CAC Tutorial 11 (Project Financing) Question 1.

(a) Project Financing is The financing of a major capital investment independently of the affairs of sponsor. The project must be technically and financially viable such that o The projected cashflow is sufficient to cover all operating costs, debt servicing and o Provide an adequate return on the investment to equity participants.
[Students should also include the essential characteristics which distinguishes project financing from conventional financial facilities as part of their answers] (b) Explain different types of risk involved. a. Resource Risk Minerals or other resources may be of inferior quality or may not be economically recoverable by the proposed facilities. b. Completion Risk The project may not be completed on time due to delays caused by infrastructure. Labour or technical difficulties etc. c. Cost Overruns Total capital requirements may be under-estimated due to inflation or inaccuracies in engineering and design. d. Operating Risk Incorrect estimates of operating costs may arise from inaccurate assessment of production, poor engineering to meet quality and quantity specifications, low productivity of labour, unexpectedly high cost of equipment replacement etc. e. Marketing Risk Market risk exposure may arise from price fluctuations or inability to sell all that is produced. f. Political Risk

Projects located overseas run the risk of nationalization or outright expropriation without compensation or creeping expropriation in the form of government interference e.g. currency convertibility, revocation of licenses.

g. Financial Risk The risk of exposure to escalating financial costs due to inability to cope with significant changes in financing cost due to changes in interest rates e.g. floating rate instruments or the exposure to foreign exchange rate movements. h. Force Majeure Risk The risk that there will be an interruption of operation for a prolonged period due to fire, flood, storm, or some other factor beyond the control of the projects sponsors. Question 2. Borrowers Advantages Disadvantages Sponsor able to raise a debt amount Long lead time- involves a lot of neogotion larger than that available against standing & discussion. as individual corporate borrower. Preparation of documents and feasibility Lenders would be more comfortable(risk) studies which are extremely costly financing a larger percentage of the (consultancy, legal & arranging fees etc). project costs in accordance to future cashflows than using the leverage & Revenues from the projects may not be capital structure of the corporate effectively locked in to service the debt or borrower in determining the amount to to further finance the project; distribution lend. It maximizes the sponsors debt of revenues may not be within the control capacity. of the borrowers as well. Timing, technological changes & political instability present high-risk-company that initiates the project can select interested parties to share the risks. with proper structuring- financing can be kept off-balance sheet thereby improving leverage ratios & capital structure reported. May be able to enjoy incentives for new projects. certain tax loans often denominated in foreign currency- currency risks which cost money to hedge.

Lenders Advantages Disadvantages financing package can be specifically long lead time involves a lot of structured to incorporate the particular negotiation & discussion. needs of the project & sponsors. bear project risks as outlined in 1(b) Sponsors have different financial strengths & credit ratings but as long as the underlying security of the project is not impaired should any of them face financial difficulties - lenders will be comfortable providing the funds may be more secure than corporate credit because usually established names are involved & there is safety in numbers

Question 3. Refer to the article Hyflux-led consortium wins $250m desalination project 20 January 2003 (a) Describe differences between financing a new desalination plant and conventional financing of the fixed assets of an established company? Project Financing A separate entity is established to undertake the project, which involves a large sum of money as well as a long time frame Heavy reliance on leverage (usually between 65% to 80% of the projects capital requirements) with higher funding obtained if the project is sponsored by several parties Project financing seldom require numerous restrictive covenants on the investors and are limited to the project itself and do not impact the general credit of the sponsors Borrowing capacity is directly tied to the expected future cash flows generated from the assets of the project. Further there is often no history of earnings to refer to. There is a single source of Conventional Loan Financing The existing entity borrows a sum of money to finance assets on short or longterm basis. Direct Borrowing from a bank to fund particular fixed assets of the company which the tangible assets can be pledged to the bank as collaterals. Usually does not lend monre than what borrower has committed Term loan agreement contains numerous restrictive covenants on the investors such as minimum working capital and do not impact on the general credit of the company. The lender has historical financing information to support the loan such as past income statements and balance sheets. Therefore, the bank can take comfort in the thought that if the

repayment from the project itself, and the only net worth that the project has is equity that has been invested at the same time as the loan has been made.

borrower has been profitable in the past, then it is reasonable to expect that the borrower will be able to earn money in the future.

(b) How does one apply project financing in this seawater desalination plant? To develop the seawater desalination plant, very huge financing ($250m) is needed. Hyflux-led consortium (SingSpring) would wish to separate the financing for this from its other operations. Ideally, it would have liked to isolate its other business from the fate of the desalination water supply. However, no bank could be expected to accept the risk of lending solely on the security of the desalination water that has not started production. SingSpring intends to sell the desalination water to Public Utility Board (PUB). In return for an assured source of water supply, PUB is willing to enter into a long-term desalination water purchase contract with SingSpring over 20years starting from the second half of 2005. SingSpring can then make use of project financing to develop the sea water desalination plant. Banks will be willing to lend due to the assured revenue and cash flow from PUB to SingSpring. Diagram (Project Financing)

Banks

Proceeds used to repay loan $250m loan

PUB

Supply Desalination water

SingSpring