1project Financing 1

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The MM Proposition

The Capital Structure is irrelevant as long as thefirms investment decisions are taken as given

Then why do corporations:

Set up independent companies to undertakemega projects and incur substantial transactioncosts, e.g. Motorola-Iridium.

Finance these companies with over 70% debt

even though the projects typically havesubstantial risks and minimal tax shields, e.g.Iridium: very high technology risk and 15%marginal tax rate.


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What is a Project?

High operating margins.

Low to medium return on capital.

Limited Life. Significant free cash flows.

Few diversification opportunities. Asset

specificity.


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What is a Project?

Projects have unique risks: Symmetric risks:

Demand, price.

Input/supply.

Currency, interest rate, inflation.

Reserve (stock) or throughput (flow).

Asymmetric downside risks:

Environmental.

Creeping expropriation.

Binary risks

Technology failure.

Direct expropriation.

Counterparty failure

Force majeure

Regulatory risk


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What Does a Project Need?

Customized capital structure/asset specific

governance systems to minimize cash flowvolatility and maximize firm value.


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What is Project Finance?

Project Finance involves a corporatesponsor investing in and owning asingle purpose, industrial asset

through a legally independent entityfinanced with non-recourse debt.


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Conventional Methods of Financing (1)

Methods of Financing

The two broad choices a firm has for financing aninvestment project are:

1. Equity financing, and

2. Debt financing

Equity Financing:

It can take one of two forms:

- the use of retained earnings otherwise paid

to stockholders,

- the issuance of stock.

Both forms of equity financing use funds invested by

the current or new owners of the company.


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Conventional Methods of Financing (2)

Debt Financing:

It includes both short-term borrowing from financialinstitutions and the sale of long-term bonds, whereinmoney is borrowed from investors for a fixed period.

With debt financing, the interest paid on the loans orbonds is treated as an expense for income-taxpurposes.


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Typical Project Financing Models(1)

The most common structures used to finance projects are:

Project Financing (also known as limited recourse financing),

Corporate Financing, and

Lease Financing.

Project Financing

The term project finance refers to financing structures wherein thelender has recourse only or primarily to the assets of the project andlooks primarily to the cash flows of the project as the source of funds

for repayment.

The terms limited recourse finance and non-recourse finance areused interchangeably with projectfinance.


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Project Financing Definition

A form of financing projects, primarily based

on claims against the financed asset or

project rather than on the sponsor of theproject. However, there are varying degrees

of recourse possible. Repayment is based on

the future cash flows of the project.


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Typical Project Financing Models(2)

Corporate Financing It involves the use of internal company capital to finance a project

directly, or the use of internal company assets as collateral to obtain

a loan from a bank or other lender.

Lease Financing Leasing essentially involves the supplier of an asset financing the

use and possibly also the eventual purchase of the asset, on behalf

of the project sponsor.

Assets which are typically leased include land, buildings, and

specialized equipment.

A lease may be combined with a contract for operation and

maintenance of the asset.


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Project Financing

The raising of funds to finance aneconomically separable capitalinvestment project in which the

providers of the fund look primarily tothe cash flow from the project as thesource of funds to service their loans

and provide the return of and a returnon their equity invested in the project.(Finnerty)


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A financing of a particular economicunit in which a lender is satisfied tolook initially to the cash flow andearnings of that economic unit as thesource of funds from which a loan willbe repaid and to the assets of theeconomic unit as collateral for the loan.

(Nevitt & Fabozzi)


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The financing of long-terminfrastructure, industrial projects andpublic services based upon a non-recourse or limited recourse financialstructure where project debt and equityused to finance the project are paidback from the cash flow generated by

the project. (International ProjectFinance Association)


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A project companyis defined as a group of

agreements and contracts between lenders,project sponsors, and other interested parties

that creates a form of business organization that

will issue finite amount of debt on inception; will

operate in a focused line of business; and willask that lenders look only to a specific asset to

generate cash flow as the sole source of

principal and interest payments and collateral.

(Standard & Poors Corporation)


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Although none of these definitions

uses the term non-recourse debtexplicitly (i.e., debt repayment comesfrom the project company only rather

than from any other entity); they allrecognize that it is an essential featureof project financing


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Project Finance Involves the creation of

a legally and economically independentproject company financed with non-recourse debt (and equity from one or

more corporate sponsors) for thepurpose of financing a single purpose,capital asset usually with a limited life.


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Project financing involves raisingfunds to finance an economicallyseparable capital investment projectby issuing securities or incurring bank

borrowings that are designed to beserviced and redeemed exclusive outof project cash flow.


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Project financing v/s Corporate Financing

It may be termed financing on a firms generalcredit

Conventional direct financing, lenders to the firm

look to the firms entire asset portfolio togenerate the cash flow to service their loans.

The assets and their financing are integratedinto the firms asset and liability portfolios.

Such loans are not secured by any pledge orcollateral.


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The project is a distinct legal entity; projectassets, project related contract, and projectcash flow are segregated to an substantialdegree from the sponsoring entity.

The financing structure is designed to allocatefinancial returns and risks more efficientlythan a conventional financing structure

Project financing, the sponsors provide, atmost ,limited recourse to cash flows from theirother assets, that are not part of the project.

They typically pledge the project assets, butnone of their other assts, to secure the projectloans.


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Characteristics of project Finance

Project financing arrangements invariablyinvolve strong contractual relationship amongmultiple parties

Project financing can only work for thoseprojects that can establish such relationshipsand maintain them at a tolerable cost.

To arrange a project financing, there must bea genuine community of interest among theparties involved in the project.

For experienced practitioners, the acid test ofsoundness for a proposed project financing iswhether all parties can reasonably expect tobenefit under the proposed financingarrangement


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Project financing will not necessarily lead to a

lower cost of capital in all circumstances.

Usually may be more cost-effective than

conventional direct financing when:

Permits a higher degree of leverage than the

sponsors could achieve on their own

Increase in leverage produces tax shield benefits

sufficient to offset the higher cost of debts funds,resulting in a lower over all cost of capital for the

project.


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To arrange financing for a stand-alone

project, prospective lender (andprospective outside equity investors, if

any) must be convinced that the project is

technically feasible and economically

viable. And the project will be sufficiently

creditworthy if financed on the basis the

project sponsors.


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That construction can be completed on scheduleand within budget and that the project will beable to generate sufficient cash flow so as tocover its overall cost of capital.

Establishing creditworthiness requiresdemonstrating that even under reasonablypessimistic circumstances, the project will beable to generate sufficient revenue both to cover

all operating costs and to service project debt ina timely manner.


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Lenders to a project will require that they

be protected against certain risks.

Recent innovations in finance, including

currency futures, interest rate swaps andcaps, and currency swaps have provided

project sponsors with new vehicles for

managing certain types of project relatedrisks cost-effectively.


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The term projectfinance is generally used to refer to anon-recourse or limited recourse financing structure in

which debt, equity, and credit enhancement arecombined for the construction and operation, or therefinancing, of a particular facility in a capital- intensiveindustry, in which lenders base credit appraisals on theprojected revenues from the operation of the facility,

rather than the general assets or the credit of thesponsor of the facility, and rely on the assets of thefacility, including any revenue- producing contracts andother cash flow generated by the facility, as collateral forthe debt.


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The Rationale for Project Financing

Several studies have explored the

rationale for project financing. These

studies have generally analyzed the issue

from the following perspective

When a firm is contemplating a capital

investment project, three interrelated questionsarise:


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Should a firm undertake the project as part of itsoverall asset portfolio and finance the project onits general credit, or should the firm form aseparate legal entity to undertake the project?

What amount of debt should the separate legalentity incur?

How should the debt contract be structured that

is, what degree of recourse to the projectsponsors should lenders be permitted?


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Corporate Finance vs. Project

Finance

Item Corporate Finance Project Finance

Destination of the financing Multipurpose Single purpose

Duration of the financing Variable Long-term and limited by

the lifetime of the project

Financial structure

Debt holders not related Debt holders tied by ageneral agreement


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Risk analysis

Corporate Finance:Highly dependent on financial statements and cash flow

Project Finance:In addition, technical considerations, contractual agreementsand the debt structure are all very important


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Liquidity of the financialinstruments

Corporate Finance:

Can be high if they are negotiated on capital markets

Project Finance:

Generally low, as the financial agreement is private,made to measure and impregnated with contractual

relationships


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Financial costs

Relatively low

Project Finance:

Relatively high owing to both the structuring costs and

the low liquidity of the instruments

Corporate Finance:


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Room for management tomake decisions

Plenty if the company has open capital

Project Finance:

Little, owing to the rigid contractual structure

Corporate Finance


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Agency costs

High if the company has open capital

Project Finance:

Low, as the contractual structure leaves little margin for

independent action by the partners

Corporate Finance

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