Dimitrios V.

Siskos

Basics of Project Finance

To: Dr. Igor Gvozdanovic

May 14, 2014

This paper is submitted in partial fulfillment of the requirements for Project Finance (Doctorate of
Finance)

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Contents

Contents.................

List of tables.............. 3

Abstract..............

Introduction- Project Finance and its relation to fund investments........ 5

The Advantages of Project Finance over traditional corporate finance/..

The major short-comings of project finance..

A typical project finance transaction.. 7

References....................... 9

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List of Tables
Number

Page

Figure 1: A typical Project Finance transaction...... 9

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SMC Working Papers

Basics of Project Finance

Siskos V. Dimitrios
Swiss Management Center (SMC) University
May 14, 2014

Abstract
The term project finance is used mostly by entrepreneurs, bankers and authors to describe a range of
financing arrangements. Project financing is an innovative and timely financing technique that has been used
on many high-profile corporate projects, including Euro Disneyland and the Eurotunnel (Finnerty, 1996).
The core of a project financing is typically the project company, which is a Special Purpose Vehicle (SPV)
that consists of the consortium shareholders (Fight, 2006). This paper examines the reasons why project
financing is relied on to fund investments, it determines the advantages over traditional corporate finance as
well as the major short-comings, and last it describes a typical project finance transaction.

Keywords: Project, Project Finance, Corporate Finance, Risk, Special Purpose Vehicle.

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Introduction- Project Finance and its relation to fund investments

In recent years project finance has become an increasingly popular method of funding long-term capital
intensive infrastructure projects like highways, Eurotunnel, metro systems, or airports worldwide (Girardone
and Snaith, 2011). It is a technique that has been used to raise huge amounts of capital in which traditionally
only the cash flows generated by the project serve as the source of loan repayment and only the project assets
serve as collateral1 to a non recourse loan. There are two basic types of project financing: limited and nonrecourse. In the case of limited project financing, lenders look mainly at the cash flows of a project to repay
debt service, but permit creditors and investors some recourse to the sponsors for repayment (Akbiyikli et al.,
2006). In non-recourse project financing, lenders look solely on the anticipated cash flows of the project, and
credit appraisal is independent of the creditworthiness of the project sponsors (Fight, 2006).
Therefore, project finance encourages new investment by structuring the financing around the project's
own operating cash flow and assets, without additional sponsor guarantees. Thus, the main reason which the
project financing is relied on to fund investments is its ability to alleviate investment risk and to raise finance
at a relatively low cost, to the benefit of sponsor and investor alike (Ahmed, 1999). However, in recent years
the economic and financial crisis has impaired the ability of the financial sector to channel funds to the real
economy, in particular long-term investment and as such governments seek ways to overcome this fact.
Within this ambit, EU examines the possibility to use the savings of the European Union's 500 million
citizens to fund long-term investments to boost the economy.

The Advantages of Project Finance over traditional corporate finance

To understand the motivations for using project finance, it is needed a thorough understanding of the
main differences between project finance and corporate finance:

Collateral offers some security to the lender in case the borrower fails to pay back the loan.

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1. the legal setup and cash flow separation - Particularly, in project finance there is a limited life to
the project company whereas in corporate finance, the company exists in principle to perpetuity
(Boamah, 2011).
2. the non-recourse financing - In corporate finance, lenders have recourse to both the assets of the
project and the assets of the sponsoring company (Subramanian and Tung, 2007), whereas in project
company, they have recourse only to the cash flows or assets of the project company.
Since project financing is predicated on the equitable allocation of risks between projects stakeholders,
a well defined project provides a number of compelling reasons for stakeholders to undertake project
financing as a method of investment. For sponsors, the key benefit is that they remain a legal entity separate
from the project company, and as such the extent of loss, if any, is limited to the amount of equity invested in
the project company by the sponsor (Gatti, 2008). Additionally, isolating the risk of the project by taking it
off balance sheet2, does not affect the companys investment rating by credit rating analysts.
Another economic benefit pointed out by Esty (2004) and Fight (2006) is the reduction of corporate
taxes, since tax allowances and tax breaks for capital investments etc. can stimulate the adoption of project
finance. Similarly, a project finance structure permits a project sponsor to avoid restrictive covenants, it
prevents of regulatory problems affecting the sponsor and last, it ensures better credit terms as well as lower
interest costs (Fabozzi et al., 2006; Fight, 2006). To conclude, in project finance the cash flows from the
project are separate from that of the sponsors, providing a more transparent cash flow monitoring.

The major short-comings of project finance

While many projects benefit from project finance techniques, this is not always the case. Project
finance can often be complex. Firstly, the large number of participants with diverse interests results in
number of complex transactions and contracts as well as in many conflicts of interest on risk allocation
(Fight, 2006). In addition, the creation of an independent entity along with the need of high level technical
2

Off-balance sheet financing means a company does not include a liability on its balance sheet.

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experts results in higher transaction and administrative costs. Similarly, the complex nature of the transaction
structure may lead into higher interest rates on project financings. Thus, the total costs may reach 7 to 10
percent of total project value (Estache and Strong, 2000).
In order to protect themselves, lenders tend to monitor the project closely restricting managerial
flexibility in the management and operations of the project (Estache and Strong, 2000). Moreover, the nonrecourse nature of project finance means that risks need to be mitigated. However, the non-recourse debt is
typically expensive (50 400 bps higher).

A typical project finance transaction

Project finance transactions play an important role in financing development throughout the world.
However, he complexity that describes the project finance transactions requires numerous contractual
agreements among numerous players involving the sponsors, financiers, contractors, suppliers and off takers
(Hillion, 2011). The core of a project financing is typically the project company, which is a Special Purpose
Vehicle (SPV) that consists of the consortium shareholders (Fight, 2006). SPV provides a good framework
for raising funds, linking participants legally and assuring supply, production and marketing of products
(Chowdhury et al., 2012). It can be structured either as a local project company or a joint venture (JV)3.
The SPV is a separate legal entity, which enters into contractual agreements with a number of other
parties necessary to the project. The parties involved in a project finance transaction are:
Sponsors The sponsors of a project financing is the party that organizes all the other ones and typically
controls, and makes an equity investment in the project company.
Lenders They consist of a group of financial institutions that provide loans to the project company to
develop and construct the project and that take a security interest in all of the project assets. Lenders can also
include bond investors in capital markets.

It is a business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific
task.

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Government usually provides indirect financing through guarantees, take-or-pay contracts, sole provider
licenses and other commitments. The governments objective is to provide affordable and best value-formoney services.
Suppliers and Contractors this involves professional companies which may provide funding to the
project in the form of short- to medium-term debt.
End users they are the receivers of the completed project. Theirs financing can be prepayment for the
future delivery of services.
Figure1 below summaries the structure of a project finance showing the link between the various
parties sponsors, the project company, financiers and the numerous contracts signed (National Treasury,
2001).

Figure 2: A typical Project Finance transaction

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References
Ahmed, P. (1999), Project Finance in Developing Countries: IFCs lessons of experience series No. 7,
(Washington DC,USA:International Finance Corporation).
Akbiyikli, R., Eaton, D. and Turner, A. (2006) "Project Finance and the Private Finance Initiative (PFI)",
Journal of Structured Finance, 12(2), pp. 67-75.
Boamah, K. (2011), The Essential Elements and Issues of Project Finance. Available at SSRN:
http://ssrn.com/abstract=1911111 or http://dx.doi.org/10.2139/ssrn.1911111
Chowdhury, A.N., Chen, Po-Han and Tiong, L.K.R. (2012) Establishing SPV for Power Projects in Asia: An
Analysis of Critical Financial and Legal Factors. Journal of Business Economics and Management,
13(3), 546-566.
Gatti, S. (2008). Project management in theory and Practice. Burlington: Academic Press
Estache, A., & Strong, J. (2000). The rise, the fall, and . . . the emerging recovery of project finance in
transport. World Bank Policy Research, Working Paper, No. 2385. Retrieved from www.ssrn.com.
Esty, B. (2004). An overview of project finance. Boston: Harvard Business School Publishing.
Fabozzi, F., H. Davis, and M. Choudhry (2006), Introduction to Structured Finance, Wiley Finance.
Fight, A. (2006). Introduction to Project Finance. Essential Capital Markets.Elsvier 1st Edition.
Finnerty, J.D., 1996, Project Financing: Asset-Based Financial Engineering. New York, NY: John Wiley &
Sons.
Girardone C. and Snaith S. (2011),"Project Finance Loan Spreads and Disaggregated Political Risk" Applied
Financial Economics, 21(23), pp. 1725-1734.
Graham, J. and Harvey, C., (1999) The Theory and Practice of Corporate Finance: Evidence from the Field.
AFA 2001 New Orleans; Duke University Working Paper. Available at SSRN:
http://ssrn.com/abstract=220251 or http://dx.doi.org/10.2139/ssrn.220251
Hillion, P. (2011). Project finance [PowerPoint slides]. Retrieved May 5, 2014 from www.insead.edu
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10

Subramanian, K.V. and Tung F. (2007, April). Project finance versus corporate finance. Retrieved from
http://swissmc.blackboard.com.
South Africa National Treasury. (2001).Intergovernmental Fiscal Review. Pretoria: South Africa National
Treasury.

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Dimitrios V. Siskos