Overview Of Project Appraisal

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

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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

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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 Transaction costs for borrower Guarantees for financing from sponsors viewpoint Financial elasticity for the sponsor Accounting treatment for sponsor Permissible leverage (D/E ratio)

Project Financing High

Corporate Financing LOW

Heavily reduced only project assets

High , existing assets also encumbered Reduced significantly On balance sheet

No significant reduction or constraint Off balance sheet High

Low (depends upon borrowers balance

Appraisal criteria

Cash flows generated by the project

sheet) Customer relations. 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

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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.

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

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Key contracts used in project finance deals ○ Turnkey construction contract ○ Operations and maintenance contract ○ Purchasers and sales agreement ○ Suppliers and raw material supplies agreement

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Risk Management aspects

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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

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High country risk and low market/technology risk Industrial plants Mining Oil and gas Power generation Low country risk and low market/technology risk Industrial plants Mining Oil and gas Power generation

High country risk and High market/technology risk

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Low country riskand high market/technology risk Toll roads Telecom Rail and infrastructure Hotel/leisure Water and sewerage PPPs

Market for Project Finance Country -wise Value of Project Finance (US$ billion) Share of Americas Share of central Asia and Asia Pacific Europe Africa/Middle East Others

2003-06 (aggregate) 461.68

2008 250.8

22.30% 17.29%

16.75% 28.02%

Sector-wise (%) Energy and power Industrials Materials Financials Telecommunications Others

2003-06 (aggregate) 49.5% 25.2% 8.0% 4.8% 3.9% 8.6%

38.78% 18.11% 3.52%

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.