Project Finance

By
S.CLEMENT
 Project Finance -features

• To finance – New, Expansion, Modernization,

Diversification etc
• High value investment
• Longer Gestation period – break even period is
longer
• High risk – spread over longer time horizon and
future is full of uncertainty
• Irreversible decision – difficult to come out or quit
 Project Finance
• A funding structure that relies on future cash
flow from a specific development as the primary
source of repayment, with that development’s
assets, rights and interest legally held as
collateral security
• It looks in to cash flow as compared to
conventional corporate lending which looks to
the balance sheet and income statement.
 Project finance - structure
• Cost of project • Means of finance
• Land & site dev. • Capital
• Building • Bank loans
• Machinery • Un sec. loans
• Other assets • Subsidy
• Pre op. exp.
• Margin for W.C
• Contingencies
 Project finance involves
• MANGERIAL
• FINANCIAL
• TECHNICAL
• COMMERCIAL
• LEGAL
• ECONOMICAL
 Managerial Appraisal
• Most subjective aspect
• Types of promoters
– Existing companies – RIL/Bajaj Auto
– First generation – E.g. Mr. Narayana
Murthy of Infosys
– Government/ PSUs – SAIL, ONGC etc
– Foreign promoters – Pepsi/Coke/Ford
motors. Covered under FDI.
 Managerial Appraisal
• Managerial
• Promoters’ track record – individual /group/ how
group companies are managed.
• Qualification – technical or otherwise
• Composition of board - % of independent
/professional directors
• Management structure – centralized
/decentralized/ reporting systems
• Corporate governance – ethics/
/transparency/disclosure
• Stake in the business – high or low
 Financial appraisal
• Estimates of profitability, cash-flow and balance
sheet
• More emphasize on cash flows
• Assumptions underlying profitability projections
• Critical assumptions
– Installed capacity
– Capacity utilization – 1st/2nd/3rd year etc
– Product mix
– Consumption of inputs & prices
-- Sales realization
-- Cash realization
 FINANCIAL APPRAISAL
• Debt Equity
• Cash flows –realistic vis-à-vis to loan
repayment
• Breakeven/ cash BE
• profitability
• DSCR
• NPV/IRR
• Sensitivity analysis
 Financial appraisal
• Compare profitability with that of existing firms in
similar line, particularly the PBIDT margin.
• NPV/(net present value) IRR (internal rate of
return) method: Considered to be best method for
evaluating the capital investment proposals.
• It takes into account time value of money
• The sum of money received in future is less valuable
than it is today. Present value of rupee to be
received is less than one. E.g. Re 100 today may
not have the same value after one year.
• With Passage of time present value of rupee to be
received in future will go on decreasing
• Technique of finding present value of money
through discounting is NPV/IRR method
 Financial appraisal –
Sensitivity analysis
• Effect of adverse variance of critical
elements on viability is examined
• Typical tests are
• Reducing sales vol./ Price
• Increasing cost of inputs
• Increase in project cost
• Effect of FE fluctuation
• Reduction in capacity utilization.
 Technical appraisal
• Various areas covered are
– Locational aspects
– Process
– Technical arrangements
– Raw materials
– Utilities
– Environmental factors
– Manpower
– Implementation schedule
 Location

– Proximity to markets [e.g. perishable products]

– Proximity to raw material supplies [resource
based, imported raw material] E.g. Cement/Sugar
– Proximity to market – E.g. Electronics
– Availability of labour [quality, quantity, cost,
relations]
– Effluent disposal
– Other infrastructure [power, transportation, water
etc]. Stand by arrangement for power, water etc
– Governmental Policies [restrictions and sops]
 Technical arrangements
• Technical collaboration
• Licensor of know-how/ basic engineering
• Patents/ updation clause
• Plant & machinery
• Guarantees/ warrantees – Collaborator/ P&M
supplier/ Details of engineering contractor
• Approach to “force majeure” conditions –
earthquake/storm etc
• Termination
 Technical arrangements
• Technical know-how agreement
– Supply/ vetting of basic engineering
– Guarantees
– Liquidated damages for non-performance
– Training of personnel
– Royalty
– Indemnity
 Raw Material

• Raw materials & quantity

• Sustained availability
– Imported/ indigenous
– Major suppliers
• Prices of raw material
– Price volatility – E.g. oil
– Past trends in growth
– Duties – customs/excise
• Arrangements for supply
 IMPLEMENTATION
SCHEDULE
• Consequences of delay
– Increase in project cost
– Funding overrun
– Effect on viability
– Loss of market
– Confidence level of FIs
 Commercial
• Product profile – substitutes,inventions
• Customer profile – high or low
end/corproates/government/overseas etc
• Competitors profile – local/international
• Demand & supply/market share
• Import threat- WTO/ Trade block or CECA
(comprehensive economic cooperation
agreement)
• Pricing – compatible with market/elasticity of
price change
• Marketing/Selling arrangements
• Govt. Policy – budget/foreign trade policy /FDI
 Legal
• Title to the property
• Object clause in Memorandam
• Powers to borrow & create charge
 PROJECT STRUCTURE
Shareholder’s Agreement Construction and
Sponsor 1 Sponsor 2 O&M Contractors

EPC
O&M Contract
Contract

Equity

Insurance Loan & Security

Policy Documents

Insurance Project SPV LENDERS

Lenders
Company

TRA Concession
Agreement Agreement

Lenders Engineer
TRA Bank Government
 Risks Analysis –Why?
• Many projects have:
– Large investment outlays
– Long periods of project payout
– Incomplete sharing of information and technology
especially with foreign investors
– Differences in the ability of the parties to bear
risks
– Unstable contracts
– Projects may be attractive in aggregate, but are
unattractive to one or more parties due to
uncertainties about sharing risks and returns.
 Risk analysis
• Strategic Risks
– Market demand [more often than not the demand
projections have little credibility].
– Operating costs [often underestimated].
– Unexpected/ unanticipated capital costs.
• Financial Risks
– Interest rate changes.
– Currency/ foreign exchange fluctuations.
– Liquidity – cashs flow mismatch
 Risk analysis
• Operational Risks
– Supply chain management
– Information systems
– Key managers
• Hazard Risks
– Property damage
– Legal risks
– Workers' compensation
– Natural disasters
 Risk control
• Within Company’s Control

• Outside Company’s Control

• Within Lender’s Control

 WITHIN COMPANY’S
CONTROL
• Operating Risk -
– Technical
– Cost
– Management
• Participant Risk
• Engineering Risk or Design Risk
• Completion Risk
 OUTSIDE COMPANY’S
CONTROL
• Supply Risk
• Market Risk
• Infrastructure Risk
• Environmental Risk
• Political Risk
• Force Majeure Risk -
– Temporary
– Permanent
• Foreign Exchange Risk
 RISK SHARING
SPONSORS BANKS SUPPLIERS

SHAREHOLDERS’ CREDIT SUPPLY

AGREEMENT ENHANCEMENT AGREEMENTS

PROJECT COMPANY

OPERATOR
LOCAL LAWS
O&M AGREEMENT

GOVERNMENT EPC CONTRACTOR

AGREEMENTS EPC CONTRACT

 Risk and risk mitigation
• Risks • Risk mitigation
• Political • Arbitration clause
• Interest rate • Hedging
• Liquidity • Cash flow
• Force Majeure arrangement/
• Exchange rate standby
* Insurance
* Hedging - FC
 Strategy of Reliance Petroleum
• Why RPL is the most profitable refinery in
the world?
• How RPL can achieve a refining margin of $
9-10/barrel which is one and half times
higher than the global players ?
• Singapore refineries can achieve just
$3/barrel.
• What is the strategy? What is secret of
success ?
 Strategy of Reliance Petroleum
• Ability to build larger projects cheaply(37%
less than in US)
• Most other refineries sign long term contracts
covering all their needs and tailor made
refinery technology. It assures supply security
but not price security.
• RPL opted for highly complex refinery (out of
2300 different configurations) for a) to crack all
low-value fractions (as fuel oil) into higher
value products and b) complex refinery could
refine a wide variety of crude.
 Strategy of Reliance Petroleum
• Of course, this flexibility came at a price
since complex refinery cost is much more
than stand alone.
• How did RPL justify such an expensive and
complex compared to others.?
• RPL took huge bet on composition of future
oil supplies i.e. expected that supply low
quality crude will outstrip that of high quality
crude creating widening price discount for
low quality varieties.
 Strategy of Reliance Petroleum
• This will make it profitable to buy low quality
crude which could not be processed in
efficiently in simple refinery but in complex
refinery.
• By tracking, the prices of different crude and
products, RPL could spot opportunities
continuously to buy cheap crude variety.
• Simple refinery lacked the flexibility to switch
from one to another crude.
• RPL bet that this flexibility would justify high
cost of complex refinery.
 Strategy of Reliance Petroleum
• RPL strategy is based on opportunism in
selecting profitable crude to import at any
point of time
• It does not assure supply security. RPL has
firm contracts for only half its capacity . For
the rest, it scans the market for short term
bargains.
• Insecurity of supply can translate in to
security of high profits.
 Successful project finance
entails ...
• Identification of proper project
• Right transaction structure
• Proper risk identification, allocation and
mitigation