Project Financing (1)

Project financing

Project financing • Raising of funds to finance an economically separable legal entity • Sources of funds - lenders, equity investors/ sponsors, subsidies and aids • Project cash flows service debt and provide returns to equity investors • Government and other agencies providing subsidies and aids look forward to the project’s economic, social and environmental benefits

Government subsidies and assistance • • • • • • • • • •

Capital subsidy Tax break / Tax holiday Exemption or reduction of import duty Export credit financing – direct loan, loan guarantee and insurance Grant of land free of cost or at a nominal price Assurance of availability of raw materials, power etc. Assurance of output off-take for a guaranteed price and duration Infrastructural support at no or nominal cost Arranging finance at concessional rates Accelerated depreciation for tax benefits

Basic elements of project financing Lenders Debt repayment

Debt funds Raw materials

Purchase contracts

Project entity

Suppliers Supply contracts

Purchasers Output

Equity funds

Returns to investors

Equity investors

Project financing vs. direct financing • In direct financing – project assets and liabilities are integrated into the sponsor’s balance sheet – lenders look to the firm’s entire asset portfolio to generate the cash flow to service their debt – loans are often unsecured

• In project financing – project assets, liabilities and cash flows are segregated from the sponsoring entity – project assets are pledged to secure loans – lenders have no recourse or limited recourse to cash flows from the sponsor’s other assets not part of the project

Special Purpose Vehicle (SPV) • A separate legal entity • It has a finite life since a project’s life is finite • Project cash flows are distributed to lenders and equity investors • Equity investors make reinvestment decisions unlike in direct financing where corporate managers may retain cash flows from profitable projects and/or reinvest in other projects of their own choice at the expense of lenders’ and shareholders’ interests

Advantages of project financing • More efficient in terms of allocation of financial risks and returns • Project ownership and better management control and monitoring • Performance-linked compensation • Reduction of the underinvestment problem • Reduction of information asymmetry and signaling cost • Reduction of agency cost

Advantages of project financing • • • •

Enhancement of shareholder value Highly leveraged capital structure Lower overall cost of funds Ability of the project sponsor to negotiate with equity investors to invest free cash flows in other seemingly profitable projects so that the dividend requirement can be waived • Reduction of dispute resolution and legal or regulatory costs

Disadvantages of project financing • Complex structure of financing – requires negotiations by all parties – generally involves more cost and time

• Lenders have no or limited recourse to the sponsor’s other assets • Project-related information has to be shared with lenders and investors for arranging finance that may reduce the sponsor’s competitive advantage

Project appraisal • Project feasibility – Technical – Commercial – Economic – Financial – Managerial

• Risk assessment – Completion – Technological – Supply of raw materials – Economic – Financial – Currency – Political – Force majeure

Technical feasibility • Product, process, technology, technical specifications • Detailed engineering work, capacity and possibility of expansion • Details of cost projections and escalation factors • Project time schedule and milestones – Land acquisition, infrastructure development, approvals from government departments etc.

Technical feasibility • • • •

Supply of raw materials, power, water etc. Details of plant, machinery, equipment etc. Transport and communication facilities Housing, education, healthcare, recreation etc., if applicable • Pollution control, effluent / waste disposal • Requirement and availability of manpower • Consultation with external specialists

Commercial feasibility • Projection of demand for project’s output – Market survey for project’s output – Demand forecasts of industry associations

• Evaluation of the project firm’s advertising, sales promotion, warehousing, distribution and other marketing aspects • Incorporation of forecast information into project time, cost and other parameters

Economic feasibility • Break-Even Analysis • Net Present Value • Internal Rate of Return Break-Even Analysis • Break-even volume is given by Unit contribution × Break-even volume = Total fixed costs • Margin of safety = Installed capacity – Breakeven volume

Economic feasibility Net Present Value (NPV) • NPV is given by the present value of all future cash flows minus the initial investment n

CFt NPV = ∑ −I t t =1 (1 + r )

Where CF = After tax operating cash flows or PAT + Non-cash expenses + Interest r = Weighted Average Cost of Capital I = Initial investment n = Useful life of project

Economic feasibility Weighted Average Cost of Capital (WACC) = θ (1-T)rd+ (1- θ )re Where θ = Debt as a fraction of investment T = Tax rate rd = Cost of debt re = Cost of equity

Economic feasibility Cost of debt, rd, can be obtained by solving the following equation: L Ct NP = ∑ t ( ) 1 + r t =1 d Where NP = Net proceeds, i.e. gross proceeds minus floatation expenses such as underwriting fees, legal fees etc. C = Interest + principal payment L = Length of the loan period

Economic feasibility Cost of equity, re, can be obtained by using the Capital Asset Pricing Model (CAPM): re = rf + β (rm - rf) Where rf = Risk-free rate of return rm = Return on market portfolio β = Riskiness of asset rm-rf is called the market risk premium

Economic feasibility Example Investment = 100, Debt : Equity = 60:40 Useful life = 2 years, C1 = C2 = 34.48 CF1 = 48, CF2 = 74, Tax rate = 0.30 rf = 0.08, rm = 0.2, β = 1 Cost of debt:

34.48 34.48 60 = + ⇒ rd = 0.1 or 10% 2 (1 + rd ) (1 + rd ) Cost of equity: re = 0.08 + 1(0.2 – 0.08) = 0.2 or 20%

Economic feasibility WACC =

0.6×(1-0.3)×0.1+0.4×0.2 = 0.122 or 12.2%

Therefore 48 74 NPV @ 12.2% = + − 100 2 (1 + 0.122) (1 + 0.122) = 101.56 − 100 = 1.56 > 0 Since NPV > 0, the project is economically viable

Economic feasibility Internal Rate of Return (IRR) • IRR is the rate of return that makes NPV zero. IRR can be obtained by solving the following equation: n

CFt −I =0 ∑ t t =1 (1 + IRR ) Considering the previous example, IRR = 13.3% Since IRR > WACC, the project is viable

Economic feasibility • NPV and IRR may lead to contradictory decisions depending on the size and cash flows of projects • Considering the previous example, if CF1 = 113.5 and CF2 = 0 for an alternative way of operation, NPV = 1.16 and IRR = 13.5% • For size differential, NPV is a better rule since it adds more wealth • For cash flow differential also, NPV makes more realistic reinvestment assumptions

Economic feasibility • Social rate of discount and Economic Rate of Return (ERR) • ERR is the rate of return when the present value (PV) of all social benefits equals the PV of all social costs • Discrepancies between social valuations and market valuations occur due to – Price distortions – Administered/regulated pricing

Economic feasibility – Taxes and duties – Foreign exchange regulations – Monopolistic status of the company, etc.

• Social valuations should reflect opportunity costs of resources, i.e., the valuations of foregone economic outputs • Taxes and duties are passed on to the government. Since they do not consume resources, they cost nothing to the society. Hence their inclusions give rise to price aberrations

Economic feasibility • Consider the previous example Year 0

1

2

Land

8

-

-

Plant & M/C

80

10

-

Duties/Taxes

6

4

-

Others

6

6

-

100

20

-

-

82

126

Total cost

100

102

126

Revenue

-

150

200

Cash flow

-100

48

74

Capital cost

Total Operating cost

Economic feasibility • Considering social valuations – Agricultural land. The present value (PV) of the agricultural outputs during the project’s useful life is, say, 5 – Plant & M/C are imported. Say about 20% of their costs is accounted for by import duties, which must be deducted – Duties/Taxes should be removed – The following table shows social costs, social benefits and resultant cash flows

Economic feasibility Year 0

1

2

Land

5

-

-

Plant & M/C

64

8

-

Duties/Taxes

-

-

-

Others

6

6

-

Total

75

14

-

-

82

126

Total cost

75

96

126

Revenue

-

150

200

Cash flow

-75

54

74

Capital cost

Operating cost

Economic feasibility • Considering a social rate of discount, 12% – NPV@12% = 54/1.12 + 74/(1.12)2 – 75 = 32.2 – Economic Rate of Return (ERR) = 40.5% – Since NPV > 0 and ERR > Social rate of discount, the project is socially desirable

• If it is an import substitution project and the imported output would have cost more to the society, the project would be more socially desirable

Economic feasibility • Suppose now that the project company is a monopolist, charging 15% more than the economic worth of the output • Then social benefits in year 1 and year 2 should be 150/1.15 and 200/1.15 or 130 and 174, respectively • Also cash flows in year 1 and year 2 would become 34 and 48, respectively

Economic feasibility • Therefore, NPV@12% = 34/1.12 + 48/(1.12)2 – 75 = - 6.4 • Economic Rate of Return (ERR) = 5.8% • Since NPV < 0 and ERR < Social rate of discount, the project is not socially viable • Hence, a project which is otherwise viable may not be desirable from the social point of view

Financial feasibility • Inherent value of project assets – Marketability of assets in case the project fails

• Borrowing capacity/Maximum loan amount – PV/α where PV represents the present value (PV) of future cash flows and α is the target cash flow coverage ratio

• Debt-Equity ratio – Norms stipulated by financial institutions – Different for different categories, areas and sectors

Financial feasibility • Promoter’s contribution – Higher contribution means higher stake and involvement, and lower debt-equity ratio – Lower risk to lenders – Norms may be different for different areas, type of company (private or public limited)

• Security margin – Loan is sanctioned against tangible assets – Financing of intangible assets is promoter’s sole responsibility – Security margin - % of tangible assets financed with promoter’s contribution

Financial feasibility • Debt Service Coverage Ratio (DSCR) – (Operating cash flows – Tax) / (Interest + principal payments) – (PAT + Non-cash expenses + Interest) / (Interest + principal payments) – DSCR ~ 1.5 – 2 is considered healthy – If DSCR is too high, loan repayment can be effected quickly forcing financial institutions to charge higher rates of interest – Assumptions should be realistic to keep DSCR within acceptable limits

Financial feasibility • Loan repayment schedule – Moratorium of, say, 2 years – Period and instalments depend on cash flow projections and DSCR

• Syndication – Group of financial institutions extending loan

• Conversion of debt – Convertible debenture – Conversion period and cap on equity holding

Financial feasibility • Some examples – Project cost – 100; Debt-equity ratio – 3:1 – For a private limited company with no capital subsidy, promoter’s contribution (equity)= 25 and debt = 75. Promoter’s contribution = 25% – If capital subsidy is 10, promoter’s equity is 15 • Equity – Promoter’s contribution – Capital subsidy 10 » Total 25

15

• Debt 75 » Project cost

100

Financial feasibility – Promoter’s contribution drops to 15% – If debt-equity ratio falls or capital subsidy is reduced, promoter’s contribution increases which may necessitate public issues – Public issue = 60%, promoter’s equity = 40% • Equity – promoter’s contribution – Public issue » Total equity

• Debt » Project cost

10 15 25 75 100

Financial feasibility – Promoter’s contribution drops to 10% – Minimum promoter’s contribution = 15% • Equity – Promoter’s contribution – Public issue 15 » Total equity 25

10

• Debt – Unsecured loan

arranged by promoter – Term loan » Total debt » Project cost

70 75 100

5

Financial feasibility – Promoter’s contribution = promoter’s equity + unsecured loan arranged by promoter = 10 + 5 = 15; promoter’s contribution = 15% – Debt-equity ratio = 70:30 = 2.33:1 < 3:1 – Public issue = 40%, promoter’s equity = 60% • Equity – Promoter’s contribution – FI’s contribution – Public issue » Total equity

• Debt » Project cost

10 5 10 25 75 100

Managerial feasibility • Experience and track record in previous similar projects • Seriousness and financial soundness • Technical background and competence • Capabilities of key management personnel • Review of staff assigned to the project • Site visits and joint study with the project teams of financial institutions and experts • Financial institutions’ nominees on Board

Risk assessment • Completion risk – Inaccurate cash flow projections – Technical infeasibility / Environmental issues

• Technological risk – New / unproven technology – Technological obsolescence

• Raw material supply risk – Price and availability of raw materials during the loan repayment period

Risk assessment • Economic risk – Demand may not pick up as expected – Price realization may not match expectation – Operating cost may shoot up due to inflation – Volatility in foreign exchange rates may have adverse impacts on operations – Servicing debt and providing returns to equity investors may be difficult after meeting costs – Can be hedged by entering into forwards and futures contracts with suppliers and buyers

Risk assessment • Financial risk – Floating rate of interest – Interest rate cap contract – Interest rate swap agreement Loan

Bank

Pay 8%

Project Pay LIBOR + 1%

Receive LIBOR

Swap counterp arty

Risk assessment • Currency risk – If revenue realization and debt servicing are denominated in different currencies, varying exchange rates may affect cash flows – Remedies – (i) revenue, cost and debt are in the same currency, (ii) hedging with currency forwards or futures, and (iii) currency swap

Loan in Rs

Bank

Pay 10% ($)

Project Pay 8% (Rs)

Swap counterp arty

Receive 8% (Rs)

Risk assessment • Political risk – New policies, taxes, legal restrictions – Change of government

• Force majeure – Acts of God – Earthquake, fire, flood, cyclone, strike etc. – Some of the above may get insurance cover – In case of force majeure, lenders require sponsors to pledge insurance payments

Public-Private Partnership (PPP) • Private participation in infrastructure projects is sought for – financing and efficiency

• Issues – ownership, management and operations, financing, responsibility, sharing of risks and rewards Private ownership

Government ownership

Govt. control on safety, quality, fees charged etc.

Private leasing, management and operations

Public-Private Partnership (PPP) • Build-Operate-Transfer (BOT) – Private party builds and operates the facility for a fixed term (concession period) after which ownership is transferred to the govt. – Period should be such that capital invested is recovered and adequate return on capital is received – Govt. may have to pay the private party an amount equal to the remaining value of the facility upon transfer of ownership

Public-Private Partnership (PPP) • Build-Transfer-Operate (BTO) – Ownership is transferred to the govt. as soon as the project is completed – The facility is leased by the private party from the govt. for a fixed period – After that the govt. can run the facility itself or again lease it to a private party

• Buy-Build-Operate (BBO) – A loss-making govt.-owned unit or a unit in urgent need of repair or expansion may be bought (with ownership) by a private party, developed and run as a profit-making public-use facility

Public-Private Partnership (PPP) • Lease-Develop-Operate (LDO) – The private party leases a govt. facility/land, develops and operates for a fixed period – There is a revenue sharing arrangement between the private party and the govt. – This is a useful model when the govt. would not sell the facility or the private party cannot arrange adequate finance to buy the facility – This is also a useful model when the facility is currently losing money

Advantages of PPP • Private financing arrangement. Scope for raising funds through multi-lateral lending agencies • Efficient project execution, management and operations • Expertise and experience of private party • Adoption of state-of-the-art technology • Sharing of risks and rewards between the govt. and the private party

Advantages of PPP • Govt. assistance in acquisition of land, getting permits and approvals, financing, assured supply of raw materials, tax/duty concessions, infrastructural support etc. • Commercial development of the property (mall, shopping complex, multiplex etc.) • Allowing private investments will indicate govt.’s willingness to attract more private and foreign investments

Disadvantages of PPP • Govt. regulations on fees to be charged. Returns may not be commensurate with those of alternative projects • Uncertainty in demand for/usage of the facility and hence uncertainty in toll/fee collection and revenue streams • Possible competition from comparable govt. projects