Project financing
• Raising of funds to finance an economically separable
legal entity
• Sources of funds - lenders, equity investors/ sponsors,
subsidies and aids
• Project cash flows service debt and provide returns to
equity investors
• Government and other agencies providing subsidies and
aids look forward to the project’s economic, social and
environmental benefits
Government subsidies and assistance
• Capital subsidy
• Tax break / Tax holiday
• Exemption or reduction of import duty
• Export credit financing – direct loan, loan guarantee and
insurance
• Grant of land free of cost or at a nominal price
• Assurance of availability of raw materials, power etc.
• Assurance of output off-take for a guaranteed price and
duration
• Infrastructural support at no or nominal cost
• Arranging finance at concessional rates
• Accelerated depreciation for tax benefits
Basic elements of project financing
Lenders
Debt Debt
funds repayment
Raw Purchase
materials contracts
Supply Output
contracts
Equity Returns to
funds investors
Equity
investors
Project financing vs. direct financing
• In direct financing
– project assets and liabilities are integrated into the
sponsor’s balance sheet
– lenders look to the firm’s entire asset portfolio to
generate the cash flow to service their debt
– loans are often unsecured
• In project financing
– project assets, liabilities and cash flows are
segregated from the sponsoring entity
– project assets are pledged to secure loans
– lenders have no recourse or limited recourse to cash
flows from the sponsor’s other assets not part of the
project
Special Purpose Vehicle (SPV)
• A separate legal entity
• It has a finite life since a project’s life is finite
• Project cash flows are distributed to lenders and
equity investors
• Equity investors make reinvestment decisions unlike
in direct financing where corporate managers may
retain cash flows from profitable projects and/or
reinvest in other projects of their own choice at the
expense of lenders’ and shareholders’ interests
Advantages of project financing
• More efficient in terms of allocation of
financial risks and returns
• Project ownership and better management
control and monitoring
• Performance-linked compensation
• Reduction of the underinvestment problem
• Reduction of information asymmetry and
signaling cost
• Reduction of agency cost
Advantages of project financing
• Enhancement of shareholder value
• Highly leveraged capital structure
• Lower overall cost of funds
• Ability of the project sponsor to negotiate
with equity investors to invest free cash
flows in other seemingly profitable projects
so that the dividend requirement can be
waived
• Reduction of dispute resolution and legal
or regulatory costs
Disadvantages of project financing
• Complex structure of financing
– requires negotiations by all parties
– generally involves more cost and time
• Lenders have no or limited recourse to the
sponsor’s other assets
• Project-related information has to be shared
with lenders and investors for arranging finance
that may reduce the sponsor’s competitive
advantage
Project appraisal
• Project feasibility • Risk assessment
– Completion
– Technical
– Technological
– Commercial – Supply of raw
materials
– Economic – Economic
– Financial – Financial
– Currency
– Managerial – Political
– Force majeure
Technical feasibility
• Product, process, technology, technical
specifications
• Detailed engineering work, capacity and
possibility of expansion
• Details of cost projections and escalation
factors
• Project time schedule and milestones
– Land acquisition, infrastructure development,
approvals from government departments etc.
Technical feasibility
• Supply of raw materials, power, water etc.
• Details of plant, machinery, equipment etc.
• Transport and communication facilities
• Housing, education, healthcare, recreation
etc., if applicable
• Pollution control, effluent / waste disposal
• Requirement and availability of manpower
• Consultation with external specialists
Commercial feasibility
• Projection of demand for project’s output
– Market survey for project’s output
– Demand forecasts of industry associations
• Evaluation of the project firm’s advertising,
sales promotion, warehousing, distribution
and other marketing aspects
• Incorporation of forecast information into
project time, cost and other parameters
Economic feasibility
• Break-Even Analysis
• Net Present Value
• Internal Rate of Return
Break-Even Analysis
• Break-even volume is given by
Unit contribution × Break-even volume = Total
fixed costs
• Margin of safety = Installed capacity – Break-
even volume
Economic feasibility
Net Present Value (NPV)
• NPV is given by the present value of all future cash flows minus
the initial investment
n
CFt
NPV = ∑ −I
t =1 (1 + r )
t
Where
NP = Net proceeds, i.e. gross proceeds minus
floatation expenses such as underwriting fees,
legal fees etc.
C = Interest + principal payment
L = Length of the loan period
Economic feasibility
Cost of equity, re, can be obtained by using
the Capital Asset Pricing Model (CAPM):
re = rf + β (rm - rf)
Where
rf = Risk-free rate of return
rm = Return on market portfolio
β = Riskiness of asset
rm-rf is called the market risk premium
Economic feasibility
Example
Investment = 100, Debt : Equity = 60:40
Useful life = 2 years, C1 = C2 = 34.48
CF1 = 48, CF2 = 74, Tax rate = 0.30
rf = 0.08, rm = 0.2, β = 1
Cost of debt:
34.48 34.48
60 = + ⇒ rd = 0.1 or 10%
(1 + rd ) (1 + rd ) 2
arranged by promoter 5
– Term loan 70
» Total debt 75
» Project cost 100
Financial feasibility
– Promoter’s contribution = promoter’s equity +
unsecured loan arranged by promoter = 10 +
5 = 15; promoter’s contribution = 15%
– Debt-equity ratio = 70:30 = 2.33:1 < 3:1
– Public issue = 40%, promoter’s equity = 60%
• Equity
– Promoter’s contribution 10
– FI’s contribution 5
– Public issue 10
» Total equity 25
• Debt 75
» Project cost 100
Managerial feasibility
• Experience and track record in previous
similar projects
• Seriousness and financial soundness
• Technical background and competence
• Capabilities of key management personnel
• Review of staff assigned to the project
• Site visits and joint study with the project
teams of financial institutions and experts
• Financial institutions’ nominees on Board
Risk assessment
• Completion risk
– Inaccurate cash flow projections
– Technical infeasibility / Environmental issues
• Technological risk
– New / unproven technology
– Technological obsolescence
• Raw material supply risk
– Price and availability of raw materials during
the loan repayment period
Risk assessment
• Economic risk
– Demand may not pick up as expected
– Price realization may not match expectation
– Operating cost may shoot up due to inflation
– Volatility in foreign exchange rates may have
adverse impacts on operations
– Servicing debt and providing returns to equity
investors may be difficult after meeting costs
– Can be hedged by entering into forwards and
futures contracts with suppliers and buyers
Risk assessment
• Financial risk
– Floating rate of interest
– Interest rate cap contract
– Interest rate swap agreement
Loan Pay 8%
Swap
Bank Project counterp
arty
Pay LIBOR + 1% Receive LIBOR
Risk assessment
• Currency risk
– If revenue realization and debt servicing are
denominated in different currencies, varying exchange
rates may affect cash flows
– Remedies – (i) revenue, cost and debt are in the same
currency, (ii) hedging with currency forwards or
futures, and (iii) currency swap