PROJECT FINANCING

Presented by Bijo Joseph 3rd Sem MBA DCMS University of Calicut

Introduction
While riding on a high-speed train through India, Europe, or Taiwan, a passenger may see massive wind turbines scattered throughout the countryside. Marveled by the landscape, the passenger may take a snapshot on her phone camera and send it to her family. Without realizing it, the passenger is likely to have benefitted from infrastructure projects that have been financed by a mechanism called project finance. The high-speed rail, the wind turbine, and the telecommunication towers are all large and complex infrastructure undertakings. Sometimes such projects are made possible by traditional financial methods; increasingly, however, infrastructure projects are financed by a mechanism that engages a multitude of participants including multilateral organizations, governments, regional banks, and private entities..

Project Finance Defined

Raising of funds to finance an economically separable capital investment project in which the providers of funds look primarily to cash flow from the project to service their debt and provide returns on their equity

Meaning of Project Financing

Project finance is a method of financing where the lender accepts future revenues from a project as a guarantee on a loan. . In contrast, traditional method of financing is where the borrower promises to transfer to the lender a physical or economic entity (collateral) in the case of default. The focus in project finance, however, is mostly on loans to the project company, with project revenues as the source of the return on the investment to lenders.

Difference between Project financing and Traditional financing

In traditional or corporate financing, the sponsoring company (the company building the project) typically procures capital by demonstrating to lenders that it has sufficient assets on its balance sheets. That is, in the case of default, the lender will be able to foreclose on the sponsor companys assets, sell them, and use the proceeds to recover its investment. In project finance, the repayment of debt is not based on the assets reflected on the sponsoring companys balance sheet, but on the revenues that the project will generate once it is completed.

 corporate finance most often involves private investors who provide financing in return for ownership (equity) in a project company. The focus in project finance, however, is mostly on loans to the project company, with project revenues as the source of the return on the investment to lenders. Project finance greatly minimizes risk to the sponsoring company, as compared to traditional corporate finance, because the lender relies only on the project revenue to repay the loan and cannot pursue the sponsoring companys assets in the case of a default.

TYPES OF PROJECT FINANCE

Build operate transfer (BOT)

Build own operate transfer (BOOT) Build own operate (BOO

Built Operate and Transfer In BOT the private contractor constructs and operates the facility for a specified period. The public agency pays the contractor a fee, which may be a fixed sum, linked to output or, more likely, a combination of the two. The fee will cover the operators fixed and variable costs , including recovery of the capital invested by the contractor. In this case, ownership of the facility rests with the public agency.

Built Operate Own and Transfer A BOOT funding model involves a single organization, or consortium (BOOT provider) who designs, builds, funds, owns and operates the scheme for a defined period of time and then transfers this ownership across to a agreed party. BOOT projects are a way for governments to bundle together the design and construction, finance, operations and maintenance and potentially marketing and customer inter face aspects of a project and let these as a package to a single private sector service provider. The asset is transferred back to the government after the concession period at little or no cost.

Bulit Own Operate In BOO, the concessionaire constructs the facility and then operates it on behalf of the public agency. The initial operating period {over which the capital cost will be recovered} is defined. Legal title to the facility remains in the private sector, and there is no obligation for the public sector to purchase the facility or take title. The private sector partner owns the project outright and retains the operating revenue risk and all of the surplus operating revenue in perpetuity. As an alternative to transfer, a further operating contract {at a lower cost} may be negotiated.

Participants in project finance

The Development Company-Every project must have a core entity responsible for organizing, developing, and ensuring that the project is operational. In project finance that entity is called the Special Purpose Vehicle (SPV). A Sponsor Company creates an SPV for the sole purpose of achieving the limited goals of construction and operation of a particular project. Sponsor Company. The Project Sponsor can be a company, a group of companies, a joint venture, or a subsidiary of another company that initiates a project. A project sponsor has a limited but important role; it is the company or group of companies that either solicits bids or receives tender from a host government to construct a site. The project sponsor then creates a special purpose vehicle that will conduct all the business associated with the project on behalf of the project sponsor.

The Special Purpose Vehicle. A project sponsor creates a SPV for the purpose of constructing the project. The Host Government-The government may decide to build a project, for example, a desalination plant or a power station, but will often lack the economic resources to construct the site. Moreover, a government may not want to assume construction risks or face political risks if the project does not have strong political support. In order to mitigate construction risks and to draw together the necessary capital, a government may procure a sponsor company to build the project on behalf of the government. Financial Institutions-There are numerous financial institutions that may be involved in building a site financed by project finance. Furthermore, there is an even greater variety of capital support structures that a financial organization can provide for a project. Most projects engage some combination of multilateral organizations (for example, the International Finance Corporation), regional development banks (for example, the Islamic Development Bank), bilateral organizations and commercial bank financial assistance

Risks associated with project finance

Commercial Risks. There are two main types of financial risks: interest rate risk and currency risk. a) Interest rate risks-Changes to the interest rate may negatively affect the financier or the SPV, or both. When interest rates rise, the costs of the project will increase and the SPV may find itself unable to meet its financial obligations. In order to mitigate this problem, when possible, it is best for the SPV to negotiate a either a fixed interest rate or a floating interest rate, but one that floats only within a fixed manageable range. b) Currency risk -Currency risk is also a serious financial risk to project finance, and one that is not easily mitigated. Currency risk occurs when revenues are generated in one currency while debts must be repaid in a different currency. This is called currency mismatch.

Political Risks -Political risks take various forms, which include changes in a governments authority, legislation, and budget. Sponsoring companies often overlook the possibility of a change of authority, yet a regime change or a change in power of a ruling party can influence the success of both the construction and operation of a project. Legal Risks -Changes to the laws governing elements of agreement, status, or operations of the project can significantly affect the costs of an operation. Construction, Operation, and Technical Risks -Construction, operation and technical risks are usually assessed during the first stages of the project in a feasibility study that carefully examines risks associated with putting up the project as well as the technical and environmental regulations that may impact the project. Mitigating Risk with Guarantees -One important method of mitigating commercial, political, legal and construction risks is for the SPV (the most common recipient) to acquire guarantees by the parties best able to bear the associated risk.

Advantages of Project Finance

Project finance allows countries to build the infrastructure necessary to increase growth and development. It draws a greater volume of financing than under traditional schemes. Risks are often spread among the various participants. Multinational and regional organization, like the World Bank or the African Development Bank, whose goals are often poverty prevention and developing economic prosperity, are more willing to provide financing. The financing is likely to be at a discounted interest rate The debt of the SPV is not reflected on the sponsor companys balance sheet. This is called off-balance sheet accounting, This allows the sponsoring companys credit rating to remain unaffected. Advantages of the project finance structure include debt leveraging, favorable financing terms, and access to capital.

Disadvantages of Project Financing Complexity of risk allocation: project financing is complex transaction involving many participants with diverse interest. If a project is to be successful risk must be allocated among the participants in an economically efficient way. However, there is necessary tension between the participants. For e.g. between the lender and the sponsor regarding the degree of recourse, between the sponsor and contractor regarding the nature of guarantees. Increase transaction cost: it involves higher transaction costs compared too there types of transactions, because it requires an expensive and time-consuming due diligence conducted by the lenders lawyer, the independent engineers etc., since the documentation is usually complex and lengthy.

 Higher interest rates and fees: the interest rates and fees charged in project financing are higher than on direct loan made to the project sponsor since the lender takes on more risk.
Lender supervision: in accordance with a higher risk taken in project financing the lender imposes a greater supervisor on the management and operation of the project to make sure that the project success is not impaired. The degree of lender supervision will usually result into higher costs which will typically have to be borne by the sponsor

References
Nicholas,john M.Project Management For Business And Technology: Principles And Practice,new Delhi, 2004 Nagarajan,k,project Management, New Age International Publishers, New Delhi, 2004

Sebastian Nokes And Sean Kelly,the Definitive Guide To Project Management,pearson Power,2nd Edition