Overview of Project Finance

What is a project?

– A set of well defined activities , clear cut beginning and end

– Having a desired objective/ outcome.
– Consumption of large amounts of money
– Limitations on resources
– Not undertaken frequently
–

– Definition:
○ Channelizing predetermined amounts of money to generate
something that will assist the organization in designing and
executing its strategies.
Project idea

What is project appraisal?

– A process of analyzing the technical feasibility and economic viability of a

project proposal with a view to financing their costs.

Importance of project appraisal

– It is a capital investment decision
– It has long term effects
– Decision once taken is irreversible
– Expenditures are high

Difficulties in respect of project appraisal

– Measurement of costs and potential benefits are difficult
– High degree of uncertainty
– Long term spread – time value of money

Types of projects
– Mandatory investment (to comply with statutory requirement)
– Replacement investment
– New projects
– Expansion projects
– Diversification projects
– Research and Development projects
– Public good /social welfare projects
– Infrastructure projects

Project Financing

○ In India barring infrastructure projects , project financing is identical

to corporate financing
 Balance sheet based financing
  Project financing is based on the credit worthiness of the
sponsor (company or the body proposing the business idea
to launch the project )
 Such loans are secured by not only the pool of assets created
out of the project but also the existing assets of the sponsor.

○ However in Western Economies the term “ Project Financing “

connotes financing that as a priority does not depend on the
soundness or creditworthiness of the sponsors .
○ Instead, it is a function of the project’s ability to repay the debt
contracted and remunerate capital invested at a rate
commensurate with degree of risk associated with the project.

Modern definition of project finance

○ Structured financing of a specific economic entity, the SPV created
by sponsors using equity or mezzanine debt and for which lenders
consider cash flows as the primary source of loan repayment,
whereas assets represent only collateral .

○ Distinctive features
 The debtor is a project company
 Lenders have only limited recourse or no recourse to the
sponsors
 Sponsors involvement in the deal is limited in terms of time,
amount and quality.
 Project risks are equitably allocated between all parties with
the objective of assigning risks to those parties who are best
able to control and manage them.
 Cash flows generated by the SPV must be sufficient to cover
payments for operating costs and to service debt.
 Only residual funds after servicing debt are payable to the
sponsors.
 Collateral is given by the sponsors to lenders for receipts and
assets tied up in managing the project.

Difference between project finance and corporate finance/ Pros and cons
of “project financing “ vis a vis corporate financing

Project Financing Corporate Financing

Transaction costs for High LOW
borrower
Guarantees for financing Heavily reduced only High , existing
from sponsors viewpoint project assets assets also
encumbered
Financial elasticity for the No significant reduction Reduced
sponsor or constraint significantly
Accounting treatment for Off balance sheet On balance sheet
sponsor
Permissible leverage (D/E High Low (depends upon
ratio) borrowers balance
 sheet)
Appraisal criteria Cash flows generated Customer relations.
by the project Solidity of balance
sheet
Overall Profitability

Two relevant issues in choosing between Corporate Financing and

Project Financing

– Avoidance of contamination risk

○ Where the size of the proposed project is very large compared to
size of the existing operations
○ Where the project means of financing involves higher leverage (D/E
ratio)
○ In such a scenario with traditional Corporate Financing the
failure of the project (inability to yield ROI higher than WACC of the
project) can pull down even the existing operations of the sponsor
and jeopardize returns to existing shareholders.
○ Failure of the new project leads to failure of existing operations and
failure of the business
○ In such cases project financing option is preferable

– Conflict of interest between sponsors and lenders and wealth

expropriation

○ However project financing will not provide the co-insurance benefit

to the creditors.
○ This would happen in a case where the project fails but the existing
operations continue to perform.
○ The absence of contamination effect saves the existing creditors
and shareholders but the new creditors lose as they do not partake
the benefits of existing operations.

– Categories of project sponsors

○ Industrial sponsors
○ Public sponsors with social welfare goals
○ Contractor/sponsors who develop , build and run the plant
○ Pure financial investor

– Key contracts used in project finance deals

○ Turnkey construction contract
○ Operations and maintenance contract
○ Purchasers and sales agreement
○ Suppliers and raw material supplies agreement

– Risk Management aspects

 ○ Project finance is seen as a system for distributing risk among
parties involved in the venture.
○ Risk allocation works as per the following model
 Allocation to SPV counterparties
 Allocation to insurers
 Residual risk borne by SPV
 Loans raised for financing by SPV are priced accordingly.

The market for project finance

Historical Evolution

X –axis market and /or technology risks

Y- Axisdenotes country risks

High country risk and High country risk

low and High
market/technology market/technology
risk risk
– Industrial plants
– Mining
– Oil and gas
– Power generation
Low country risk and Low country
low riskand high
market/technology market/technology
risk risk
– Industrial plants – Toll roads
– Mining – Telecom
– Oil and gas – Rail and infrastructure
– Power generation – Hotel/leisure
– Water and sewerage
– PPPs
 Market for Project Finance

Country -wise 2003-06 (aggregate) 2008

Value of Project Finance (US$ 461.68 250.8
billion)
Share of Americas 22.30% 16.75%
Share of central Asia and Asia 17.29% 28.02%
Pacific
Europe 38.78%
Africa/Middle East 18.11%
Others 3.52%

Sector-wise (%) 2003-06 (aggregate)

Energy and power 49.5%
Industrials 25.2%
Materials 8.0%
Financials 4.8%
Telecommunications 3.9%
Others 8.6%

Project life cycle and its impact on feasibility

○ Conception and selection phase

○ Planning and scheduling phase
○ Implementation, monitoring and control phase
○ Evaluation and termination phase

– Life cycle impact on feasibility Impact on feasibility

○ Uncertainty regarding cost and time estimates in respect of later
stages
○ Estimates need to be adjusted and revised periodically depending
on the lessons leant in the earlier cycles.
○ Typically the focus of project managers is initially on performance,
and then shifts to costs and finally meeting the deadline. But focus
should be on performance fro the beginning.