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T H E N E E D F O R C O N T R A C T S One theme is clear. Project nancing arrangements invariably involve strongcontractual relationships among multiple parties.

Project nancing can onlywork for those projects that can establish such relationships and maintainthem at a tolerable cost. To arrange a project nancing, there must be a genuinecommunityofinterestamongthepartiesinvolv e d i n t h e p r o j e c t . O n l y if it is in each partys best interest for the project nancing to succeed willall parties do everything they can to make sure that it does. For experiencedpractitioners, the acid test of soundness for a proposed project nancing iswhether all parties can reasonably expect to benet under the proposed nancingarrangeme nt.Toachieveasuccessfulprojectnan cingarrangement,therefore, the nancial engineer must design a nancing structureand em-body that structure in a set of contractsthat will enable each of the partiesto gain from the arrangement.It seems unlikely that a single theory is capable of fully explaining therationale for every project nancing. Nevertheless, a brief review of the var-ious explanations of the rationale for project nancing can provide valuableinsights. This review will also serve as a useful backdrop for our discussionof project nancing in the remainder of the book. C O U N T E R I N G T H E U N D E R I N V E S T M E N T P R O B L E M The underinvestment problem arises when a rm has a highly leveraged capital structure. A rm with risky debt outstanding may have an incentiveto forgo a capital investment project that would increase its total marketvalue. If the business risk does not change, the rms shareholders wouldhave to share any increase in total market value with the rms debtholders.The underinvestment problem

involves a bias against low-risk projects. (SeeEmery, Finnerty, and Stowe, 2007, page 386.) The Underinvestment Incentive John and John (1991) have developed a model in w h i c h o u t s t a n d i n g debt gives rise to an underinvestment incentive. They analyze how projectnancing arrangements can reduce this incentive, and they identify circum-stances in which project nancing is the optimal nancing structure for aproject. Their model builds on the prior work of Myers (1977), who argued that outstanding debt tends to distort a rms capital investment choices.Risky (i.e., not free of default risk) debt can cause corporate managers topass up positive-net-present-value projects in situations where the projectswould operate to the benet of debtholders but to the detriment of share-holders. For example, suppose that, without the project, the rm could notfully repay its debt under all possible scenarios. However, the project is suf-ciently protable that if the rm undertakes it, the debtholders are assuredof being repaid in full. The debtholders would clearly benet. But the rmsmanagers will only undertake the project if the rms shareholders can ex-pect to realize a positive net present value on their equity investment in theprojectexcluding whatever benet the debtholders realize. Thus, a projectmight involve a positive net present value from the standpoint of the rm asa whole (i.e., debtholders and shareholders taken together) but a negativenet present value from the narrower perspective of its shareholders. In thatcase, the rms managers, who presumably operate the rm for the benetof its shareholders, would decide not to invest in the project.Passinguppositive -net-presentvalueprojectsisno tcostlesstothesha re-holders, however. Prospective lenders will demand a higher rate of returnfor their loans if they nd the rm engaging in such behavior. The higherrate of return represents an agency cost.

Agency costs a r i s e o u t o f t h e competing claims of shareholders and debtholders to corporate assets andcash ow. They occur because security holdings in large corporations arewidely dispersed, and monitoring tends to be costly and therefore incom-plete. For example, lenders can observe the rms overall investment levelbut they generally do not have access to full informa tion regarding spe-cic capital investment projects. Project nancing can alter that situationby enabling lenders to make their lending decisions on a project-by-projectbasis. How Project Financing Can Counter This Bias In John and Johns model, each project can be nanced separately. Alldebt is nonrecourse (although the conclusions would be equally valid if thedebt were only limited-recourse). The economic interests of debtholders andshareholders become better aligned when nancing is accomplished on aproject basis. Debt is allocated between the project sponsor and the projecte n t i t y i n a v a l u e - m a x i m i z i n g m a n n e r . J o h n a n d J o h n c o m p a r e p r o j e c t n a n c - ing to straight debt nancing entirely on the sponsors balance sheet. Projectnancing increases value (1) by reducing agency costs (the underinvestmentincentive is countered) and (2) by increasing the value of interest tax shields.Because more projects are nanced, more debt is issued, and therefore moreinterest tax shields are created. Both factors enhance shareholder value. R E A L L O C A T I N G F R E E C A S H F L O W In the traditional corporate form of organization, the board of directorsdetermines how the free cash ow is allocated between distributions to in-vestors and reinvestment. Free cash ow is what is left over after a companyhas paid all its costs of production, has paid its lenders, and has made anycapital

expenditures required to keep its production facilities in good work-ing order. Generally, when a corporation decides to invest in a new project,cash ow from the existing portfolio of projects will fund the investment inthe new one. Management has the option to roll over the existing portfoliosf r e e c a s h o w i n t o s t i l l n e w e r v e n t u r e s w i t h i n t hecompanylateron withoutnecessarilyexposingitsdecisionstothediscip lineofthecapitalmarket. 6 Thisdiscretion gives corporate management considerable power in determiningthe direction of the corporation. Whether this discretion is misapplied hasbecome an important issue in the debate over shareholder rights. 7 Free Cash Flow and Project Financing Project nancing can give investors control over free cash ow from theproject. Typically, all free cash ow is distributed to the projects equityinvestors. As noted, because a project nancing is specic to a particularpool of assets, the entity created to own and operate it has a nite life.Moreover, the project nancing documents that govern the terms of theequity investments in the project typically spell out in writing the projectentitys dividend policy over the life of the project Why Project Financing Can Be Benecial Jensen (1986) developed the concept of the agency cost of free cash ow.M a n a g e r s , w h e n l e f t t o t h e i r o w n d e v i c e s , m a y n o t b e s u f c i e n t l y d e m a n d i n g when comparing projects that can be nanced internally with other projectsthat must be nanced externally. Giving managers (or boards of directors,w h i c h a r e o f t e n d o m i n a t e d o r c o n t r o l l e d b y t h e

m a n a g e r s o f t h e c o r p o r a t i o n ) the discretion to reinvest free cash ow can result in a loss of shareholdervalue. Forcing the free cash ow to be dispersed exposes the managers of thecorporation to the discipline of the capital market because investors controlt h e u s e s t o w h i c h t h e f r e e c a s h o w w i l l b e p u t . S u c h a s h i f t i n c o n t r o l s h o u l d enhance shareholder value. 8 Project nancing can be benecial because direct ownership of assetsplaces investors in control when the time comes to make reinvestment de-cisions. Giving investors control resolves potential conicts of interest thatcan arise when management has discretion over reinvestment. With projectnancing, funding for the new project is negotiated with outside investors. As the project evolves, the capital is returned to the investors, who decidefor themselves how to reinvest it. How Project Financing Can Solvethe Communication Problem Project nancing provides a potential solution. Managers can reveal suf-cient information about the project to a small group of investors and nego-tiate a fair price for the project entitys securities. In this way, the managerscan obtain nancing at a fair price without having to reveal proprietary information to the public. The danger of an information leak is small be-cause the investors have a nancial stake in maintaining condentiality.According to Shah and Thakor (1987), project nancing is useful forprojects that entail high informational asymmetry costs (e.g., large mineralexploration projects are often project nanced). As Chen, Kensinger, and Martin (1989) note, Shah and Thakors argument does not explain the useof project nancing for low-

risk projects that do not require the sponsor tohold back proprietary information.