the most important reason that Gencor/Alusaf chose to finance the project via
project financing, as opposed to corporate financing, in order to minimize their risk exposure and be
able to raise capital.
Project was structured in the following way to ensure that an expropriation would have international
consequences, and also lenders would be comfortable enough to participate in the project:
– As much as IFC involvement was the critical issue, securing political risk insurance
was important as well to provide comfort to potential lenders:
+ Political risk insurance is an instrument to help shift (not mitigate) the political
risks (like expropriation, war, breach of contract, or currency inconvertibility) to
parties that are best able to bear it
+ PRI providers generally have a more diversified portfolio than banks to
absorb these risks
+ PRI providers are more competent in analyzing sovereign risks, whereas
commercial banks in analyzing commercial risks
+ A French ECA supporting the use of the French technology was expected to
provide 85% insurance for loans from French banks, and IDC was in advance
discussions with the South African ECA for insurance for $400 M senior debt
+ The French ECA may be more willing to bear the political risk than banks
do because it attaches a higher value to the project in order to be able to
export the technology
+ Similarly, the South African ECA may be more willing to bear the political
risk than banks do because it attaches a higher value to the project in
order to be able to promote the south African exports
Real options
• Option to expand
+ Mozal would be constructed with all the infrastructure to double the capacity
when needed.
The role of IFC
• IFC approved the $120M investment in 1997, its largest investment by then
• In 1998, Project Finance International declared Mozal as the “Industrial Deal
of the Year”
• Construction temporarily stopped in 1998 when workers went on strike to
protest low wages and poor working conditions
• Workers on strike held management hostage in 1999
• Despite the ongoing strike, the project proceeded as planned, and was in
fact on time and below budget
• Critics argued that the sovereign risk had been too high, showing the strike
as evidence
• Critics also defended that sponsors were treated too generously in the deal
compared to Mozambique
• Despite the criticisms, the Mozal project appeared to set the stage for an
inflow of additional private investments in Mozambique in the final analysis
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project Valuation
4. Case analyses
5. Recap
Recap - Type of assets/projects and
appropriate method of financing:
Corporate Finance:
– When the asset is less than perfectly correlated to the rest of
company’s asset portfolio, corporate financing may help eliminate
idiosyncratic risks via diversification
– When the sponsor has strong balance sheet to secure debt in
favorable terms, and a vertically integrated business model (which
minimizes variability)
– When the sponsor is better equipped than anyone else in assessing
and bearing risks
– Corporate finance is preferred when it results in lower combined
variance due to diversification (co-insurance).
– When the benefits of above told co-insurance outweighs cost of risk
contamination
Recap - Type of assets/projects and
appropriate method of financing:
Project Finance:
– Discrete, non-core assets that can be separated from the rest of the
business) Example: power plants
– Large, highly risky projects with cash flows highly correlated with those of
sponsor (no benefits from diversification under one portfolio)
– Projects appropriate for high leverage (those with predictable cash flows,
low distress costs, and minimal ongoing investment requirements)
– Projects that are more transparent and easier to monitor during
construction, development, and ongoing operations (transparency can
lower cost of capital by facilitating credit decisions)
– Projects with a structure that minimizes overall costs associated with
market imperfections
– When it is possible and cost effective to allocate the project risks
contractually
– Projects whose cash inflows and outflows can be set by long-term
contracts (to reduce variability)
Recap - Type of assets/projects and
appropriate method of financing:
Project Finance:
– For oil industry, production projects, rather than exploration or development: Banks
generally reluctant to lend on project basis until the underlying stock/flow is proven
and capable of production ( reducing variability and risk)
– High risk projects such as first-time investments in new industries, markets,
technologies: project finance may bring added discipline and access to
experienced partners
– Projects exposed to high degree of sovereign/political risk may benefit from the
existence of outside lenders in project finance structure: host governments cannot
risk project due to potential reaction from international finance community
– Project financing may help accommodating critical partners (such as governmental
agencies) who cannot finance their shares via corporate borrowing (Joint venture
projects)
– Project finance is preferred when it results in higher combined variance when
added to corporate portfolio
– When firm value decreases due to cost of financial distress which increases with
combined variance.
– Project finance is preferred when cost of risk contamination exceeds the benefits
of co-insurance.
– When creation of an independent entity allows project to obtain tax benefits not
available to sponsors
Acknowledgements
The content of this presentation has been derived from: