Project financing

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

Suppliers Project entity Purchasers

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 CF = After tax operating cash flows or

PAT + Non-cash expenses + Interest
r = Weighted Average Cost of Capital
I = Initial investment
n = Useful life of project
 Economic feasibility
Weighted Average Cost of Capital (WACC)
= θ (1-T)rd+ (1- θ )re
Where
θ = Debt as a fraction of investment
T = Tax rate
rd = Cost of debt
re = Cost of equity
 Economic feasibility
Cost of debt, rd, can be obtained by solving the
following equation:
L
Ct
NP = ∑
t =1 ( 1 + rd ) 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

Cost of equity: re = 0.08 + 1(0.2 – 0.08) = 0.2 or 20%

 Economic feasibility
WACC = 0.6×(1-0.3)×0.1+0.4×0.2 = 0.122
or 12.2%
Therefore
48 74
NPV @ 12.2% = + − 100
(1 + 0.122) (1 + 0.122) 2

= 101.56 − 100 = 1.56 > 0

Since NPV > 0, the project is economically viable

 Economic feasibility
Internal Rate of Return (IRR)
• IRR is the rate of return that makes NPV zero.
IRR can be obtained by solving the following
equation:
n
CFt
∑
t =1 (1 + IRR )
t
−I =0

Considering the previous example, IRR = 13.3%

Since IRR > WACC, the project is viable
 Economic feasibility
• NPV and IRR may lead to contradictory
decisions depending on the size and cash
flows of projects
• Considering the previous example, if CF1 =
113.5 and CF2 = 0 for an alternative way of
operation, NPV = 1.16 and IRR = 13.5%
• For size differential, NPV is a better rule
since it adds more wealth
• For cash flow differential also, NPV makes
more realistic reinvestment assumptions
 Economic feasibility
• Social rate of discount and Economic Rate
of Return (ERR)
• ERR is the rate of return when the present
value (PV) of all social benefits equals the
PV of all social costs
• Discrepancies between social valuations
and market valuations occur due to
– Price distortions
– Administered/regulated pricing
 Economic feasibility
– Taxes and duties
– Foreign exchange regulations
– Monopolistic status of the company, etc.
• Social valuations should reflect
opportunity costs of resources, i.e., the
valuations of foregone economic outputs
• Taxes and duties are passed on to the
government. Since they do not consume
resources, they cost nothing to the
society. Hence their inclusions give rise to
price aberrations
 Economic feasibility
• Consider the previous example
Year
0 1 2
Capital cost
Land 8 - -
Plant & M/C 80 10 -
Duties/Taxes 6 4 -
Others 6 6 -
Total 100 20 -
Operating cost - 82 126
Total cost 100 102 126
Revenue - 150 200
Cash flow -100 48 74
 Economic feasibility
• Considering social valuations
– Agricultural land. The present value (PV) of
the agricultural outputs during the project’s
useful life is, say, 5
– Plant & M/C are imported. Say about 20% of
their costs is accounted for by import duties,
which must be deducted
– Duties/Taxes should be removed
– The following table shows social costs, social
benefits and resultant cash flows
 Economic feasibility
Year
0 1 2
Capital cost
Land 5 - -
Plant & M/C 64 8 -
Duties/Taxes - - -
Others 6 6 -
Total 75 14 -
Operating cost - 82 126
Total cost 75 96 126
Revenue - 150 200
Cash flow -75 54 74
 Economic feasibility
• Considering a social rate of discount, 12%
– NPV@12% = 54/1.12 + 74/(1.12)2 – 75 = 32.2
– Economic Rate of Return (ERR) = 40.5%
– Since NPV > 0 and ERR > Social rate of
discount, the project is socially desirable
• If it is an import substitution project and
the imported output would have cost more
to the society, the project would be more
socially desirable
 Economic feasibility
• Suppose now that the project company is
a monopolist, charging 15% more than the
economic worth of the output
• Then social benefits in year 1 and year 2
should be 150/1.15 and 200/1.15 or 130
and 174, respectively
• Also cash flows in year 1 and year 2 would
become 34 and 48, respectively
 Economic feasibility
• Therefore, NPV@12%
= 34/1.12 + 48/(1.12)2 – 75 = - 6.4
• Economic Rate of Return (ERR) = 5.8%
• Since NPV < 0 and ERR < Social rate of
discount, the project is not socially viable
• Hence, a project which is otherwise viable
may not be desirable from the social point
of view
 Financial feasibility
• Inherent value of project assets
– Marketability of assets in case the project fails
• Borrowing capacity/Maximum loan amount
– PV/α where PV represents the present value
(PV) of future cash flows and α is the target
cash flow coverage ratio
• Debt-Equity ratio
– Norms stipulated by financial institutions
– Different for different categories, areas and
sectors
 Financial feasibility
• Promoter’s contribution
– Higher contribution means higher stake and
involvement, and lower debt-equity ratio
– Lower risk to lenders
– Norms may be different for different areas, type of
company (private or public limited)
• Security margin
– Loan is sanctioned against tangible assets
– Financing of intangible assets is promoter’s sole
responsibility
– Security margin - % of tangible assets financed with
promoter’s contribution
 Financial feasibility
• Debt Service Coverage Ratio (DSCR)
– (Operating cash flows – Tax) / (Interest +
principal payments)
– (PAT + Non-cash expenses + Interest) /
(Interest + principal payments)
– DSCR ~ 1.5 – 2 is considered healthy
– If DSCR is too high, loan repayment can be
effected quickly forcing financial institutions to
charge higher rates of interest
– Assumptions should be realistic to keep DSCR
within acceptable limits
 Financial feasibility
• Loan repayment schedule
– Moratorium of, say, 2 years
– Period and instalments depend on cash flow
projections and DSCR
• Syndication
– Group of financial institutions extending loan
• Conversion of debt
– Convertible debenture
– Conversion period and cap on equity holding
 Financial feasibility
• Some examples
– Project cost – 100; Debt-equity ratio – 3:1
– For a private limited company with no capital
subsidy, promoter’s contribution (equity)= 25 and
debt = 75. Promoter’s contribution = 25%
– If capital subsidy is 10, promoter’s equity is 15
• Equity
– Promoter’s contribution 15
– Capital subsidy 10
» Total 25
• Debt 75
» Project cost 100
 Financial feasibility
– Promoter’s contribution drops to 15%
– If debt-equity ratio falls or capital subsidy is
reduced, promoter’s contribution increases
which may necessitate public issues
– Public issue = 60%, promoter’s equity = 40%
• Equity
– promoter’s contribution 10
– Public issue 15
» Total equity 25
• Debt 75
» Project cost 100
 Financial feasibility
– Promoter’s contribution drops to 10%
– Minimum promoter’s contribution = 15%
• Equity
– Promoter’s contribution 10
– Public issue 15
» Total equity 25
• Debt
– Unsecured loan

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

Loan in Rs Pay 10% ($)

Swap
Bank Project counterp
arty
Pay 8% (Rs) Receive 8% (Rs)
 Risk assessment
• Political risk
– New policies, taxes, legal restrictions
– Change of government
• Force majeure
– Acts of God
– Earthquake, fire, flood, cyclone, strike etc.
– Some of the above may get insurance cover
– In case of force majeure, lenders require
sponsors to pledge insurance payments
 Public-Private Partnership (PPP)
• Private participation in infrastructure
projects is sought for
– financing and efficiency
• Issues – ownership, management and
operations, financing, responsibility,
sharing of risks and rewards

Private ownership Government ownership

Govt. control on safety, Private leasing, management
quality, fees charged etc. and operations
 Public-Private Partnership (PPP)
• Build-Operate-Transfer (BOT)
– Private party builds and operates the facility
for a fixed term (concession period) after
which ownership is transferred to the govt.
– Period should be such that capital invested is
recovered and adequate return on capital is
received
– Govt. may have to pay the private party an
amount equal to the remaining value of the
facility upon transfer of ownership
 Public-Private Partnership (PPP)
• Build-Transfer-Operate (BTO)
– Ownership is transferred to the govt. as soon as the
project is completed
– The facility is leased by the private party from the
govt. for a fixed period
– After that the govt. can run the facility itself or again
lease it to a private party
• Buy-Build-Operate (BBO)
– A loss-making govt.-owned unit or a unit in urgent
need of repair or expansion may be bought (with
ownership) by a private party, developed and run as a
profit-making public-use facility
 Public-Private Partnership (PPP)
• Lease-Develop-Operate (LDO)
– The private party leases a govt. facility/land,
develops and operates for a fixed period
– There is a revenue sharing arrangement
between the private party and the govt.
– This is a useful model when the govt. would
not sell the facility or the private party cannot
arrange adequate finance to buy the facility
– This is also a useful model when the facility is
currently losing money
 Advantages of PPP
• Private financing arrangement. Scope for
raising funds through multi-lateral lending
agencies
• Efficient project execution, management
and operations
• Expertise and experience of private party
• Adoption of state-of-the-art technology
• Sharing of risks and rewards between the
govt. and the private party
 Advantages of PPP
• Govt. assistance in acquisition of land,
getting permits and approvals, financing,
assured supply of raw materials, tax/duty
concessions, infrastructural support etc.
• Commercial development of the property
(mall, shopping complex, multiplex etc.)
• Allowing private investments will indicate
govt.’s willingness to attract more private
and foreign investments
 Disadvantages of PPP
• Govt. regulations on fees to be charged.
Returns may not be commensurate with
those of alternative projects
• Uncertainty in demand for/usage of the
facility and hence uncertainty in toll/fee
collection and revenue streams
• Possible competition from comparable
govt. projects