Project Finance

SESSION ON
PROJECT FINANCE
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Learning Objectives
q Review of Financial Project Evaluation Methods
q Estimation of Cash Flows
q Definition of Project Finance
q Identify the key characteristics of project finance
q Discuss Legal and financial considerations in project finance
q Understand Debt finance
q Understand Mezzanine finance
q Understand Equity finance
q ListSources of debt and equity
q Social Cost Benefit Analysis: Introduction
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Project Evaluation Methods
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§ Net PresentValue (NPV)
§ NPV= PVCIF – PVCOF. Accept project if NPV > 0
§ Internal Rate of Return (IRR)
§ The rate that makes NPV=0.Accept if IRR > r.
§ BenefitCost Ratio (BCR)
§ BCR = PVCIF/PVCOF. Accept if BCR > 1.
§ Profitability Index (PI)
§ PI = PVCIF/ Initial Investment. Accept if PI > 1.
§ Payback Method
§ Time required to recover investment.Accept if payback < Cut-off period.
§ Discounted Payback

Project Evaluation Methods: Exercise
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Project A
Year Cash flow
0 (5000)
1 3000
2 (1000)
3 2000
4 4000
5 2000
Project B
Year Cash flow
0 (5000)
1 3000
2 1000
3 2000
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Other information:
Discount rate (r) = 10%, Cut-off Payback: 2.4 years, Cut off BCR = 1.1
Calculate and decide which project should be selected based on:
(i) Payback, (ii) NPV (iii) BCR (iV) IRR

Estimation of Cash Flows
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Revenue
(-) Direct Expense
Gross Profit
(-) Operating Expense
Earning before interest, tax, depreciation and amortization (EBITDA)
(-) Depreciation and Amortization
Earnings before interest and tax (EBIT)
(-) Interest
Earnings before tax
(-)Tax
Net Income
Cash flow for project:
(1) Capital Expenditure . (At the beginning and in the end as salvage value)
(2) Operating Cash Flow (OCF) = Net income + Depreciation and Non-cash expense + Change in net working
capital. (Every year of the project)
(3) Release of working capital (at the end of the project)
Net Working Capital = Current Asset – current liability

Project finance
According to a definition provided by Nevitt and Fabozzi (2000), project finance refers to:
A financing of a particular economic unit in which a lender is satisfied to look initially to
the cash flows and earnings of that economic unit as the source of funds from which a
loan will be repaid and to the assets of the economic unit as collateral for the loan.
Merna andOwen (1998) define ‘project finance’ as follows:
Financing of a stand-alone project in which the lender looks primarily to the revenue
stream created by the project for repayment, at least once operations have commenced,
and to the assets of the project as collateral for the loan. The lender has no or limited
recourse to the project sponsors.
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There is no single agreed definition for project finance as yet. It is no surprise that the
market has not standardised these definitions because the field of finance is extremely
dynamic and constantly changing.For the purpose of this guide, the concept of project
finance is defined as follows:
Financing of a stand-alone project (or bundle of projects) is structured by using a group
of agreements and contracts between lenders, project sponsors and other
interested parties that create a form of economic unit; lenders and investors will look
primarily to the economic unit to generate cash flow as the sole source of repayment
of principal and interest and collateral. The lender has no or limited recourse to the
project sponsors. (Chu 2007)
Project finance
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The ultimate goal in project financing is to arrange borrowing for a project, which will
benefit the sponsor (SPV), whilst not affecting its credit standing or balance sheet.
Requirements for successful projects are summarised as follows:
• Enforceable contractual arrangements
• Robust financial structures
• Detailed cash flow modelling
• Effective risk management
• Sensible risk apportionment
• Effective monitoring
• Stakeholder coordination
Project finance
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The key characteristics of project finance
Below five features can distinguish project finance from other financing
methods:
•SPV (Special PurposeVehicle)
•Contractual agreements of various third parties
•Non-/limited recourse
•Off-balance sheet financing
•Robust income stream
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Special project/purpose vehicle (SPV)
An SPV is an independent legal entity, which will be committed and responsible to a contractual
agreement with the parties involved in the project finance transaction (Ellafi 2005). SPVs are
used in a variety of transactions, including securitisations, project finance and leasing. In this
guide, the definition of anSPV is limited to:
A legally and economically independent project company financed with non-/limited
recourse debt for the purpose of financing a single purpose, capital asset usually with a
limited life.
Contractual arrangement
Projects procured using project finance have to be structured through a series of contracts.
Those contracts represent substantial components of credit support for a project (Orgeldinger
2006). The authors also suggest that the contractual arrangement in project finance
transactions determines how the risks are structured among the parties, which provides a
security to the project’s cash flow.
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The major contracts in typical project finance
transactions are the construction contract,
the product offtake contracts, the raw
material supply contracts, the operations
and maintenance contracts, and a large
number of financial agreements, including
loan agreement, bond agreement,
shareholders agreement and agreements
which address support from the host country
(Merna and Njiru 2002).
These contracts transfer many of the
individual risk elements to appropriate
parties. A typical structure of build-own-
operate-transfer (BOOT) indicating the
number of organisations and contractual
arrangements that may be required to
realise a particular project is shown in Figure
1.
Figure 1: A typical BOOT corporate
structure (Merna and Smith 1994)
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Non-/limited recourse
Non-/limited recourse is one of the key distinguishing factors used in project financing. In
corporate finance, the primary source of repayment for investors and lenders is backed by the
entire balance sheet of the sponsors’ companies. Even if an individual project fails, lenders still
retain a significant level of comfort in being repaid depending on the overall strength of the
sponsor’s balance sheet. But in project finance, if non-recourse finance is used then the
lender will get repayment only from the cash flows of the project and not from any other
assets of the borrower.
Off-balance sheet transaction
One of main reasons for choosing project finance is to isolate the risks and take them off the
balance sheet so that a project failure does not damage the owner’s financial condition. An
off-balance sheet transaction simply means that all financial matters relating to a project
cannot affect the balance sheet of the sponsor’s organisation: the project stands on its own.
Debt payment comes only from SPV rather than from any other entity.
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Robust income stream of the project as the basis for financing:
The future income stream of a project is the most important element in project
finance. Repayment of the financing relies on the cash flow and assets of a
project itself as the lenders have no recourse to other funds or assets owned by
the SPV. Therefore, the SPV has to demonstrate strong evidence of future
income through various means such as power sales contracts for a power plant or
through tolls for a market-led bridge project.
A contract-led revenue stream provides more security to the lenders as they look to
the revenues to repay both principal and interest on loans. Lenders often provide
more favourable terms of loans to projects having contract-led revenues since the
risk of default is less than in market-led projects. This is often in the form of a
lower interest rate.
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Legal and financial considerations in project finance
Legal
The commercial influences on the choice of both legal and financial structures are dependent
on:
❒The extent of recourse to the borrower group or the public sector;
❒Credit appraisal of the borrower group or the public sector;
❒Nature of the project such as static or dynamic;
❒Technical complexity of the project and its product or service;
❒Exposure to precompletion, operating and market risk;
❒Volatility of cash flows;
❒Political risk;
❒One-off financing or a series of financings.
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The legal considerations in the choice of structure typically depend on the following:
❒Types of concession agreements
• Availability-based payments:The concessionaire is paid for making the facility available for public use.
• Production sharing agreements: The concessionaire is paid a share of the revenue generated from the
facility.
• Forward purchase agreements: The concessionaire is paid a fixed price for its product or service over a
specified period.
• Demand-based payments: The concessionaire is paid on the basis of demand for the facility such as tolls
for a bridge project.
❒Security for lenders includes:
• step in rights; guarantees; liquidity facilities; equity; cover ratios.
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Financial
Operatingparameters
❒Cost forecasts (capital expenditures and operational expenditures);
❒Revenue forecasts based on throughput and price;
❒Cost to the public sector in terms of unitary payments and/or subsidies;
❒Tax;
❒Global concerns such as interest rate, inflation, price of product or service;
❒Length of concession/operation.
Funding parameters
❒Equity returns such as nominal (time-related) and real (non-time related internal rate of returns);
❒Debt coverage ratios such as debt service coverage ratio, loan life coverage ratio, project life cover ratio and
interest rate cover ratio;
❒Valuation multiples;
❒Gearing in terms of debt/equity ratio;
❒Security on fixed and floating loans;
❒Parent company guarantees
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Financial considerations in terms of sources of finance include:
❒Senior ranking bank loans which can be split into multiple tranches for different maturities or purposes
such as working capital and also used as bridging finance;
❒Mezzanine bank loans which fill the void between debt and equity;
❒Junior ranking bank loans often in the form of loan stock or subordinated debt;
❒Equity in the form of ordinary shares or preference shares which attract voting rights;
❒Capital markets utilising fixed coupon bonds, index-linked bonds or asset-backed commercial paper;
❒Monoline insurers who take on credit risk by selling protection on the default of loans or bonds;
❒Development finance through institutions such as EBRD,World Bank;
❒Export credit agencies and political risk insurance such asOPIC and ECGD.
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Debt finance
Most projects are financed utilising debt as part of the financing package. In project
finance, mobilising commercial debt can be quite difficult due to several reasons:
❒High demand, cautious lenders. Lenders face the same risks as equity investors
when arranging loans to finance a project.They also fear the risk of not getting any
money back in the event of default. In addition, there is a limit to how far loan pricing
can be pushed. So, the lenders often have the major say in how financing is to be
structured and seek to reduce the project risks by negotiating the conditions with the
borrower under which they will participate.
❒Foreign lenders. In developing countries, most domestic markets cannot mobilise
high volumes of long-term debt, so they turn to foreign lenders. Foreign lending
involves foreign currency, thus exposing the borrower to currency risks.
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❒The number of banks involved in project finance has increased greatly in the last 5
years. Each bank has exposure limits to the project finance environment, and thus
organising a syndicate of lenders is complex and time-consuming.
❒In developing countries, there are not many potential non-bank lenders such as
pension funds and insurance companies. However, this potential is not being met as
many of these companies are publicly owned monopolies and most developing countries
also require pension funds and insurers to invest mostly in government securities.
Senior debt
The senior debt of project financing usually constitutes the largest portion of the
financing and is usually the first debt to be in place. Senior debt is debt which is not
subordinated to any other liability. It is first in the priority of payment from general
revenues of the borrower in the event of project default. Generally, senior debt will be
more than 80% of the total financing.
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Debt finance

Mezzanine finance
Development in the financial markets and financial innovations has led to the development of
various other kinds of financial instruments. Mezzanine finance or quasi- equity groups together
form a variety of structures positioned in the financing package somewhere between the high-
risk/high-upside equity position and lower-risk/fixed returns debt position. There is no one
definition for mezzanine finance. Mezzanine finance typically takes the form of subordinated debt,
junior subordinated debt, and preferred stock or some combination of each.
Subordinate debt
Subordinated debt, a type of mezzanine, is the debt that ranks below senior debt in terms of its
priority of payment (cash waterfall) or in liquidation (Nevitt and Fabozzi 2000). The senior debt
is usually bank debt, and there may be several layers of subordinated debt between the bank
debt and equity. Subordinated debt is paid only after the principal and interest of the senior
debt are paid. As it is second only to senior debt in terms of claims on the project’s assets, the
interest rate on subordinated debt is usually higher than that on senior debt.
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Equity finance
Equity usually comes from individuals, companies involved in a project such as project sponsors
and equipment manufactures, or sometimes from institutional investors such as insurance
companies or energy investment funds. Equity represents the investment injected by the owners
of the project. Both ordinary equity and preferred equity represent ownership of the project.
However, sponsors have a priority over the ordinary equity holders in receiving dividends and
funds in the event of liquidation.
A project financing starts with the setting up of a particular project legal entity, known as SPV.
The sponsors of the project provide the initial equity capital known as the seed equity capital.
Merna and Owen (1998) define equity capital as follows:
Pure equity is the provision of risk capital by investors to an investment opportunity and usually
results in the issuance of shares to those investors. A share may be described as an intangible
bundle of rights in a company, which both indicates proprietorship and defines the contract
between the shareholders.
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Sources of debt and equity
There are various funding sources which are available for project financing. These
sources are from both internal and external sources. The parties participating in project
investment include those with a commercial interest in the project, for instance, project
sponsors, raw material suppliers and purchasers of a product or service.
Cash flow modelling and project financing
In project finance, it is the future cash flow that becomes the basis for raising resources
for investing in the project (Merna and Njiru 2002). Mills (1996) claims that, compared to
other financing methods, predictability of cash flows is even more important because
the lenders have limited or no recourse to the sponsor for repayment obligations of the
SPV. The lender principally looks to the project’s cash flow as the source of repayment.
Therefore, the focus should be mainly on the elements that influence cash flow.
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Within project finance, raising the finance is an important issue. Without finance the project
cannot go ahead.Therefore, the borrower needs to determine the sources of finance available.
Each of the instruments discussed has a claim on future revenue generation. The seniority of
these instruments, in terms of their claim on project assets, in the event of default is illustrated
in Figure 2.
Debt is the most used instrument to fund projects. With debt there is an interest charge on the
loan. Bond issues are becoming popular amongst borrowers to raise project finance. Projects
have been funded worldwide partly by bonds. Equity is considered risk capital because investors
bear a higher degree of risk than other lenders. Equity ranks the lowest in terms of its claim on
the assets of the project.
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Figure 2: Seniority of financial instruments (Merna and Faisal Fahad Al-Thani
2008).
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Social Cost Benefit Analysis
• Concept of “Shadow Pricing”
• Merit Goods
• Demerit Goods
• UNIDO (United Nations Industrial Development Organization) Approach
• A shadow price is a monetary value assigned to currently unknowable or
difficult-to-calculate costs in the absence of correct market prices. It is
based on the willingness to pay principle – the most accurate measure of
the value of a good or service is what people are willing to give up in order
to get it.

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Social Cost Benefit Analysis

Project Finance

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