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Why should a company segregate the cash flows from a particular business, and make it self financing?

Swapnil Potdukhe (89) Rashi Jain (100) Group Members Shraddha Ghag (117) Vrinda Mohan (142)

UK based worlds 3rdlargest Oil & Gas giant Operations in 70 countries 56,000 employees CEO Sir John Browne Assets $ 54.6 bn. Revenues $ 71.3 bn. Profits $ 4.1 bn. (1997)

US based worlds 6rdlargest Oil & Gas giant Operations in 25 countries 43,000 employees CEO H Lawrence Fuller Assets $ 32.5 bn. Revenues $ 31.9 bn. Profits $ 2.7 bn. (1997)

British Petroleum

Amoco Corporation

In spite corporate rivalry, both agreed to a $48 billion merger in 1998 to form BP Amoco

to create financial synergies required to fund capital intensive projects.

Cost saving of $2 billion annually Complementary commercial strength BP in upstream operation , Amoco in downstream Sustainable long term growth & strong competitive return Debt to capitalization ratio-30% , target pay-out ratio 50%

Global HQ in London with Sir John Browne (BP) as CEO H Lawrence Fuller (Amoco) & Peter Sutherland (BP) as non exe co-chairman Finance Group: CFO: John Buchanan (BP) Treasurer: David Watson (BP) Head Specialized Finance: Bill Young (Amoco) Both companies had highly centralized finance functions with preference for corporate financing over project financing.

Goal: To work out new financing policy for the merged entity. Process: Watson & Bill sought opinion of finance executives of both the firms regarding their take on project finance vis--vis corporate finance. BP sparingly used project finance Amoco too, believed in corporate finance more. But they sometimes used project finance.

Long term financing of the project in which lenders are totally reliant on the assets and cash flows of that project for interest and loan repayment

Fund projects off balance sheet and cash flows are separated from parent company The financier usually has little or no recourse to the nonproject assets of the borrower or the sponsors of the project
A special purpose entity is created with limited liability which borrows funds directly and pledges its assets and cash flows to support the loan, thereby shielding other assets owned by a project sponsor from the detrimental effects of the project failure

Project financing has been most commonly used in the extractive mining, transportation, telecommunication and energy industries. Component of debt is very high

Firms bear deadweight costs (DWC) when they invest in and finance new assets. DWCs result from market imperfections. They include:
Agency costs and incentive conflicts Asymmetric information costs Financial distress costs Transaction costs Taxes

Sponsors should use project finance whenever the DWC are lower than their corporate finance counterparts To manage risks more effectively and more efficiently.

The Capital Structure is irrelevant as long as the firms investment decisions are taken Then why do corporations:

Set up independent companies to undertake mega projects and incur substantial transaction costs Finance these companies with over 70% debt inspite of the projects typically having substantial risks and minimal tax shields

- Symmetric risks including: market risk (quantity), market risk (price), input or supply risk, exchange, interest and inflation rate risks, reserve risk, throughput risk. Exposures to symmetric risks causes larger positive and negative deviations from the expected outcome. - Asymmetric risks including: environmental risk, expropriation risk. These risks cause only negative deviations in the expected outcome. - Binary risks including: technology failure, full expropriation, counterparty failure, regulatory risk, force majeureThese risks increase the probability that an asset ends up worthless.

In practice, projects have relatively low asset risk allowing a high debt capacity. The use of leverage introduces financial risk which allow equity-holders to capture unlimited upside once debt claims have been satisfied

Financing vehicle Secured debt Subsidiary debt

Similarity Collaterized with a specific asset

Dis-similarity Recourse to corporate assets Possible recourse to corporate balance sheet

Asset backed securities LBO / MBO Venture backed companies

Collaterized and nonrecourse High debt levels Concentrated equity ownership

Hold financial, not single purpose industrial asset No corporate sponsor Lower debt levels; managers are equity holders

Project Finance (PF) v/s Corporate Finance (CF)

Project finance allows firms:

to minimize the net costs associated with market imperfections such as: incentive conflicts, asymmetric information, financial distress, transaction costs, taxes.

to manage risks more effectively and more efficiently.

Purpose: a single purpose capital asset, usually a long-term illiquid asset. The project company is dissolved once the project is completed. No growth opportunities. A legally independent project: the project company does not have access to the internally-generated cash flows of the sponsoring firm and vice versa. The investment is financed with nonrecourse debt. All the interest and loan repayments come from the cash flows generated from the project. Project companies have very high leverage ratios, with the majority of debt coming from bank loans.

A company invests in many projects simultaneously. The investment is financed as part of the companys existing balance sheet. The lenders can rely on the cash flows and assets of the sponsor company apart from the project itself. Lenders have a larger pool of cash flows from which to get paid. Cash flows and assets are cross-collateralized. Publicly traded firms have typical leverage ratios of 20% to 30%.

Project Finance

Corporate Finance

Financing decisions matter under imperfect/inefficient markets. Firms bear deadweight costs (DWC) when they invest in and finance new assets.
DWCs result from market imperfections. They include:

agency costs and incentive conflicts asymmetric information costs financial distress costs transaction costs taxes

DWCs change under alternative financing structures, i.e., corporate finance versus project finance. Sponsors should use project finance whenever the DWC are lower than their corporate finance counterparts.

Project finance reduces costly agency conflicts: -Conflicts between ownership and control - Conflicts between ownership and related parties - Conflicts between ownership and debtholders

Project finance reduces information costs (asymmetric information). Project finance reduces costly underinvestment, in particular leverage-Induced underinvestment. Project finance, as a organizational risk management tool, reduces the potential collateral damage that a high risk project can impose on a sponsoring firm, i.e., risk contamination. It also reduces the costs of financial distress and solves a potential underinvestment problem

Project company is dissolved once the project gets completed. No future growth opportunities. Cash flows of the project are separated from cash flows of sponsors. The single discrete project enable lenders to easily monitor project cash flows. The verifiability of CFs is enhanced by the waterfall contract that specifies how project CFs are used.

Company invests in many projects and possesses many growth opportunities. Cash flow separation is difficult to accomplish in corporate finance. Project cash flows are co-mingled with the cash flows from other assets making monitoring of cash flows difficult. The verifiability flows is difficult. of cash

Project Finance

Corporate Finance

Monitoring mechanisms include: Managerial discretion is constrained by extensive contracting. Claims on cash flows are prioritized through the CF waterfall. Concentrated equity ownership provides critical monitoring, The unique board of directors and separate legal incorporation makes monitoring more simple and efficient. High leverage both the amount and type (maturity); Bank loans provide credit monitoring.

Traditional monitoring mechanisms include:


Takeover market Product market

Reputation
Staged investment Leverage: high debt service forces managers to disgorge free cash flows.

Creditors rights: lenders threat to seize collateral and threat of liquidation to deter borrowers opportunism.

Project Finance

Corporate Finance

Problem of Hold Up & Expropriation


Standard Approach Vertical Integration Long term contracts, with contract duration increasing with asset specificity. To avoid Expropriation High Visibility High Leverage Project Finance Approach Joint Ownership High Level of Debt

To avoid Expropriation Multilateral lenders Joint Ownership

Problem - Debt/Equity holder conflict in distribution of cash flows, re-investment and restructuring during distress. High leverage can lead to risk shifting and underinvestment
Project Finance Approach

Standard Approach

Strong debt covenants allow both equity/debt holders to better monitor management

Concentrated ownership ensures close monitoring and adherence to the prescribed rules

To facilitate restructuring, concentrated debt ownership, less classes of debtors, and bank debt, are preferred. Bank debt is much easier to restructure than bonds Opportunities for risk shifting do not exist because the cash flow waterfall restrict investment decisions.

Problem- .Insiders know more about the value of assets in

place and growth opportunities than outsiders. Asymmetric information increases monitoring costs and increases cost of capital (equity is more costly than debt).
Project Finance Approach Segregated cash flows enhance transparency, which decreases monitoring costs Segregation eliminates the need to analyze other corporate assets or cash flows. Creditors can analyze the project on a stand-alone basis. Project structure reserves the sponsors debt capacity/ flexibility to fund higher risk projects internally

Standard Approach Disclosure

Analyst-relationship

Signaling

Debt Overhang: Firms with high leverage, risk averse managers


and asymmetric information have trouble financing attractive investment opportunities. This leads to under investment in positive NPV projects due to limited corporate debt capacity as new debt is limited by covenants.
Project Finance Approach Non recourse debt in an independent entity allocates returns to new capital providers without any claims on the sponsors balance sheet. This preserves scarce corporate debt capacity and allows the firm to borrow more cheaply than it otherwise would. Project finance is more effective than secured debt because it eliminates recourse back to the sponsoring firm.

Standard Approach Use of secured debt, senior bank debt, new equity (raised at a discount).

A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility, the expected costs of financial distress, and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it.
Standard Approach Hedging, or foregoing the project (under-investment) Project Finance Approach Exposes losses only to the extent of equity commitment Sponsors can share project risk with other sponsors. Pooling of capital reduces each providers distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced

Reduces the probability of distress both at sponsors and project level.

Tax: An independent economic entity allows projects to obtain tax benefits that are not available to the sponsors. When a project is located in a high-tax country and the project company in a lower tax country, it may be beneficial for the sponsor to locate the debt in the high tax country. Location: Large projects in emerging markets cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. Debt is the only option and project finance is the optimal structure. Heterogeneous partners: Financially weak partner needs project finance to participate. The bigger partner is better equipped to negotiate terms with banks than the smaller partner and hence has to participate in project finance.

Overall Advantage to BP Amoco from project finance can be explained by 2 charts

Example: BP AMOCO The Corporate Finance Model


BP Amoco Long-term Financing: Bonds Equity Short-term Financing: Commercial paper Bank loans Cash Management and Money Market Instruments
$400m
40% of Cash Flow

Business Units

Operating Cash Flow

Treasury Group

Partner A 25% share

$250m 25% of Cash Flow

Project Cost = $1 billion

$350m 35% of Cash Flow

Partner B 35% share


25

Example:BP AMOCO The Project Finance Model


BP Amoco

Partner A 25% share

Partner B 35% share

Treasury Group (40% share)

Business Units

$140 million equity

$160 million equity 40% of operating cash flow

$100 million equity

$300 million secured loan

Banks
payback+interest

Project Cost = $1 billion Equity = $400 million Debt = $600 million


Government

$300 million secured loan

144A A Bond Market


payback+ Interest

Contractors

Suppliers

International Org.

26

Total Investment = $2 Billion Corporate Finance (Exhibit 6A)


BP Amoco (Investment) BP Amoco Subsidiary (DV=60%) BP Amoco (Own Resources like Business Units) BP Amoco Debt (Proportioned to its DV=30%) Partner A Partner B Direct Debt (DV=60%) 0.8 0.56 0.24 0.7 0.5 -

Project Finance (Exhibit 6B)


0.32 0.224 0.096 0.28 0.2 1.2

Project Finance (Exhibit 6C)


0.32 0.48 0.224 0.096 0.7 0.5 -

Total Returns = $4 Billion BP Amoco (Investment) BP Amoco Subsidiary BP Amoco (Own Resources like Business Units) BP Amoco Debt (Proportioned to its DV=30%) Partner A Partner B Direct Debt Return on own Equity employed for BP Amoco

Corporate Finance (Exhibit 6A) 1.6 1.576 0.024 1.4 1 281%

Project Finance (Exhibit 6B) 1.528 1.5184 0.0096 1.337 0.955 0.18 678%

Project Finance (Exhibit 6C) 1.528 0.072 1.5184 0.0096 1.4 1 678%

Investment Share BP Amoco: 40% Partner A : 35% Partner B : 25%

Project is viable for only 1 year


Initial Investment is $2 Billion and Operating profit is $4 Billion

Corporate Loans at 10% p.a. while project loans 15% p.a.


All numbers used are in $ Billion

BP Amoco should use internal corporate funds to finance new projects except in three particular circumstances
In most situations, costs outweighed the benefits for BP Amoco

Mega Projects
Projects large enough to harm companys earnings, debt ratings, and in the extreme case survival

Projects in Politically Volatile Areas


High degree of political risk: War, Strikes, Sabotage, Lack of property rights, direct or creeping expropriation, or currency inconvertibility Host country less like likely to take or tolerate hostile action against project Commercial lenders would lend only if MLAs like EBRD and ADB or an ECA was involved

Joint Ventures with Heterogeneous Partners


Host governments or their agencies could be participants in the project without the will to use or lack of large funds

Senior Management begins to feel uncomfortable about the size and level of risk

Partners with weak balance sheets couldnt raise the required amounts on their own
Negotiate with lenders by itself rather than letting weaker partners negotiate which would give BP Amoco more leverage in decisions

Exceptions

Quantify the incremental costs and benefits of using project finance A project with positive NPV using a pre-determined corporate WACC and assuming debtto-capitalization ratio of 30% Business Unit

Various financial structures using an incremental cost analysis

Specialized Finance Team Financing NPV was generally negative

Estimate incremental, after-tax cash flows associated with fees, interest, and principal payments and discount these cash flows at the firms marginal cost of debt

Financing NPV when combined with investment NPV and other possible benefits, the result could be positive

Finance Group Recommend project finance and seek approval for chosen structure

No. In our view BP Amoco should use project finance as far as possible instead of corporate finance for its downstream or upstream businesses alike.

Risk associated with projects in Oil & Gas industry is very high. Huge investments in the initial stages with no guaranteed returns. BP Amocos revenues & net profit declined by ~26% & ~46% respectively on a Y-o-Y basis in 1998. Capital expenditure is very high ~$10 billion. It also has long term debts above $10 billion.

BP Amoco doesnt have substantial cash reserves to fund projects in the range of $0.5-2.0 billion. Most of its current assets are in the form of accounts receivables which mainly would be used for paying back the current liabilities. BP Amoco also pays substantial part of its profits to its share holders in the form of dividends, a crash crunch may occur if corporate finance is used and the investment required is substantially high.

BP Amoco already has a high debt to capital ratio compared to Royal Dutch Shell & Exxon. Any further debt for providing corporate finance may not be appreciated by the market. Any loss or abandonment of the new project would have a direct recourse on BP Amoco as a whole and can impact its market capitalization.

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