NATIONAL UNIVERSITY OF SCIENCE AND

TECHNOLOGY

FACULTY OF THE BUILT ENVIRONMENT

DEPARTMENT OF QUANTITY SURVEYING

Msc in Construction Project Management

Construction Project Finance

2019

LECTURER: L.MAPOSA
lifa.maposa@nust.ac.zw
0772 857 609
 Contents

Chapter 1- Introduction & Background

Scope of project finance
Sources of finance/funding
Uses of project finance
Project finance versus conventional financing
Parties in a project finance Transaction

Chapter 2- Project Financing Risks and Risk management Project financing

risks

Risk identification
Risk Analysis
Risk Allocation and transfer
Residual risk management
Other risks and their management

Chapter 3 – Project Financing approaches

Bond Financing
Securitisation
Equity Financing
North Sea Model
Borrowing base model
Leasing
Public Financing

Chapter 4- Financial Statement Analysis for Construction Projects

Appraisal approaches- NPV, IRR

Efficiency analysis – Financial ratios
Net Cash-flow determination

Chapter 5 - Optimal capital structure in Project finance

Cash-flows to optimal capital structure
Waterfall structure of optimal capital structure
 Chapter 1
Scope of Project Financing

Definition of Project Finance Borrowing

 The financing of the development or exploitation of a right, natural resource or

other asset where the bulk of the financing is to be provided by way of debt
and is to be repaid principally out of the assets being financed and their
revenues.”
 “Project Finance Borrowing” means any borrowing to finance a project:
(a) which is made by a single purpose company whose principal assets and
business are constituted by that project and whose liabilities in respect of the
borrowing concerned are not directly or indirectly the subject of a guarantee,
indemnity or any other form of assurance, undertaking or support from any
member of the except as expressly.
(b) in respect of which the person or persons making such borrowing available
to the relevant borrower have no recourse whatsoever to any member of the
group for the repayment of or payment of any sum relating to such borrowing
other than:
(i) recourse to the borrower for amounts limited to aggregate cash flow or
net cash flow from such project and/or
(ii) recourse to the borrower for the purpose only of enabling amounts to be
claimed in respect of that borrowing in an enforcement of any security
interest given by the borrower over the assets comprised in the project (or
given by any shareholder in the borrower over its shares in the borrower) to
secure that borrowing or any recourse referred to in

(c) which the lender shall have agreed in writing to treat as a project finance
borrowing.

Project finance is the structured financing of a specific economic entity—the SPV, or

special-purpose vehicle, also known as the project company—created by sponsors
using equity or mezzanine debt and for which the lender considers cash flows as
being the primary source of loan reimbursement, whereas assets represent only
collateral. The following five points are, in essence, the distinctive features of a project
finance deal.
1. The debtor is a project company set up concerned with one specific purpose that
is financially and legally independent from the sponsors.

2. Lenders have only limited recourse (or in some cases no recourse at all) to the
sponsors after the project is completed. The sponsors’ involvement in the deal is, in
fact, limited in terms of time (generally during the setup to start-up period), amount
(they can be called on for equity injections if certain economic- financial tests prove
unsatisfactory), and quality (managing the system efficiently and ensuring certain
performance levels). This means that risks associated with the deal must be
assessed in a different way than risks concerning companies already in operation.
3. Project risks are allocated equitably between all parties involved in the
transaction, with the objective of assigning risks to the contractual counterparties best
able to control and manage them.
4. Cash flows generated by the SPV must be sufficient to cover payments for
operating costs and to service the debt in terms of capital repayment and interest.
Because the priority use of cash flow is to fund operating costs and to service the
debt, only residual funds after the latter are covered can be used to pay dividends to
sponsors.
5. Collateral is given by the sponsors to lenders as security for receipts and assets
tied up in managing the project.

Comparison of Project Financing with Corporate Financing

Factor Project Finance Corporate Finance
Accounting treatment Off-balance On-balance sheet
Effect on financial No effect on sponsor on Flexibility reduced
flexibility borrower
Main variables -customer base Future cash flows
underlying granting of -profitability -balance sheet size
financing
Leverage utilizable Depends on firms balance Depends on cash flows
sheet generated by project
Corporate Finance - Project Finance
Dimension Corporate Finance Project Finance

Financing vehicle Multi-purpose Single purpose

Permanent - an Finite – time horizon matches

Type of capital indefinite time life of project
horizon for equity
Fixed dividend policy -
Dividend policy and Corporate immediate payout; no
Investment management reinvestment allowed
decisions makes decisions

Opaque to creditors Highly transparent to

-Risk shared by Creditors
Capital investment lender & Risk shared over a number of
decisions shareholder only parties

Easily duplicated; Highly-tailored structures

common forms which cannot generally be
Financial structures re-used

Low costs due to Relatively higher costs due

Transaction costs competition from to documentation and
for providers, longer gestation period
financing routinized
mechanisms and
short
turnaround time

Size of financings Flexible Might require critical mass to

cover high costs

Basis for credit Technical and economic

 evaluation Overall feasibility; focus on
financial health of project’s assets, cash flow
Basis for credit corporate entity; and contractual
evaluation focus on arrangements
balance sheet and
cashflow

Cost of capital
Relatively lower Relatively higher

Investor/lender Investor/lender Typically smaller group;

base base Typically limited secondary markets
broader
participation; deep
secondary markets

Sources of Finance /funding

Common stock/public

Equity Pvt issuance

Project finance

Bank loans (variable rate)

 Debt

Fixed rate loans/bonds

Government

Leasing/securitisation

Why Do Sponsors Use Project Finance?

A sponsor can choose to finance a new project using two alternatives:

1. The new initiative is financed on balance sheet (corporate financing).
2. The new project is incorporated into a newly created economic entity, the SPV, and
financed off balance sheet (project financing).

Alternative 1 means that sponsors use all the assets and cash flows from the
existing firm to guarantee the additional credit provided by lenders. If the project is not
successful, all the remaining assets and cash flows can serve as a source of
repayment for all the creditors (old and new) of the combined entity (existing firm plus
new project).
Alternative 2 means, instead, that the new project and the existing firm live two
separate lives. If the project is not successful, project creditors have no (or very
limited) claim on the sponsoring firms’ assets and cash flows. The existing firm’s
shareholders can then benefit from the separate incorporation of the new project into
an SPV. One major drawback of alternative 2 is that structuring and organizing such a
deal is actually much more costly than the corporate financing option. The small
amount of evidence available on the subject shows an average incidence of
transaction costs on the total investment of around 5–10%. There are several
different reasons for these high costs.
1. The legal, technical, and insurance advisors of the sponsors and the loan arranger
need a great deal of time to evaluate the project and negotiate the contract terms to
be included in the documentation.
2. The cost of monitoring the project in process is very high.
3. Lenders are expected to pay significant costs in exchange for taking on greater
risks.

On the other hand, although project finance does not offer a cost advantage, there
are definitely other benefits as compared to corporate financing.
1. Project finance allows for a high level of risk allocation among participants in
the transaction. Therefore the deal can support a debt-to-equity ratio that could not
otherwise be attained. This has a major impact on the return of the transaction for
sponsors (the equity IRR),

2. From the accounting standpoint, contracts between sponsors and SPVs are
essentially comparable to commercial guarantees.

3. Creating a project company makes it possible to isolate the sponsors almost

completely from events involving the project if financing is done on a no recourse (or
more often a limited-recourse) basis. This is often a decisive point, since corporate
financing could instead have negative repercussions on riskiness (therefore cost of
capital) for the investor firm if the project does not make a profit or fails completely.

The following are some of the more obvious reasons why project finance might be
chosen:

• The sponsors may want to insulate themselves from both the project debt and the
risk of any failure of the project

• A desire on the part of sponsors not to have to consolidate the project’s debt on to
their own balance sheets. This will, of course, depend on the particular accounting
and/or legal requirements applicable to each sponsor. However, with the trend
these days in many countries for a company’s balance sheet to reflect substance
over form, this is likely to become less of a reason for sponsors to select project

• There may be a genuine desire on the part of the sponsors to share some of the risk
in a large project with others. It may be that in the case of some smaller companies
their balance sheets are simply not strong enough to raise the necessary finance to
 invest in a project on their own and the only way in which they can raise the
necessary finance is on a project financing basis

• A sponsor may be constrained in its ability to borrow the necessary funds for the
project, either through financial covenants in its corporate loan documentation or
borrowing restrictions in its statutes

• Where a sponsor is investing in a project with others on a joint venture basis, it can
be extremely difficult to agree a risk-sharing basis for investment acceptable to all the
co-sponsors. In such a case, investing through a special purpose vehicle on a limited
recourse basis can have significant attractions

There may be tax advantages (e.g. in the form of tax holidays or other tax
concessions) in a particular jurisdiction that make financing a project in a
particular way very attractive to the sponsors

• Legislation in particular jurisdictions may indirectly force the sponsors to follow the
project finance route (e.g. where a locally incorporated vehicle must be set up to
own the project’s assets).

 This is not an exhaustive list, but it is likely that one or more of these reasons
will feature in the minds of sponsors which have elected to finance a project on
limited recourse terms.

Attractive Qualities of Project Finance

Project finance, therefore, has many attractions for sponsors. It also has attractions for the
host government. These might include the following, especially for PPPs:

• Attraction of foreign investment

• Acquisition of foreign skills and know-how

• From a government perspective, it results in reduction of public sector borrowing

requirement by relying on foreign or private funding of projects

• Possibility of developing what might otherwise be non-priority projects

• Education and training for local workforce.

 For private companies, Project financing allows a firm to pursue a profitable
venture which is generally not within the core business of a company since it
can be managed separately.
  Allows the sponsors to pursue risky ventures without affecting their existing
business portfolios
 Allows for an extensive sharing of risks in business ventures
 There is reduced moral hazard on the part of the financier (deliberate financing
of lemons)
 Financier /lender forced to offer professional financial advice at no cost
 Large scale (capital intensive) projects can be pursued (conventional corporate
finance is limited to balance sheet size).

Parties in a Project Finance Deal

Host government (in

PPPs) Project sponsor
Lending banks,
market, Insurance
companies

Raw Material Product purchaser

Project Company
supplier

Energy/Fuel
Supplier

Plant constructor
Plant Operator

Who Are the Sponsors of a Project Finance Deal?

By participating in a project financing venture, each project sponsor pursues a clear
objective, which differs depending on the type of sponsor. In brief, four types of
sponsors are very often involved in such transactions:
1. Industrial sponsors, who see the initiative as forward or backward integrated
or in some way as linked to their core business
2. Public sponsors (central or local government, municipalities, or
municipalized companies), whose aims centre on social welfare. So
project finance initially was a technique that mainly involved parties in the
private sector. Over the years, however, this contractual form has been used
increasingly to finance projects in which the public sector plays an important
role (governments or other public bodies). As we see in the next chapter,
governments in developing countries have begun to encourage the
involvement of private parties to realize public works. From this standpoint, it is
therefore important to distinguish between projects launched and developed
exclusively in a private context (where success depends entirely on the
project’s ability to generate sufficient cash flow to cover operating costs, to
service the debt, and to remunerate shareholders) from those concerning
public works. In the latter cases success depends above all on efficient
management of relations with the public administration and, in certain cases,
also on the contribution the public sector is able to make to the project. Private-
sector participation in realizing public works is often referred to as PPP (public–
private partnership). In these partnerships the role of the public administration
is usually based on a concession agreement that provides for one of two
alternatives. In the first case, the private party constructs works that will be
used directly by the public administration itself, which therefore pays for the
product or service made available. This, for instance, is the case of public
works constructing hospitals, schools, prisons, etc.
The second possibility is that the concession concerns construction of works in
which the product/service will be purchased directly by the general public. The
private party concerned will receive the operating revenues, and on this basis
(possibly with an injection in the form of a public grant) it will be able to repay
the investment made. Examples of this type of project are the construction of
toll roads, the creation of a cell phone network, and the supply of water and
sewage plants.
 Various acronyms are used in practice for the different types of concession.
Even if the same acronyms often refer to different forms of contract, the
following are very common:
.i. BOT (build, operate, and transfer)
.ii BOOT (build, own, operate, and transfer)
iii.BOO (build, operate, and own)

3. Contractor/sponsors, who develop, build, or run plants and are interested in

participating in the initiative by providing equity and/or subordinated debt. In this case
a contractor is interested in supplying plants, materials, and services to the SPV. This
aim of this player is to participate in the project finance deal:

1. in the initial phase by handling design and construction of the plant;

2. during the operational phase, as shareholder of the SPV.

This interest is entirely possible, and is in fact legitimate, in private projects. However,
PPPs involving the public administration are normally subject to more rigid
procurement procedures. These rules serve to safeguard the public’s interest and
ensure that sponsors win contracts for a given project only after undergoing a more or
less complex public tender. When the contractor is also a shareholder in the SPV,
there is an additional advantage: The contractor will benefit directly if the project
succeeds. As builder, this company will be highly motivated to finish the plant on time,
within budget, and in accordance with the performance specifications set down in the
contract. In fact, in this way operations can be activated as planned, the project will
begin to generate cash flows, and, as a shareholder in the SPV, the contractor will
start earning dividends after having collected down payments for construction
It is quite common to find contractors who also offer to run the plant once it is
operational. Plant managers have a clear interest in sponsoring a project
finance deal because they would benefit both from cash flows deriving from the
operation and maintenance (O&M) contract as well as from dividends paid out
by the SPV during the operational phase.
 Chapter 2
Project Finance as a Risk Management Technique

The process of risk management is crucial in project finance for the success of any
venture and is based on four closely related steps:
1. Risk identification
2. Risk analysis
3. Risk transfer and allocation of risks to the actors best suited to ensure
coverage against these risks
4. Residual risk management

 -Risks must be identified in order to ascertain the impact they have on a

project’s cash flows; risks must be allocated, instead, to create an efficient
incentivizing tool for the parties involved.
 -If a project participant takes on a risk that may affect performance adversely in
terms of revenues or financing, this player will work to prevent the risk from
occurring.
 -From this perspective, project finance can be seen as a system for distributing
risk among the parties involved in a venture. In other words, effectively
identifying and allocating risks leads to minimizing the volatility of cash inflows
and outflows generated by the project.
 -This is advantageous to all participants in the venture, who earn returns on
their investments from the flows of the project company. Risk allocation is also
essential for another reason.
This process, in fact, is a vital prerequisite to the success of the initiative. In fact, the
security package (contracts and guarantees, in the strict sense) is set up in order to
obtain financing, and it is built to the exclusive benefit of original lenders.
-Therefore, it is impossible to imagine that additional guarantees could be given to
new investors if this were to prove necessary once the project was under way.

Risks and Mitigants Pyramid

 ©

Environment

Country

Industry

Company

Competition

Market

Project

Product

Supply

Funding

Currency

Inter
est

Country Risks .
 Country risks cover the political economy.
 Examples of country risk include civil unrest, guerrilla sabotage of projects,
work stoppages, any other form of force majeure, exchange controls, monetary
policy, inflationary conditions, etc.
 country risk in some cases serves as the ceiling for a project’s risk rating.
 For instance, Standard & Poor’s credit rating agency limits specific project
ratings by the sovereign credit rating that the agency assigns the country. That
is, no project, despite its particular circumstances, can have a higher credit
rating than the country’s credit rating.
 Specific mitigants might include political risk insurance against force majeure
events or allocating risk to the local company.
  Involving participants from a broad coalition of countries also gives the project
sponsors leverage with the local government.
Political Risk.
 These risks cover changes within the country’s political landscape, i.e., change
of administration (eg The second Republic in Zimbabwe), as well as changes
in national policies, laws regulatory frameworks.
 Environmental laws, energy policies and tax policies are particularly important
to pipeline projects.
 These risks are not confined to the most unstable regimes in the developing
world. It is a mistake to simplify political risks into only the most drastic actions
such as expropriation.
 In the political environment of the 1990s, these drastic actions are rare.
 Nevertheless, infrastructure projects in developing countries continue to face
significant political risks, albeit in more subtle forms “such as price regulation,
restrictions on working permits for foreign managers, renegotiation of
contracts, and even buyouts.”
 In a recent article in Harvard Business Review, Louis Wells and Eric Gleason
cite an example in Thailand where the government “unilaterally ordered a
private toll road opened and lowered the amount its foreign owners could
charge in tolls.” The local sponsor, Thai Expressway and Rapid Transit
Authority obtained a court order to force the project sponsors to open the toll
road at a lower.
 It would be a mistake to confine these political risks to the developing world.
State regulatory bodies in the United States can be just as fickle with rate
regulations for power plants as any foreign ministry of energy.
 Mitigants include, again, political risk insurance as well as flexible tariff
agreements that incorporate adjustments for these types of contingencies. An
intimate acquaintance with the local political environment also increases a
project sponsor’s ability to foresee trouble spots.
 There are two ways of managing this risk :

1. Government Support Agreement -The first is to draw up an agreement with the

government of the host country stating that the government. will create a favorable (or
at least non-discriminatory) environment for the sponsors and the SPV. This kind of
contract, called a government support agreement, can include provisions with the
following intent:
a. To provide guarantees on key contracts (for example, the government provides
guarantees that a key counterparty will fulfil its obligations as off-taker or input
supplier)
b. To create conditions that would serve to prevent possible currency crises from
adversely affecting the convertibility of the debt service and the repatriation of
dividends (for example, the host country could set up ad hoc currency reserves
through its central bank)
c. To facilitate the operational capacity of the SPV from a fiscal standpoint through tax
relief or exemptions

3. Insurance -The second way to cover against political risks is through the
insurance market. Insurance policies are available offering total or partial
coverage against political risks. These policies are offered by multilateral
development banks and export credit agencies as well as by private insurance
companies.
4. Moral Suasion – Including government as a shareholder in the Project

Industry Risk .
 Competitive forces within the industry represent significant risks to the project.
 It is necessary for project sponsors to analyzes the potential risks that their
particular project faces vis-à-vis global and local industries.
 The prices of substitute products, inputs and outputs are critical factors in
determining the economics of the project.
 Other competing projects within the country or in the neighbouring region have
competitive implications for the project.
 Standard and Poor’s checklist for competitive forces for pipelines projects
provides an example of the types of industry risks that creditors emphasize:
o the influence of other existing or planned pipelines in the area;
o cost of transportation - the economics of the pipeline to the end users;
o substitutes - other sources of energy that could compete with the fuel
being transported;
 o the potential for other uses and/or users of the feedstock being
transported by the pipeline, which could render the pipeline obsolete;
o present and prospective commodity price and supply situation;
o potential for supply disruptions and exposure to price fluctuations.
 The primary mitigant against industry or competitive risk is thorough industry
analysis and insight into the industry’s underlying dynamics.

Project Risk.
 Project risk is generally associated with the adequacy and track-record of the
concerned technology and the experience of the project’s management.
 The chief mitigant in this area is the selection of contractors, developers and
operators who have proven track records.
 Independent consulting engineers can play a role in assessing the technical
feasibility of projects by making technical risks transparent to lenders.

Customer Risk.
 The risk with customers is that demand for the product or throughput declines
or widely fluctuates.
 Given the high fixed costs of infrastructure projects, it is difficult, if not
impossible, for these projects to reduce costs to match lower demand.
 Thus, the chief mitigant against this type of risk is an offtake agreement, i.e., a
contract which guarantees purchase of the through put.
 Essentially, a project company agrees to sell a large share of its output
(minerals, electricity, transportation services through a pipeline, etc.) to a
customer or group of customers for an extended period of time.
 The price per unit of output can be fixed, floating or adjusted for inflation or
other factors.
 The customer benefits from this arrangement by securing a long-term,
guaranteed source of supply for the output, but generally forfeits a certain
amount of flexibility in sourcing.
 The project company benefits by eliminating or substantially reducing its
marketing risk.

Supplier Risk .
  The general issue here is with securing supplies for the project - electricity,
water, etc. - and, again, long-term agreements that guarantee that the project
will have access to critical inputs for the duration of the project’s life are the
chief instruments used to mitigate the risk.
 The three critical dimensions of supply risk are:
 quality,
 quantity and
 availability.
 Does the input meet the necessary quality requirements of the project? Can
the project get enough of the input? Is the supply reliable or are interruptions
likely?

Sponsor Risk.
 The project sponsor is typically an entrepreneur or consortium of
entrepreneurs who provide the motivating force behind the project.
 Often, the project sponsor is an entrepreneur without sufficient capital to carry
out the project.
 In other cases, the sponsor might have the necessary capital but is unwillingly
to bet the parent corporation’s balance sheet on a high-risk venture.
 The primary risks with sponsors revolve around:
 the sponsor’s experience,
 management ability,
 its connections both international and with the local agencies,
and
 the sponsor’s ability to contribute equity.
 Investors and lenders can mitigate these risks by carefully evaluating the
project sponsor’s track record with similar transactions.

Contractor Risks.
 The principal construction risks are time over runs and cost overruns.
 Standard & Poor’s, in fact, “believes that it would be difficult for a project to
achieve investment-grade ratings prior to substantial completion of the project
and initial start-up.”
 Mitigating these risks involves scrutinizing the contractor, specifically the:
  contractor’s experience with similar projects,
 reputation in the field,
 Back log of other projects and cash flow.
 The primary method of putting the burden of successful completion on the
contractor, as opposed to on the lenders and investors, is a Turnkey contract.
 A turnkey contract essentially binds the contractor to finish construction by a
specified date for a fixed amount.
 The completed project must also meet the agreed upon technical specifications
as certified by an independent engineer before payment is made.
 Additional mechanisms to ensure compliance with schedules and budgets
include performance bonus and penalty clauses in the construction contract.
 A contractor which has a history of consistently bidding too low presents a
greater risk of cost overruns.
 Additionally, independent engineers can play a role in monitoring the project’s
progress and certifying that the contractor has achieved the milestones on
schedule.

Operating risk.
 The operator is the company or entity charged with the responsibility of
maintaining the quality of the assets that generate the project’s cash flow.
 Of course, lenders and investors want to make sure that the assets remain
productive throughout the life of the project, or more importantly from their
perspective, the life of the loan or investment.
 Hence, operating risks centre around:
 the efficient, continuous operation of the project, whether it is a mining
operation, toll road, power plant or pipeline.
 Contracted incentive schemes are one way to allocate this risk to the operator.
 Operational risk is also managed through ensuring that main process flows are
within your control (Example is that of the recent Paynet saga in Zimbabwe,
May/April/June 2019).

Product Risk .
 Product risks might include product liability, design problems, etc.
  The underlying risk here is unperceived risks with the product, e.g.,
unforeseen environmental damages.
 For instance, an electrical transmission project running through a populated
area might carry the risk of affected population through the detrimental health
effects of the electro-magnetic radiation.
 Using older, tested designs and technologies reduces the risk of unforeseen
liabilities.
 For instance, the Asian infrastructure developer Gordon Wu built his reputation
by recycling one straightforward power plant design in his many projects
instead of re-designing each individual project. Through using a tested design,
Wu was able to not only reduce product and construction risks, but also to
reduce design costs through economies of scale.

Competitor Risk .
 This risk is related to industry risk, however it focused more directly on
resources with which the competitor might be able to circumvent competitive
barriers.
 Exclusive agreements, offtake agreements and supply arrangements all
contribute to defending a long-term competitive advantage.

Funding Risk .
 The funding risk is that the capital necessary for the project is not available.
 For example, equity participants might fail to contribute their determined
amount.
 Or, the underwriters might not be able to raise the target amount in the market.
 Another funding risk is re-financing which occurs if the duration of the initial
funding does not match the duration of the project.
 Funding risks can also relate to the division between local and foreign currency
funding.
 As funding is often the linchpin of project financings, it is difficult to reduce the
risk of not finding the funding.
 The choice of an experienced financial advisor as well as seeking capital
from a broad range of sources represent two ways to mitigate this risk.
  Also, it is sometimes possible to restructure transactions to delay drawdown
dates or to change the amounts of foreign versus local currency.

Currency Risk .
 There are two currency risks facing project companies.
 exchange rate fluctuation, i.e., devaluation erodes the value of a
contract or payment in the project company’s home currency, or the
currency in which it must service its debt.
 The second risk is currency controls, i.e., the sovereign government
limits the project company’s access to foreign exchange or curtails its
ability to make foreign currency payments outside of the country.
Another possible means of mitigating currency risk is to engage in a
currency swap.
 Instruments used to manage currency risks are :
 Currency forward contracts
 Currency swaps

Interest rate Risk .

 Interest rate fluctuations represent a significant risk for highly-leveraged project
financings.
 Arranging for long-term financing at fixed rates mitigates the risk inherent in
floating rates.
 Furthermore, projects can enter into interest rate swaps to hedge against
interest rate fluctuations.
 Derivative instruments can be used to manage this risk as well eg
 Forward Rate Agreements (FRAs)
 Options ---------Calls and Puts
 Interest rate Swaps

Risk Analysis, and Risk Management

 A successful project financing initiative is based on a careful analysis of all the

risks the project will bear during its economic life.
  Such risks can arise either during the construction phase, when the project is
not yet able to generate cash, or during the operating phase.
 Risk is a crucial factor in project finance since it is responsible for unexpected
changes in the ability of the project to repay costs, debt service, and dividends
to shareholders.
 Cash flows can be affected by risk, and if the risk hasn’t been anticipated and
properly hedged it can generate a cash shortfall. If cash is not sufficient to pay
creditors, the project is technically in default.
 Most of the time allocated to designing the deal before it is financed is, in
fact,dedicated to analyzing (or mapping) all the possible risks the project could
suffer from during its life.
 Above all, focus lies on identifying all the solutions that can be used to limit the
impact of each risk or to eliminate it.

There are three basic strategies the SPV can put in place to mitigate the impact of
a risk:
1. Retain the risk.
2. Risk allocation----- involves assigning it to one of the key counterparties.
3. Transfer of risk -------- offloading it to professional agents whose core
business is risk management (insurers).

Risk Retention
 strategy is quite common in a corporate finance setting.
 An industrial firm may retain a given risk because it considers risk allocation to
third parties too expensive
 or the cost of insurance policies excessive compared to the effects determined
by that risk.
 In this case the firm usually tries to implement internal procedures for the
control and prevention of the risk.
 On the other hand, the same risk is likely to have a lower impact compared to
a project finance setting.
 If a firm must close a plant that has caught fire, production can continue in
other premises of the firm. Technically speaking, the risk is not idiosyncratic.
This is not true for project financing.
  If the plant burns down, the SPV doesn’t have other premises where
production can continue, the project is technically (and economically) in
default.
 This explains why even though Strategy 1 is implemented in SPVs, it remains
not enough.
 Lenders would never accept financing an SPV subject to risks that are
completely internalized.

Risk Transfer
 is the cornerstone of the project finance design, a strategy that is implemented
through extensive work performed by the legal advisors of sponsors and
lenders.
 The principle is intuitive. Since the key contracts revolving around the SPV
(construction, supply, purchase, O&M) allocate rights and obligations to the
SPV and its respective counterparties,
 such agreements can be used as an effective risk management tool.
 Every counterparty will bear the cost of the risk it is best able to control and
manage.
 In this way, each player has the incentive to respect the original agreement in
order to avoid the negative effects determined by the emergence of the risk in
question.
 If a risk arises and it has been allocated (transferred) to a third party, this
same party will bear the cost of the risk without affecting the SPV or its
lenders.
 Each party can then BUY INSURANCE and other derivatives instruments to
manage risks allocated to them.
 Derivative instruments include forward contracts, calls & puts options, Credit
default swaps, Forward rate agreements among others

Transfer risk to Professionals

 is implemented to mitigate residual risk , ie risk that can neither be retained or
allocated to other parties in the structure.
  Some risks are so remote or so difficult to address that any one of the SPV
counterparties is open to bear them.
 Insurers are in the best position to buy them from the SPV against the
payment of an insurance premium.
 These companies can do so because they manage large risk portfolios where
the joint probability of emergence of all the risks in the portfolio at the same
time is very low.

Identifying Project Risks

Risks inherent to a project finance venture are specific to the initiative in question;
therefore there can be no exhaustive, generalized description of such risks. This is
why it is preferable to work with broader risk categories, which are common to various
initiatives.
Risk identification/mapping Risk allocation
Project life cycle: Allocation through contracts
1. Pre-completion phase risks Turnkey (EPC) contract
• Activity planning
• Technological
• Construction

2. Post-completion phase risks

• Supply risk Put or pay agreements
• Operational risk Operations & Mantainance agreements
• Market risk Offtake agreements (when possible)

3. Risks common to pre-completion

and post-completion phases
• Interest rate risk
• Exchange risk Use of derivative contracts
• Inflation risk Use of insurance policies
• Environmental risk
• Regulatory risk
• Legal risk
• Credit/counterparty risk

Pre-completion Phase Risks

 The phase leading up to the start of operations involves building the project
facilities.
  This stage is characterized by a concentration of industrial risks, for the most
part.
 These risks should be very carefully assessed because they emerge at the
outset of the project, before the initiative actually begins to generate positive
cash flows.

Activity Planning Risk

Project finance initiatives are carried out on the basis of a project management logic.
 This involves delineating the timing and resources for various activities that are
linked in a process that leads to a certain result within a preset time frame.

 -The logical links among various activities are vital in order to arrive at the
construction deadline with a plant that is actually capable of functioning.

 Grid analysis techniques (the critical path method—CPM—and the project

evaluation and review technique—PERT), supported by software, make it
possible to map out the timing of the project activities(Gantt chart)

 -Delays in completing one activity can have major repercussions on

subsequent activities. The risk is, in fact, that the structure on which the SPV
depends to generate cash flows during the operations phase may not be
available. This is known as planning risk.

For example, in a recent project in the cogeneration sector, a problem came up in

coordinating the construction of a deasphalting plant (required to treat tar so that it
can be used as fuel in the cogeneration plant) with the activation of the power station.
The timing of the two activities (building the plant and initiating power production) was
critical for the economic sustainability of the project. In fact, the deasphalting plant
had to be completed on time in order for the power plant to be tested with fuel that
was to be supplied by one of the sponsors. If the plant was not finished, the test
would be run on an alternative feedstock, which the SPV’s sponsor would have to
supply for the entire duration of the project, with a sizeable increase in costs.
Additional effects of bad planning are possible repercussions on the SPV are other
key contracts. For example, a delay in the completion of a facility could result in
penalties to be paid to the product purchaser.
As a worst-case scenario, the contract might even be cancelled.
Technological Risk
 In some sectors where project finance is applied, construction works can
require the use of technologies that are innovative or not fully understood.

 Under normal circumstances, it is the contractor who decides on the most

suitable technology, with the consent of the other sponsors; in this case the
contractor will almost certainly opt for tried and tested technology.

 However, it is not uncommon for a contractor to find the technological choice

made upstream by other sponsors.

 In this situation, the contractor and technology supplier do not coincide, and
the risk arises that a specific license, valid in theory, proves inapplicable in a
working plant. This is known as technological risk.

 Examples of technological risk arise in projects involving innovative

technologies that have not been adequately consolidated in the past.

 Almost all works in the sector of alternative power sources share the risk that
the plant project may not pass performance tests, and only then it would
become apparent that the project has failed from a technical standpoint.

 Given the negative potential of technological risk, it is very hard to imagine that
a project finance venture would be structured on the basis of completely
unknown, untested technology.

 In fact, technological risk requires flexibility, while the aim of project finance is
to foresee every possible future event ex ante in order to limit the behavior of
management (i.e., the SPV) and block the use of project funds for different
purposes.

Construction Risk or Completion Risk

  This type of risk can take various forms, but the key aspect here is that the
project may not be completed or that construction might be delayed.
 Some examples of construction risk pertain to:
. Non-completion or delayed completion due to force majeure
. Completion with cost overruns
. Delayed completion
. Completion with performance deficiency
 In a project finance transaction, construction risk is rarely allotted to the SPV or
its lenders.
 As a result, it is the contractor or even the sponsors themselves who must
assume this risk.
 Whether or not the banks are willing to accept construction risk also depends
on the nature of the technology (innovative or consolidated) and the reputation
of the contractor.

Post- completion Phase Risks

 The major risks in the post-completion phase involve:
 the supply of input,
 the performance of the plant as compared to project standards,
 and the sale of the product or service.
 These risks are as important as those faced by the project during its pre-
completion phase.
 their occurrence can cause a reduction of cash flows generated by the project
during its economic life.
 If cash flows are lower than expected, lenders and sponsors can find it difficult
to get repaid or to reach satisfying levels of internal rate of return.
 Supply risk arises when:
 the SPV is not able to obtain the needed production input for operations
or
 when input is supplied in suboptimal quantity or quality as that needed
for the efficient utilization of the structure.
 Or the SPV might find input, but at a higher price than expected.
  This situation is even more serious if negotiated prices exceed the retail
price of the product or service or of the contracted price to the
purchaser with long-term agreements with the SPV.
 The effects of supply risk are that the plant functions below capacity, margins
shrink and supplemental costs accrue due to the need to tap additional
sources for input.
 The operating risk (or performance risk) arises when the plant functions but
technically underperforms in post-completion testing.

In the power sector, for example, the input/output ratio of a plant might
gradually deteriorate, or emission standards might not be met, or input
consumption could be over budget. The effect of performance risk is lower
efficiency and, in the end, unwelcomes cost overruns. Demand risk (or market
risk) is the risk that revenue generated by the SPV is less than anticipated.
This negative differential may be a result of overly optimistic projections in
terms of quantity of output sold, sales price, or a combination of the two.

Risks Found in Both the Pre- and Post -completion Phases

 Risks found in both the construction and operational phases are those that
might systematically arise during the life of the project, though with differing
intensity depending on the phase in the life cycle of the initiative.
 Many risks common to both phases pertain to key macroeconomic and
financial variables such as :
5. inflation,
6. exchange rate,
7. interest rate;
 Consequently, the categories of industrial and financial risk is actually
somewhat arbitrary.
 For example, the exchange rate risk inherent in a construction contract in
dollars with an SPV can be considered both an industrial risk (since it is linked
to a nonfinancial contract) and a financial risk (because it would be covered by
recourse to financial derivatives, if need be)
  These can be managed through derivative instruments such as :

i. Forward agreements for buying or selling

ii. Futures on exchange rates
iii. Options on exchange rates
iv. Currency swaps

Other Risks
Regulatory Risk
 There are various facets to regulatory risk; the most common are the following:

o . The permits needed to start the project are delayed or cancelled.

o . The basic concessions for the project are unexpectedly renegotiated.
o . The core concession for the project is revoked.

 Delays are usually caused by inefficiency in the public administration or the

complexity of bureaucratic procedures.
 If instead delays are the result of specific political intent to block the initiative,
this situation would be more similar to political risk.

Credit Risk or Counterparty Risk

 This risk relates to the parties who enter into contracts with the SPV for various
intents and purposes.
 The creditworthiness of the contractor, the product buyer, the input supplier,
and the plant operator is carefully assessed by lenders through an exhaustive
due diligence process.
 The financial soundness of the counterparties (or respective guarantors if the
counterparties are actually SPVs) is essential for financers.
 The significance of credit risk in project finance deals lies in the nature of the
venture itself: off-balance-sheet financing with limited recourse to
shareholders/sponsors and a very high level of financial leverage.
  These features form the basis of a different approach for determining
minimum capital requirements that banks must respect with regard to project
finance initiatives.

Allocation of Construction Risk: The Turnkey (or

Engineering, Procurement, and Construction—EPC)
Agreement

A turnkey agreement—also known as EPC (engineering, procurement, and

construction)— is a construction contract by which the SPV transfers construction risk
of the structure to the contractor. In exchange for a set fee, the contractor guarantees
the SPV the following:
 The completion date
 . The cost of the works
 . Plant performance
In addition to these guarantees, there may be coverage against technological risk.
Transferring this type of risk to third parties is always quite complex, in particular if the
project’s base license is extremely innovative. In concrete terms, the options available
are the following:

 . To ask independent technical advisors their opinion on the effectiveness of

the technology
 . To oblige the technology supplier to pay penalties either in one lump sum or
proportional to the patent value of the technology
 . To oblige the contractor to provide performance guarantees on the technology
that are incorporated in the construction contract (wrapping or wraparound
responsibility). Of course, the judgments of technical consultants do not constitute
legally binding guarantees.
 Chapter 3

Project Financing Approaches / Methods

Project Finance documents

Documents that are instrumental to the project finance deal are :

1. Due diligence report

- Generally speaking, the due diligence report contains the following
essentials.
i. Summary and very institutional observations on the key legal problems
linked to project finance in general and to the project in question
specifically.
ii. This is a sort of a readers’ guide to the topics found in the analysis
carried out in the report.
iii. The legal issues described here (such as contract termination and the
determination of contract damages or supervening hardship)
iv. An analysis of project agreements to determine project bankability, in
other words the existence of factors that expose the project company to
risks that could preclude the financing for the project.
v. . A section on administrative and environmental issues; more
importantly
(a) permits and
(b) authorizations required to build and operate the project in its various
stages.
 vi. The purpose of this analysis is two-fold.
(a) On one hand, it’s meant to verify the state of the project from this
perspective, ensure its correct project development from an
administrative standpoint, and establish how soon building construction
of the project might begin. Clearly, a project that needs a particular
administrative permit is not yet bankable if this permit has not yet been
(and may not be) granted.
- (b) On the other hand, it aims to build the basis for drafting the annex to the
credit agreement containing a list of permits that the project company will
be required to obtain according to the specified timetable and to maintain
pursuant to the terms of the credit agreement corresponding to specific
obligations and conditions in the agreement.
- . A section intended to provide information on the corporate structure of the
project company and, in some cases, of the sponsor companies. Any
peculiarities that might obstruct the project’s bankability are highlighted. (A
typical example is if the articles of incorporation prohibit the granting of
security over project company shares.) In any case, this kind of problem is
almost always addressed and resolved long before the stage of the
transaction at which the due diligence report is produced, given the timing
and development methods in the arranging stage of the financing.

2. Term sheet
-.It is a document containing a schematic summary of the key terms of a
contract document and is agreed on by the parties in light of the forthcoming
drafting of the same document by legal advisors.
-Technically speaking, a term sheet can be drawn up for any contract (even
a corporate or commercial agreement).
ln financial deals, the term sheet is used systematically as a documentary
outline that forms the basis for a specific operation.
-Sponsors and arrangers negotiate the term sheet, which is the starting point
for the arranging mandate.
-This document summarizes the key aspects of the loan and therefore lays the
documentary groundwork for building the contract structure of the financing
itself.
 In this sense, it is a summary of what shall be included in the contract; it does
not summarize a contract that has already been drafted.
-The term sheet of the credit agreement sets down the basic conditions of this
contract in a short format (using schematic concepts, without detailing specific
contract clauses that will be drafted in due course and included in the final
agreement).
- This encompasses economic terms and basic contract provisions (such as
conditions precedent, covenants, events of default, and so on).
-Certain essential questions pertaining to the overall financing system are also
clarified, such as security interests and direct agreements that may be
requested by lenders.
- In some cases, certain specific points are addressed that are particularly
relevant within the framework of the project finance deal in question and that
the parties consider essential in order to progress the development of the deal.

They are therefore preliminary documents that are used to decide whether to finance
or not. Project documents are also classified into the following:

1. Finance documents
Finance documents include the:
-credit agreement (often referred to as the facilities agreement) and other
documents closely related to it. Actually, there is a primary finance document
(the credit agreement) and a series of contract documents that are
instrumental and correlated to it. Finance documents are drawn up by the
lenders’ lawyers; documents that are complementary and accessory to the
credit agreement are regulated by the same law governing the credit
agreement, as far as possible.
2. Security documents
The purpose of the security documents is to:
-create a system of security interests that assist lenders (essentially the
participating banks in the pool of lenders in the financing deal).
-Due to technical/legal requirements, the laws of the jurisdiction where the
assets are located normally regulate these security interests.
-This is one reason why security documents are kept separate from finance
documents in the strict sense.
 -The project company cannot depart in any way from the contract system
agreed on with lenders, even though the latter are not technically party to it, or
the project itself will no longer be bankable.

3. Project documents
Project agreements are the project company’s operational contracts.
-The nature of project finance is such that the list of project contracts is a
closed one, in theory.
- In fact, the project company cannot have any relationship or responsibility
that is not strictly associated with structuring the financing, in financial and
legal terms.
-Lenders are not parties to these contracts, but acquire certain rights as
regards these agreements through the security documents (either by pledging
or assigning the credits deriving from these contracts by way of security) and
on occasion through direct agreements.
- Lenders come to an agreement on the form and content of the project
agreements.
Operational contracts

Credit agreements
 lenders agree to make financial resources available to the project company up
to a preset maximum amount and on request. (The banks assume this
obligation severally; in other words each bank severally commits to a quota of
the total financing and is not responsible for the obligations of any other bank.)
 The loan is granted exclusively for the purpose specified in the agreement itself
(to cover the cost of building and operating the plant, including development
costs);
 the project company is not allowed to use these funds in any way that is not
strictly associated with this purpose.
 The credit facility will be a medium- to long-term one .
 The final maturity of the loan is strictly a financial question, but due to the
nature of project finance (where reimbursement comes from revenues
generated by project operations) loans have to be granted for a time span that
allows the resources needed for reimbursement to be generated. The project
company is granted the option of prepayment, as we will see. However, the
 banks might force the borrower to make early repayments if events occur that
show or forewarn that the borrower won’t be able to fulfill its obligation to repay
the loan.
Approaches to Financing
 We have already seen that sponsors may choose to raise finance directly
themselves for financing a project or indirectly through a project vehicle.
 If they choose the direct financing route then the financing may be raised
either on conventional balance sheet terms or on limited recourse terms.
 Whichever of these routes is followed, the vast majority of projects worldwide
that are debt financed are financed using loans as opposed to other forms of
finance.
 That is not to say that other forms of finance are not available for projects; it is
simply that the flexibility offered by loan structures makes them appealing for
many project sponsors.
 Although the great majority of limited recourse funding for projects is raised
through the international capital markets by way of loans, usually on a
syndicated basis, it is unlikely that the structure for any one project will be
identical to the structure used in another project, although there may very well
be strong similarities.
 There are two sources of finance for projects, apart from loans, that are
sometimes utilised each one of those has a different structure from the
conventional loan structure. These are outlined below.

 Syndication /Syndicated loans

 Project financed by through a loan pooled together by more than one bank
 Banks use this approach to share risks on huge construction projects which
they cannot finance as individual banks
 Projects use this approach to access capital which otherwise they cannot get
from a single financier
 Part Bank

Part Bank
Lead Bank
Borrower Part Bank
Agent bank Part Bank
Doc Bank Part bank
Parties involved include :
Lead manager,
 manager, and co-manager: These are banks that grant part of the loan
structured by the arranger. The difference between the various categories is
based on the amount of participation.
 Usually a minimum lending commitment (ticker) is established to acquire the
status of lead manager, manager, or co-manager. A further difference—but
only in some cases—is that lead managers and managers can be called on to
underwrite part of the loan together with the arranger.
Participant bank:
 This is a bank or financial intermediary that lends an amount below the
threshold established for the lending commitment. It plays no other role than to
make funds available in accordance with the agreed contractual terms.
Documentation bank:
 This is the bank responsible for the correct drafting of documents concerning
the loan (of course, produced by legal firms) as agreed by the borrower and
arranger at the time the mandate was assigned. This role is very delicate
indeed. Whereas many documents are drafted in a relatively standard manner,
 others, like those concerning covenants in favor of lenders or default by the
borrower, must be drafted ad hoc.
 It is essential that the latter guarantee lenders adequately and cannot be
impugned by sponsors or other participants in the deal in the event of changes
in the market or the borrower’s situation.

Agent bank:

 This is the bank responsible for managing the SPV’s cash flows and payments
during the project lifecycle.
 Normally the loan agreement establishes that cash flows received are credited
to a bank account from which the agent bank draws funds based on priorities
assigned to payments.

 Equity Financing
.
 Typically an SPV is a corporation or limited partnership in which the
sponsors put up equity.
 Our aim now is to clarify when shareholders must pay in equity to the
project company.
 The law in many countries requires a minimum amount of initial capital
that sponsors must confer when the SPV company is formed, but
normally this is a rather small amount.
 But there are three alternatives to pay in the majority of the equity, each
of which must be negotiated beforehand with the pool of lenders:
1. Paying in the remaining capital before starting to draw on the loan granted
by banks
2. Paying in the remaining capital after the loan facility has been fully utilized A
clause establishing pro-rata payments.

 Whereas the first alternative is easy to understand, the second and third
need to be reviewed more carefully.
 The second alternative is used only when sponsors are of the highest
creditworthiness (otherwise lenders would bear an excessive level of
credit risk) and only when sponsors provide lenders with a backup
 guarantee in the form of a letter of credit or other form of insurance
bonding.
 Since such guarantees have a cost that must be paid until the equity is
not provided, sponsors must assess the trade-off between an early
equity contribution and the opportunity cost of alternative foregone
opportunities plus the cost of the guarantee.
 The third alternative can be analyzed by means of an example.

Let us assume a project with a value of 1,000 is financed for 15% by

equity and 85% by borrowed capital. It will also be assumed for
simplicity’s sake that payment for the construction is made in four equal
installments of 250 at the end of each year during the construction
period. The stage-payment clause establishes that each payment will be
subdivided into borrowed capital and risk capital in a proportion
corresponding to the weight of each source in total financing. In this
case the creditors ask the sponsors to make stage payments and to
issue a letter of credit to cover future payments.
Table Below gives a comparison of the timing for paying in equity according to
the three alternatives mentioned. Each of the three alternatives implies a
different advantage for sponsors. Final payment means shareholders only
have to pay in capital after a certain period of time, but this also forces them to
incur higher financing costs for use of credit lines and letters of credit in the
initial years of the project. On the other hand, initial payment means saving on
interest paid but generates an opportunity cost because the funds concerned
are not available for investment for other purposes. Compared with the
previous solutions, the use of a stage-payment clause represents a
compromise falling between the two extremes. Apart from the question of
advantages for sponsors, the different timing for conferring equity is dictated by
the lenders’ inclination as regards risk. The latter will always push for an initial
equity contribution to limit risk inherent to the venture. This consideration also
explains why only those sponsors with a strong bargaining power and high
creditworthiness can propose financing solutions to banks that call for paying in
capital after credit lines have been fully exploited. In all other cases, the stage-
payment solution is the one that partially reduces conflict of interests between
 shareholders and creditors. ln project finance deals a standard business
practice is the subdivision of the debt into an initial tranche, or base facility, and
an additional tranche, or stand-by facility, only utilizable on fulfillment of certain
condition precedents.

Stage payment Initial Payment Final Payment

Yea Debt Equity Payments Debt Equity Debt Equity Payments
r Payments
1 212.5 37.5 250 100 150 250 250 0 250
2 212.5 37.5 250 250 0 250 250 0 250
3 212.5 37.5 250 250 0 250 250 0 250
4 212.5 37.5 250 250 0 250 100 150 250

Bonds
 A potential source of finance for projects is the bond market.
 In the US and elsewhere, many projects have been funded by bonds and in
the UK a number of the Government’s Private Finance Initiative (PFI) projects
were funded using bonds (the majority with monoline insurance cover and
some where the bondholders were taking pure project risk).
 Whilst the bond market has been an important source of funds for projects, it
is likely that the vast majority of projects will be financed through loans rather
than bonds as loans are seen as more flexible.

When Should Project Bonds Be Used?

 Project bonds represent a form of funding for an SPV as an alternative to the

more frequent form of a syndicated loan.
 However, this is a valid alternative only in certain well-defined situations and
markets. It should be remembered that whereas syndicated loans are contracts
an arranger structures according to sponsors’ needs in a tailor-made manner,
project bond issues are based on securities that are much less easy to
personalize.
 In effect, a project bond book- runner knows it will be more difficult to find
investors willing to hold project bonds in their portfolio if they have a large
 number of special characteristics, unless these investors have been identified
in advance as targets for a private placement.
 If, instead, the issue is to be listed on secondary markets, it must have
standard characteristics that won’t form a perfect match with the specific needs
of a project finance deal.
 A further aspect to consider is that bond investors (unlike banks) are less
inclined to run risks associated with the construction phase, preferring to
assume risks only in the operating phase.
 Also, country risk can be a handicap for a bond issue when the SPV is located
in a country where this type of risk is particularly high.
 This is why, whenever possible, bond issues are more appropriate for
refinancing deals that have already overcome the construction phase because
in this case the bonds are more similar to an asset-backed securitization than a
project finance deal.

Mechanics of Bonds

Class discussion and examples

Attraction of Bonds as financing tools

 The main attraction of the bond market is the availability of long-term fixed rate
funding
 ,which is not only generally cheaper than bank borrowing but also offers the
possibility of lengthening the repayment profile of the project debt which can
improve the project’s economics significantly.

Drawback of bonds
 However, there are a number of disadvantages to using bonds to finance
projects, including the following:
• Consents and waivers from the lenders are frequently sought in project financings
and it is considerably more difficult to obtain these from (often unidentifiable)
bondholders. Bond trustees will have certain discretions but these may not be wide
enough to cover either material changes to project timetables etc. or the situation
where a project runs into difficulties

• Bonds tend to be structured on the basis that payment by the bondholders is in one
large sum at closing.
  This does not fit very well with most project structures where drawdowns by the
project company are usually made periodically against, say, an engineer’s or
architect’s certificate confirming completion of a relevant project milestone.

NB The solution to this in most bond financings is to deposit the bond proceeds in a
deposit account with the bond security trustee and allow withdrawals by the project
company in much the same way as drawdowns under a conventional loan structure.

 However, there are two difficult issues here.

 First, what happens to these funds if there is a default before they are
withdrawn - do they belong to the bondholders, the lenders or the project
company?
 Second, it will almost certainly be the case that the interest rate on the deposit
account will be less than the interest rate payable on the bonds - the “negative
carry effect” as it is commonly referred to. This can be a significant additional
cost for the project and will need to be taken into account when measuring the
attractions of a project bond
 In as much as Bonds tend to have less onerous warranties, covenants and
events of default compared with loans, in many cases, bondholders are
anonymous it is much more difficult, expensive and cumbersome to arrange
meetings of bondholders for the purposes of determining what action should
be taken as a result of any defaults.
 Accordingly, bond trustees have a vested interest in structuring bond
documentation so as to avoid insignificant events amounting to defaults. This,
of course, conflicts with the approach of project finance lenders whose usual
approach is to cast warranties, covenants and events of default in very strict
terms so as to maintain a high degree of control over the project.
 Another reason advanced in favour of loans is the likely lack of appetite by
bond investors for pure project risks. Typically the bond market likes to invest
in sound companies with strong balance sheets rather than the speculative
more risky ventures.
 This is not to say that some potential bond investors may not have an appetite
for project risk (and there is clearly evidence that there is a project bond market
in the US and that there is a market emerging in the UK), but they are unlikely
to be able to satisfy anything other than a very small proportion of the projects
looking to raise finance.
  institutional capital markets in the US and a number of sponsors have taken
advantage of this to fund all or a part of a project’s financing requirements.

 Securitisation: Bonds/securities issued against future cash-flows

 Involves ring-fencing expected cash-flows from a project and issuing financial
securities against these
 Servicing of financial securities to be done using cash-flows once realised
 In converts a non-marketable asset into a tradable security
 In the Zimbabwean case, road construction can be financed using the
securitisation of toll fees to be received once construction is complete.

 Lease Financing

Mechanics of Lease Financing

Class Discussion and examples

 Lease finance is also a possibility, particularly in projects involving heavy

capital goods.
 However, to date, leasing has only played a very small part in the overall
financial equation and there are no real signs that the lessor market in the UK
is opening up to large scale infrastructure projects.
 There are a number of reasons for this.
 First, the tax capacity available in a country for investing in such projects
is fairly limited. The available tax capacity quickly gets used up by the
small to medium ticket lease market. At the big ticket end of the market,
most of the financing has been done on assets such as ships, aircraft
and (more recently) satellites.
 Second, there are ownership liabilities that go hand-in-hand with leasing
capital equipment that cannot always be satisfactorily laid off through
documentation. Lessors traditionally are very risk averse creatures and,
therefore, the prospect of becoming embroiled in complex disputes in a
project where they may be the owner of one of the principal assets in
question is not an appealing one to them.
  Third, the introduction of a lessor into a project structure will add
considerably to the complexity of the overall structure and, therefore, to
the documentation to an extent that the possible tax advantages may
very well not be wholly justified by the additional complexities and
 Another difficult issue with introducing leasing into project financing is
the inter-creditor arrangements between the lenders and the lessor.
Although both groups will share many of the same objectives in respect
of the project, there will be areas where their interests conflict.
 A dramatic example of this would be where there is a default under the
lease that entitles the lessor to terminate the lease and dispose of the
plant and equipment being leased. This, of course, is something that
would not be acceptable to the lenders and so an arrangement has to
be reached between them whereby the lessor forgoes its right to
terminate the lease automatically in these circumstances.
 One solution in such circumstances is for the lenders to set up a
company to buy out the lease thereby allowing the lessor to be paid out.
 However, this will not always be an acceptable solution to the parties.
Other difficult issues include the relative degree of control and
supervision that may be exercised by each party. Inter-creditor
negotiations between lenders and lessors can be extremely difficult and
time consuming, but this may be a price worth paying if the overall tax
benefits for the project company are significant.

 North Sea Model

 Adopted from the North Sea financing of oil and gas projects
 Projects conveniently projects split into the:
o development/construction phase and
o operating/producing phase.
 lenders wary of taking risks during the development/construction phase and
would usually seek to pass these risks on to the sponsors.
 If the project financing vehicle is a special purpose vehicle and has no assets
beyond the project being financed, then the lenders require
o either a completion guarantee or
o a cost overrun guarantee or a combination of both
 o management and technical assistance support guarantee
 Where the special purpose vehicle route is not used and instead the sponsor
raises limited recourse funds directly, then the transaction is usually structured
so that the loans are drawn down on the basis that they are full recourse loans
to the sponsor until “converted” into limited recourse loans.
 Typically, conversion would take place when the lenders are satisfied that
mechanical completion of the platform and other facilities has occurred and
certain operating tests have been completed to the satisfaction of the
independent engineers acting for the lenders.
 Another condition is likely to be the provision of the full security package for
the loan (which will probably not have been provided at the outset so long as
the loan remains a corporate loan)
 and another is likely to be the satisfaction of certain cover ratios immediately
following conversion. Some loans have been structured on the basis that if the
conversion of the full amount of the loan will result in any of the cover ratios
being infringed, then only a proportion of the loan will be converted.

 Borrowing Base Model

 Whilst the norm is for projects to be financed on a single project basis, this is
not exclusively the case.
 The borrowing base model is one that was developed in the US, in particular,
in relation to the financing of oil and gas assets.
 Using this approach, a blanket facility is availed to borrowers where borrowers
would be entitled to draw down funds for financing one or more designated
projects subject to the satisfaction of one or more overall borrowing base cover
ratios being satisfied.
 In other words, so long as the aggregated future cash flows from all the
projects covered the total loans and the servicing of them, the lender would not
concern itself with the fact that, when viewed on a project-by-project basis, a
borrower might not satisfy the usual cover ratios specified by the lender for a
one-off project.
 In order to safeguard its loans, the lender would take security over all of the
assets included within the borrowing base formula.
 Advantages of the borrowing base model

• It is likely to be considerably cheaper in terms of establishment costs than the costs

associated with establishing, say, three or four single field financings

• It is likely that less management time will be absorbed in administering the

borrowing base facility

• Over-performing assets can be used to support under-performing assets and

• There may be flexibility within the borrowing base facility to substitute assets within
the overall structure.

Drawbacks of the borrowing base model

The disadvantages, on the other hand, are

 the cross-defaulting of all of the individual projects within the borrowing base
structure, this is difficult to avoid.
 Also, it locks the sponsor into one group of lenders for all the relevant projects
which might reduce both competition and flexibility.

 Public Financing
 Usually funded through government coffers or a combination of government
and private initiatives commonly known as Public Private
Partnerships(PPPs).
 Government uses the fiscus or issue bonds to raise their contribution in
PPPs
 Structured in such a way that government buys out the Private partner over
time
 Used to finance huge capital construction projects where governments are
not adequately resourced to fund by themselves.

Forms of PPPs

1. “Build Operate Transfer” “BOT” Model

Many projects around the world are structured and financed on the BOT model. There
are a great number of varieties (and accompanying acronyms) and some of the more
common are:
DBFO: design, build, finance, operate DBOM: design, build, operate, maintain

BOT: build, operate, transfer

DBOT: design, build, operate, transfer

FBOOT: finance, build, own, operate, transfer

BOD: build, operate, deliver

BOO: build, own, operate

BOOST: build, own, operate, subsidise, transfer

BOL: build, operate, lease

BRT: build, rent, transfer

 The basis for all projects structured on the BOT model is likely to be the
granting of a concession or licence (or similar interest) for a period of years
involving the transfer and re-transfer of all or some of the project assets. There
are many definitions describing BOT projects and one of the more illustrative
is:

“A project based on the granting of a concession by a principal, usually a

government, to a promoter, sometimes known as the concessionaire, who is
responsible for the construction, financing, operation and maintenance of a
facility over the period of the concession before finally transferring to the
principal, at no cost to the principal, a fully operational facility. During the
concession period, the promoter owns and operates the facility and collects
revenues in order to repay the financing and investment costs, maintains and
operates the facility and makes a margin of profit.”

 The key features are:

1. therefore, the grant of a concession,
2. the assumption of responsibility by the promoter (or sponsor) for the
construction, operation and financing of the project and the re-transfer at
the end of the concession period of the project assets to the grantor of the
concession.
3. A very common variant of the BOT model is the BOO (Build Own Operate)
project which is structured on similar lines to a BOT project but without the
re-transfer of project assets at the end of the concession period.
  The concession agreement will, therefore, be the key project document and as
such is likely to be examined with considerable care by the project lenders.

Advantages concession grantor’s point of view are:

• They offer a form of off-balance sheet financing as the lending in relation to the
project will be undertaken by the project company

• Because the concession grantor (usually a government or government agency) will

not have to borrow in order to develop the project, this will have a favourable impact
on any constraints on public borrowing and will potentially free up funds for other
priority projects

• It enables the concession grantor to transfer risks for construction, finance and
operation of the facility to the private sector and

• It is a way of attracting and utilising foreign investment and technology.

NB Under the concession agreements, the project company will usually own and
operate the project for the duration of the concession. The revenue produced by the
project will be used by the project company to repay the project loans, operate the
concession and recover the investment of the sponsors plus a profit margin. Overall,
the structure is similar to many other project financings in that the project loans will
usually be provided direct to the project company (which is likely to be a subsidiary of
the sponsors based in the host country) and the lenders will take security over
(principally) the project company’s rights under the concession agreement together
with any other available project assets.

Example of BOT financing

Use of the Group 5 Project in Zimbabwe for road construction

Forward Purchase Model

 Under this structure, sometimes known as an “Advance Payment Facility”, the

project lenders (i.e become pseudo customers) will make an advance
payment for the purchase of products generated by the project which will be
deliverable to the lenders following completion of the project.
 The project company will utilise the proceeds of the advance payment towards
financing the construction and development of the project.
 On delivery of the products following completion, the lenders will either sell the
products on the market or sell them back to the project company (or a related
company of the project company) and use the proceeds to “repay” themselves.
Alternatively, the project company may sell the products as sales agent for the
lenders.
 Some structures entitle the project company to make a cash payment to the
lenders in lieu of delivering products. A common feature of most structures,
however, will be a requirement for an indemnity by the lenders for any loss or
liability that the lenders may suffer or incur as a consequence of taking title to
the products in question.
 Sometimes a more complicated structure is used whereby another company,
jointly owned by the lenders, acts as a vehicle through which the funding is
passed. In such a case this vehicle will assign the benefit of the forward
purchase agreement and any related agreements to the lenders by way of
security.
 The introduction of this further stage is usually designed to remove the lenders
from the commercial arrangements relating to the sale of products, often for
regulatory reasons, but sometimes because the lenders will not want to take
title to the products.
 This type of structure has frequently been used as a way of circumventing
borrowing restrictions.
 The argument is that a structure such as this does not amount to a borrowing
nor would it infringe negative pledges and similar covenants. Whether or not
this in fact achieves either or both of these objectives will depend on the legal
and accounting rules in the particular country, but certainly the trend in the
accountancy world these days is to look at the substance of the structure
rather than accept the strict application of the documents.
 Another reason for using this structure might be in circumstances where it is
not possible for the lenders to obtain a perfected security interest in the assets
being financed and the lender are not prepared to finance the project on an
unsecured basis.
  This type of arrangement, if it is legally effective, will give the lenders title to the
products produced by the project which is at least the equivalent of (and
probably better than) security over those assets.

Chapter 4
Financial Statement Analysis for Construction Projects

Aims
- an appreciation of income statements : Structure and meaning
-understanding of balance sheets components
-implications of financial statements through ratio analysis
-Financial statements are important for reflecting the financial health of a project.
-The most important statements for a Project are :
1. Income Statement
2. Balance Sheet

Identifying the operative components of cash flow during the feasibility study is vital
for various reasons.
1. Project finance is viable only in light of the size and volatility of flows generated by
the initiative. In fact, it is with these operating cash flows that the project pays back its
loans and pays out dividends to the SPV’s shareholders.
2. Lenders can’t count on sponsors to recover loans because limited-recourseclauses
actually prevent any such action. While these points represent two constants in
initiatives where project finance logic is applied, building the financial model of the
initiative can’t be done without taking the peculiarities of this logic into consideration.
The technological and operative aspects discussed in prior chapters are often very
specific; because of this, the modeler needs to develop ad hoc models on a case-by-
case basis. To design the financial model of a project finance initiative effectively,
advisors must first identify the cash flow components of the project.

Waterfall Structure of Project Cash-flows

Revenue/Income from Sales

Less Raw materials and Operating

costs

Less O & M fees

Less Insurance

Less Taxes
 Income Statement for Intergra Water Works
2018 2017
Revenue 40,185,000 38,438,000

Less Cost of revenue

Materials 13,000,000 12,500,000
Labour 5,500,000 5,400,000
Sub-contracts 12,500,000 12,000,000
Other direct costs 1,087,000 1,085,000
Total cost of revenue 32,087,000 30,985,000
Gross Profit 8,098,000 7,498,000

Less Operating expenses

Variable cost 2,036,500 1,943,500
Fixed costs 3,358,500 2,979,500
Total operating expenses 5,395,000 4,923,000
Operating profit 2,703,000 2,575,000

Other income/expenses
Gain/loss on sale of assets 30,000 (38,000)
Miscellaneous Income/exp (5,500) 4,000
Interest income 19,000 12,900
Interest exp (42,500) (41,000)
Net Profit before taxes 2,704,000 2,512,900
Tax@25% 676,000 628,225
Net Profit after taxes 2,028,000 1,884,675
Assets = Capital + liabilities

 This simply equation implies that what we own is financed through our
own resources (capital) and the money we borrow (liabilities)

Balance Sheet for Intergra Water Works

2018 2017
Assets

Current assets
Cash 2,589,000 1,967,890
Accounts receivable 5,767,000 5,403,670
Retained Money 1,641,750 1,350,918
Material Inventory/stock 850,000 520,000
Cost & Est earnings in excess of billings 547,250 450,306
Prepaid Expenses 894,500 983,944
Total Current assets 12,289,500 10,676,728

Fixed Assets
Property & Equip 15,536,900 13,800,000
Construction plant 2,680,040 2,039,480
Vehicles 2,070,000 1,812,000
Furn & Fitt 345,000 379,000
Total Depreciable assets 20,631,940 18,030,480
Less Depreciation 12,529,373 11,158,000
Net Fixed Assets 8,102,567 6,872,480
Total Assets (Current +Net Fixed) 20,392,067 17,549,208

Liabilities
Current liabilities
Accounts Payable 4,325,250 4,773,240
Accrued Expenses 1,586,037 1,475,918
Notes payable 647,250 491,973
Retention money payable 919,380 756,514
Bills in Excess of costs& est earnings 617,205 678,922
Other Liabilities 355,713 292,699
Total Current Liabilities 8,450,835 8,469,266
Long term liabilities 3,528,557 3,695,267
Total Liabilities 11,979,392 12,164,533

Net Worth

Capital Stock 3,500,000 2,500,000

Add Paid in capital 1,000,000 1,000,000
Retained Earnings 3,912,675 1,884,675
Total Equity 8,412,675 5,384,675
Total Equity +Liab 20,392,067 17,546,208

Income statement
- shows periodic profits or losses made generated by the project
-shows the strength or weaknesses of Revenue
-shows the costs structure of the project
-as well as the taxes paid

Balance Sheet
-reflects the financial position of a project at time =t
-it is a snap shot picture of the financial ‘health' a project
-Major components are :
1. Assets - Current Assets & Fixed Assets
2. Liabilities- Current Liabilities & Long-term Liabilities
3. Capital (Equity &/or debt)
4. Net Worth

Important Aspects to take note of

1. Equity + Liabilities = Total Assets

Our business is made up of assets which are financed through our own resources
(equity) and borrowing (liabilities)

2. Working Capital and Current ratios

Working Capital = Current assets - current liabilities

These are liquid funds available to the business now

Current Ratio = Current assets /current liabilities

Acid Test ratio= Cash +Receivables /Current liabilities

Current Assets to Total Assets = Current assets/Total Assets

3. Under Billing and Over Billing

Under billing is expressed in the B/S as Costs and estimated earnings in excess of
billings on WIP.

Over Billing is expressed as Billings in excess of costs and estimated earnings on

WIP.

Example

Suppose a construction company has the following data:

Contract sum 8,000,000

Billed to date 4,700,000
Cost incurred (cost on revenue) to date 3,700,000
Est. Cost to complete 3,000,000

Deductions

 Percentage completion to date

= Cost Incurred to date/Cost incurred to date+ Est cost to complete

= 3,700,000/(3,700,000+3,000,000= 55.22%

 Revenue todate = Contract Sum * % of completion= 8000000*55.22%=4,417,600

 Gross Profit to date=Revenue to date-Cost to date

= 4,417,600-3,700,000=717,600

 Over Billing = Billed to date - Revenue to date

=4,700,000-4,417,600= 282,400

NB= If negative , it becomes under -billing

Over Billing means construction company is borrowing money from client by billing
the client an amount of revenue more than what the construction company has
actually done ie more money is received at an earlier stage.

Under Billing means the construction company is allowing client to borrow money
from the construction company ie the construction company has incurred cost for
doing work but without billing the client for it.

Other Important Financial Ratios

1. Gross Profit Margin = Gross Profit/ Revenue

This ratios indicates how efficiently assets are utilized to generate income.
 2. Net profit Margin = Net Profit before tax /Revenue

3. Return on Equity = Net Profit Before tax/ Owners Equity

4. Debt to Equity ratio= Total Liabilities / Owners Equity ie shld be less than 2.5

5. Average age of materials = Material inventory/Material costs * 365

ie shld be less than 30 days

6. Average age of receivables = Accounts receivables / Revenue * 365

The shorter the better , too short means we too strict with our debtors , we may lose
business. It shld be optimised

7. Cash Conversion Period= Average age Material + Average age of Rec

- shorter the better

Cash Demand period = Cash Conversion Period - Average age of Payables

Ratios for Lenders /Providers of Finance

1. Project cover Ratio

 The ratio of a project’s discounted cash flow from the date of measurement up
to the end of the project’s useful/economic life to the amount of project debt
at a specified time(s).
 An equivalent of the NPV in corporate financing

2. Annual Debt Service Cover Ratio:

 this tests the ability of a project’s cash flow to cover debt service in a particular
year
 CAPITAL BUDGETING
5.0 Definition

The capital budgeting process is the process of identifying and evaluating capital projects,
that is, projects where the cash flow to the firm will be received over a period longer than a
year. Any corporate decisions with an impact on future earnings can be examined using this
framework. Decisions about whether to buy a new machine, expand business in another
geographic area, move the corporate headquarters etc can be examined using a capital
budgeting analysis.

Capital budgeting may be the most important responsibility that a financial manager has
because

· capital budgeting decisions often involves the purchase of costly long-term assets
with lives of many years. The decisions made may determine the future success of the
firm.

· the principles underlying the capital budgeting process also apply to other corporate
decisions, such as working capital management and making strategic mergers and
acquisitions.

· making good capital budgeting decisions is consistent with management's primary

goal of maximizing shareholder value.

5.1 Why is capital a limited resource ?

In the form of either debt or equity, capital is a very limited resource.

There is a limit to the volume of credit that the banking system can create in the
economy.

Commercial banks and other lending institutions have limited deposits from which
they can lend money to individuals, corporations, and governments. In addition, the
Central Bank requires each bank to maintain part of its deposits as reserves. Having
 45

limited resources to lend, lending institutions are selective in extending loans to their
customers.

But even if a bank were to extend unlimited loans to a company, the management of
that company would need to consider the impact that increasing loans would have on the
overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated among
the best investment alternatives.

One might argue that a company can issue an almost unlimited amount of common
stock to raise capital.

Increasing the number of shares of company stock, however, will serve only to
distribute the same amount of equity among a greater number of shareholders. In other
words, as the number of shares of a company increases, the company ownership of the
individual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital, whether
debt or equity (short-term or long-term, common stock) or retained earnings, accounts
payable or notes payable, and so on. Even the best-known firm in an industry or a
community can increase its borrowing up to a certain limit.

Once this point has been reached, the firm will either be denied more credit or be
charged a higher interest rate, making borrowing a less desirable way to raise capital.
Faced with limited sources of capital, management should carefully decide whether a
particular project is economically acceptable. In the case of more than one project,
management must identify the projects that will contribute most to profits and,
consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital
budgeting.

5.2 The capital budgeting process

The capital budgeting process has four administrative steps:
Step 1: Idea generation. The most important step in the capital budgeting process is
generating good project ideas. Ideas can come from a number of sources including senior
management, functional divisions, employees, or outside the company.
 46

Step 2: Analyzing project proposals. Since the decision to accept or reject a capital project is
based on the project's expected future cash flows, a cash flow forecast must be made for each
project to determine its expected profitability.
Step 3: Create the firm-wide capital budget. Firms must prioritize profitable projects
according to the timing of the project's cash flows, available company resources, and the
company's overall strategic plan. Many projects that are attractive individually may not
make sense strategically.
Step 4:Monitoring decisions and conducting a post-audit. It is important to follow up on all
capital budgeting decisions. An analyst should compare the actual results to the projected
results, and project managers should explain why projections did or did not match actual
performance. Since the capital budgeting process is only as good as the estimates of the
inputs into the

model used to forecast cash flows, a post-audit should be used to identify systematic errors
in the forecasting process and improve company operations.

5.3 Definition of terms:

a)Cash-flows Versus Profits

The focus of capital budgeting is on cash-flows and the timing of the cash-flows, because they
easily measure the impact upon the firms’ wealth. Profit on the other hand does not always
represent the net increase or decrease in cash-flows. Some of the figures in standard
financial statements may not have a corresponding cash effect for the same period.

b)Independent Versus Mutually Exclusive Projects

Independent projects are projects that are unrelated to each other, and allow for each project
to be evaluated based on its own profitability. For example, if projects A and B are
independent, and both projects are profitable, then the firm could accept both projects.
Mutually exclusive means that only one project in a set of possible projects can be accepted
and that the projects compete with each other. If projects A and B were mutually exclusive,
the firm could accept either Project A or Project B, but not both. A capital budgeting
 47

decision between two different stamping machines with different costs and output would be
an example of choosing between two mutually exclusive projects.

c)Unlimited Funds Versus Capital Rationing

If a firm has unlimited access to capital, the firm can undertake all projects with expected
returns that exceed the cost of capital. Many firms have constraints on the amount of capital
they can raise, and must use capital rationing. If a firm's profitable project opportunities
exceed the amount of funds available, the firm must ration, or prioritize, its capital
expenditures with the goal of achieving the maximum increase in value for shareholders
given its available capital.

d)Conventional Versus Unconventional Cash-flows

If the pattern of cash-flows accruing to the project being evaluated involve only starting with
an outflow and then being followed by inflows, then the cash-flows are said to be
conventional. With unconventional cash flows, cash-flows come first and the investment cost
is paid later.

5.4 Evaluation Techniques

1.Payback period
2. Discounted Payback
3. Net present value (NPV)
4. Profitability index
5. Internal rate of return (IRR) 6.Modified
internal rate of return (MIRR)

i) Payback Period

The payback period (PBP) is the number of years it takes to recover the initial cost of an
investment. Since the payback period is a measure of liquidity, for a firm with liquidity
concerns, the shorter a project's payback period, the better. However, project decisions
should not be made on the basis of their payback periods because of its drawbacks.
 48

The main drawbacks of the payback period are that it does not take into account either the
time value of money or cash flows beyond the payback period, which means terminal or
salvage value wouldn't be considered. These drawbacks mean that the payback period is
useless as a measure of profitability.
The main benefit of the payback period is that it is a good measure of project liquidity. Firms
with limited access to additional liquidity often impose a maximum payback period, and then
use a measure of profitability, such as NPV or IRR, to evaluate projects that satisfy this
maximum payback period constraint.

ii) Discounted Payback Period

The discounted payback method uses the present values of the project's estimated cash
flows. It is the number of years it takes a project to recover its initial investment in present
value terms, and therefore must be greater than the payback period without discounting.
The discounted payback period addresses one of the drawbacks of the payback period by
discounting cash flows at the project's required rate of return. However, the discounted
payback period still does not consider any cash flows beyond the payback period, which
means that it is a poor measure of profitability. Again, its use is primarily as a measure of
liquidity.

iii) Net Present Value (NPV)

The NPV is the sum of the present values of all the expected incremental cash flows if a
project is undertaken. The discount rate used is the firm's cost of capital, adjusted for the risk
level of the project. For a normal project, with an initial cash outflow followed by a series of
expected after-tax cash inflows, the NPV is the present value of the expected inflows minus
the initial cost of the project.

t =t
CFt
NPV =∑ t
−Io
t=1 ( 1+r )
 49
where:
Io = the initial investment outlay (a negative cash flow)
CFt =after tax cash flow at time t
K = required rate of return for project

A positive NPV project is expected to increase shareholder wealth, a negative NPV project is
expected to decrease shareholder wealth, and a zero NPV project has no expected effect on
shareholder wealth.
For independent projects, the NPV decision rule is simply to accept any project with a positive
NPV and to reject any project with a negative NPV. For mutually exclusive projects, the
projects have to be ranked and the one with the highest NPV accepted.

iv) Profitability Index (PI)

The profitability index (PI) is the present value of a project's future cash flows divided
by the initial cash outlay.

PI= PV cashflows/ Initial outlay

_

As you can see, the profitability index is closely related to the NPY. The PI is the ratio of
the present value of future cash flows to the initial cash outlay, while the NPV is the
difference between the present value of future cash flows and the initial cash outlay.
If the NPV of a project is positive, the PI will be greater than one. If the NPV is
negative, the PI will be less than one. It follows that the decision rule for the PI is:
If PI > 1.0, accept the project
If PI < 1.0, reject the project.

v) Internal Rate of Return (IRR)

For a normal project, the internal rate of return (IRR) is the discount rate that makes the
present value of the expected incremental after-tax cash inflows just equal to the initial cost
of the project. More generally, the IRR is the discount rate that makes the present values of
 50

a project's estimated cash inflows equal to the present value of the project's estimated cash

outflows. That is, IRR is the discount rate that makes the following relationship hold:
PV (inflows) = PV (outflows)
The IRR is also the discount rate for which the NPV of a project is equal to zero.

To calculate the IRR, the trial-and-error method is usually used, that is, keep guessing IRRs
until you get one that gives you a positive NPV and one that give you a negative NPV. An
estimation formula is then used to solve for the IRR as follows:

IRR : NPV=0

CF1 CF2 CF3

   +   +   + ...    −Initial Investment=0
1 2 3
( 1 +r ) ( 1 +r ) ( 1 +r )

Where,
   r is the internal rate of return;
   CF1 is the period one net cash inflow;
   CF2 is the period two net cash inflow,
   CF3 is the period three net cash inflow, and so on ..

IRR decision rule: First, determine the required rate of return for a given project. This is
usually the firm's cost of capital.
If IRR > the required rate of return, accept the project.
If IRR < the required rate of return, reject the project.

Key principles in Project cash flow determination

The capital budgeting process involves five key principles:

I. Decisions are based on cash flows, not accounting income.

The relevant cash flows to consider as part of the capital budgeting process are incremental
cash flows, the changes in cash flows that will occur if the project is undertaken.
Sunk costs are costs that cannot be avoided, even if the project is not undertaken. Since
these costs are not affected by the accept/reject decision, they should not be included in the
analysis. An example of a sunk cost is a consulting fee paid to a marketing research firm to
estimate demand for a new product prior to a decision on the project.
Externalities are the effects the acceptance of a project may have on other firm cash flows.
The primary one is a negative externality called cannibalization, which occurs when a new
project takes sales from an existing product. When considering externalities, the full
implication of the new project (loss in sales of existing products) should be taken into
account. An example of cannibalization is when a soft drink company introduces a diet
version of an existing beverage. The analyst should subtract the lost sales of the existing
beverage from the expected new sales

of the diet version when estimating incremental project cash flows. A positive externality
exists when doing the project would have a positive effect on sales of a firm's other project
lines.

2. Cash flows are based on opportunity costs.

 53

Opportunity costs are cash flows that a firm will lose by undertaking the project under
analysis. These are cash flows generated by an asset the firm already owns, that would be
forgone if the project under consideration is undertaken. Opportunity costs should be
included in project costs. For example, when building a plant, even if the firm already owns
the land, the cost of the land should be charged to the project since it could be sold if not
used.
3. The timing of cash flows is important. Capital budgeting decisions account for the time
value of money, which means that cash flows received earlier are worth more than cash
flows to be received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when
analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep,
not those they send to the government.
5. Financing costs are reflected in the project's required rate of return. Do not consider
financing costs specific to the project when estimating incremental cash flows. The discount
rate used in the capital budgeting analysis takes account of the firm's cost of capital. Only
projects that are expected to return more than the cost of the capital needed to fund them
will increase the value of the firm.

5.5.1 Calculating Project cash flows:

1. Initial investment

The initial net investment in a project is defined as the project’s initial cash outflow, that is,
the capital outlay (or capital expenditure or capital outflow) at the beginning of the project.
 54

It is calculated using the following typical format:

Asset Expansion Asset Replacement

Cost of new asset(s) Cost of new asset

+ Installation and shipping + Installation costs

costs

+ Initial investment in − Proceeds from

working capital sale of old asset

= Initial investment + Taxes on sale of

old asset

+ Initial investment
in working capital

= Initial investment

It is worth noting here that for the purpose of tax-allowable depreciation, working capital is
not an allowable item. The asset cost plus installation and shipping costs form the basis upon
which depreciation is computed. The typical wording of a tax act covering the value of
depreciable items says: ‘the cost of plant and equipment installed ready for use’. This
definition does not include working capital.
 55

2. Net operating cash flows

A project’s after-tax net operating cash flows for any given year during the economic life of
the project may be calculated using the following typical format. To focus on the format
without being distracted by the details of the timing of cash flows for sales and cost of goods
sold, it is assumed that they are all cash flows received or paid during the year. More
explicitly, it is assumed that all sales are for cash and that opening and closing inventories
remain unchanged (hence, the cost of goods sold equals purchases) and that all purchases
are in cash. In fact, the forecasts of sales revenues and costs of goods sold are generally done
on a cash basis and the distinction between cash and non-cash values for a given year is not
an issue.
 56

Calculation of net operating cash inflows

Asset Expansion

Cash inflow from sales

− Cost of goods sold

− Selling, general, administrative and other

expenses

− Depreciation

= Taxable income

− Tax payable

= Net income (after tax)

+ Depreciation

= After-tax net operating cash flow

This method ‘adds back’ all non cash items that are included in the calculation of taxable
income so as to come up with project cash flows.
 57

However, for asset replacement projects, it is the incremental cash-flows that are of interest.
And these are calculated as:

Incremental operating cash flows

Operating cash flow new asset

− Operating cash flow old asset

= Incremental cash flow of the proposed replacement project

3. Terminal cash flow

In the final year of a project’s economic life, there is another cash flow on top of the normal
annual operating cash flows. This is termed the terminal cash flow. Typically, it has two
components: the recovery of the working capital and the recovery of the after-tax salvage
value of the assets.
 58

The typical format for calculating the terminal cash flow is:

Asset Expansion Asset Replacement

Proceeds from sale of assets Proceeds from sale of new asset

− Taxes on sale of assets − Proceeds from sale of old asset

= After-tax salvage value − Taxes on sale of new asset

+ Recovery of working capital + Taxes on sale of old asset

= Terminal cash flow + Recovery of working capital

= Terminal cash flow

3a) Taxes on the sale of an asset

Whenever an asset is sold, there are tax consequences which will affect the net proceeds
from the sale. These tax rules vary not only among different countries but also over time
within a single country. Therefore, expert tax advice ought to be sought at the time of
evaluating the project. However, for analytical purposes, as well as to become familiar with
the different possible tax situations, the tax treatment on ‘sale of assets’ may be categorized
into four cases.
Case 1: Sale of an asset for its tax book-value. Normally if an asset is sold for an amount
exactly equal to its tax book-value, there will be no tax consequences as there will be no gain
or loss on the sale. Tax book-value is equal to the installed cost of the asset minus
accumulated tax depreciation.
 59

Case 2: Sale of an asset for less than its tax book-value. In this case there will be a loss, which
is equal to sale proceeds minus tax book-value. This loss may be treated as an operating loss,
thus reducing the total tax payment.
Case 3: Sale of an asset for more than its tax book-value but less than its original cost. In this
case the amount equal to the book-value may be treated as a tax-free cash flow while the
remainder which is in excess of the book-value may be taxed at the same rate as that applied
to the operating income.
Case 4: Sale of an asset for more than its original cost. In this case part of the gain may be
treated as ordinary income and part may be treated as capital gain. The part treated as
ordinary income may be equal to the difference between the original cost and the current tax
book-value. The capital gain portion may be the amount in excess of the original asset cost.
The tax rates for the two components may be different.

In all four cases the tax book-value will be equal to the ‘written down book-value’, a more
commonly used accounting term. Since we are using tax-allowable rates and methods of
depreciation for our analyses, these amounts will be the same. To concentrate on the
analytical side of project evaluation, we adopt only the simplest tax treatment. We assume
that a single flat corporate tax rate applies, and that it applies both to taxable income from
operations and to any gain (or loss) from the sale of assets. Gain (or loss) from the sale of
assets is defined, for simplicity, as being equivalent to the sale proceeds minus tax book-
value.

3b) Recovery of working capital

Normally the total value of the pool of working capital is assumed to be recovered at
the termination of the project. This is a capital cash inflow and has no taxation implications.
Real Options:
 Real options capture the value of managerial flexibility to adapt decisions in
response to unexpected market developments.
 Companies create shareholder value by identifying, managing and exercising
real options associated with their investment portfolio.
 The real options method applies financial options theory to quantify the value
of management flexibility in a world of uncertainty.
 If used as a conceptual tool, it allows management to characterize and
communicate the strategic value of an investment project.
 Traditional methods (e.g. net present value) fail to accurately capture the
economic value of investments in an environment of widespread uncertainty
and rapid change.
 The real options method represents the new state-of the- art technique for the
valuation and management of strategic investments.
 The real option method enables corporate decision-makers to leverage
uncertainty and limit downside risk.
 Real option (RO) is a method of evaluating and managing strategic investment
decisions in an uncertain business environment. It seeks to quantify
numerically each of the investment options available in a particular situation.
 A ‘real option’ represents a “right, to take an action in the future but not an
obligation to do so”.
 DCF and RO both assign a present value to risky future cash flows.
 DCF entails discounting expected future cash flows at the expected return on
an asset of comparable risk.
 RO uses risk-neutral valuation, which means computing expected cash flows
based on risk-neutral probabilities and discounting these flows at the riskfree
rate.
 In cases where project risk and the discount rates are expected to change
over time, the risk-neutral RO approach will be easier to implement than DCF
(since adjusting cash flow probabilities is more straightforward than adjusting
discount rates).
 The use of formal RO techniques may also encourage managers to think more
broadly about the flexibility that is (or can be) built into future business
decisions, and thus to choose from a different set of possible investments.41
Types of Real Options:
The types of real/managerial options available include:
1. Option to expand (or contract) – An important option is one that allows the firm
to expand production if conditions become favourable and to contract
production if conditions become unfavourable.

2. Options to abandon – If a project has abandonment value, this effectively

represents a put options to the project’s owner.

3. Option to post-pone – For some projects there is the option to wait and there-
by to obtain new information. Sometimes these options are treated informally
as qualitative factors when judging the worth of a project.
 The treatment given to these options may consist of no more than the
recognition that “if such and such occurs, we will have the opportunity to
do this and that.” Managerial options are more difficult to value than are
financial options.
Valuation Implications:
 The presence of managerial, or real, options enhances the worth of an
investment project.
 The worth of a project can be viewed as its NPV, calculated in the
traditional way, together with the value of any option(s).

Project Worth = NPV + Option(s) value

 The greater the number of options and the uncertainty surrounding their use,
the greater the second term in the above equation and the greater the project’s
worth.
Merits:
There are several benefits for decision makers if they decide to use real option
analysis. Some of the important benefits are:
1. It forces a change in the emphasis of decision makers (and the valuation process)
from ‘predicting the future outcome perfectly’ (the NPV rule) to identifying what can (or
rather should) be done about responding to business uncertainty;
2. It gives decision makers the ability to identify the optimal levels of flexibility; and
3. By focusing management’s attention on responding optimally to uncertainty as it
evolves, it promotes a sense of discipline in the management of assets that extends
over the entire life of the project.
Limitations:
Applying real options to a project is cumbersome and problematic. It has following
limitations.
1. Finding an option model that has assumptions that match the project being
analysed i.e. the potential disconnect between financial and real options because
strategic options lack the precise meaning and measurements that financial options
enjoy.
2. Determining the inputs to the option model correctly is critical to achieving accurate
outputs.
3. Being able to mathematically solve the options pricing algorithm. But thanks to
more powerful PCs and software, this problem has been made easier. The
sophisticated mathematics such as partial differential equations of RO, and the
consequent lack of transparency and simplicity are the real concerns.

Thus, RO analysis encourages firm to create various possibilities for the proposed
investments. It is possible that traditional capital budgeting tools may not allow firm to
adopt emerging new technologies if it does not earn its cost of capital but RO may
suggests that it is necessary price to pay for now to earn well in future.

NB Real Options are usually of value to shareholders but are of less value to lenders
of capital
 60

Practice questions

Question 1

You are considering a project whose cash flows are given below:

(a) Calculate the present values of the future cash flows of the project.

(b) Calculate the project’s net present value.

(c) Calculate the internal rate of return.

(d) Should you undertake the project?

Question 2

Your firm is considering two projects with the following cash flows:
 61

(a) If the appropriate discount rate is 12%, rank the two projects.

(b) Which project is preferred if you rank by IRR?

(c) Calculate the crossover rate—the discount rate r for which the NPVs of both projects are
equal.

(d) Should you use NPV or IRR to choose between the two projects? Give a brief discussion.

Question 3

Your uncle is the proud owner of an up-market clothing store. Because business is down, he
is considering replacing the languishing tie department with a new sportswear department.
In order to examine the profitability of such a move, he hired a financial advisor to estimate
the cash flows of the new department. After six months of hard work, the financial advisor
came up with the following calculations:
 62

The discount rate is 12% and there are no additional taxes. Thus the financial advisor
calculated NPV as follows:
7,000
Q__ = −67000 + 0.12 = −8,667

Your surprised uncle asked you (a promising finance student) to go over the calculation.
What are the correct NPV and IRR of the project?

Question 4

A company is considering buying a new machine for one of its factories. The cost of the
machine is $60,000 and its expected life span is five years. The machine will save the cost of a
worker estimated at $22,500 annually. The book value of the machine at the end of year 5 is
$10,000 but the company estimates that the market value will be only $5,000. Calculate the
NPV of the machine if the discount rate is 12% and the tax rate is 30%. Assume straight-line
depreciation over the five-year life of the machine.

Question 5
 63

The ABD Company is considering buying a new machine for one of its factories. The machine
cost is $100,000 and its expected life span is eight years. The machine is expected to reduce
the production cost by $15,000 annually. The terminal value of the machine is $20,000 but
the company believes that it would only manage to sell it for $10,000. If the appropriate
discount rate is 15% and the corporate tax is 40%:

(a) Calculate the project NPV.

(b) Calculate the project IRR.

Question 6

You are the owner of a factory located in a hot tropical climate. The monthly production of
the factory is $100,000 except during June–September when it falls to $80,000 due to the
heat in the factory. In January 2003 you get an offer to install an air-conditioning system in
your factory. The cost of the air-conditioning system is $150,000 and its expected life span is
ten years. If you install the air-conditioning system, the production in the summer months
will equal the production in the winter months. However, the cost of operating the system is
$9,000 per month (only in the four months that you operate the system). You will also need
to pay a maintenance fee of $5,000 annually in October. What is the NPV of the air-
conditioning system if the discount rate is 12% and the corporate tax rate is 35% (the
depreciation costs are recognized in December of each year)?

Question 7

ABC Corporation is considering a replacement investment. The machine currently in use was
purchased two years ago (in 2011) for $49,000. Depreciation for tax purposes is $9,800 per
year for five years. The market value of this machine today (at the beginning of year 2013) is
$35,000. The new machine will cost $123,000 and requires $3,000 for installation. Its
economic life is estimated to be three years and tax-allowable depreciation is $42,000 per
year for three years. If the new machine is acquired, the investment in
 64

accounts receivable is expected to rise by $8,000, the inventory by $25,000 and accounts
payable by $13,000. The annual income before depreciation and taxes is expected to be
$65,000 for the next three years (2013, 2014 and 2015) with the old machine, and $122,000,
$135,000 and $130,000 for the 1st, 2nd and 3rd years, respectively, with the new machine.
The salvage values of the old and new machines three years from today (end of 2015) is
expected to be $3,500 and $4,000, respectively. The income tax rate is 25%. This income tax
applies to operating income as well as to the book gains or losses on the machinery.

Required:
Calculate:
a) The project cash-flows for the replacement project.
b) Calculate NPV if the required rate of return for this project is 15%.
c) Advise ABC Corporation on whether they should replace the old machine.

Question 8
NUST Corporation is considering the purchase of a new item of equipment to replace the
current one. The new equipment will cost $100,000 and requires $7,000 in installation costs.
It will be depreciated using the straight line method over a five-year period. The old
equipment was purchased for $40,000 five years ago. It was being depreciated using the
straight line method over a five-year economic life. The old machine’s market value today is
$45,000. As a result of the proposed replacement the corporation’s investment in working
capital is expected to increase by $12,000. The tax rate is 30%.

a) Calculate the book-value of the old machine.

(b) Calculate the taxes, if any, attributable to the sale of the old machine.
(c) Determine the initial investment associated with the proposed equipment replacement.

Question 9

A new machine can be purchased for $15,000 with an economic life of 10 years and a salvage
value at that time of $3000. Its operating disbursements are $8,000 p.a. The present machine
has a net realizable value of $3000 and its operating disbursements are
 65

$10,000 p.a. If the present machine is not replaced now, it is expected to continue on this
service for 10 years. The salvage value will be zero. Alternatively, the present machine can be
overhauled and modernized for $4000, which will change the operating disbursements to
$9,000 p.a. In this case the economic life is also expected to be 10 years, but with a salvage
value of $1,500 at that date. The minimum required rate of return is 25%. Which course of
action should be selected?

Question 10

You are a financial analyst for Damon Electronics Company. The director of capital budgeting
has asked you to analyze two proposed capital investments, Projects X and Y. Each project
has a cost of $10,000, and the cost of capital for each project is 12 percent. The projects’
expected net cash flows are as follows:
EXPECTED NET CASH FLOWS
YEAR PROJECT X PROJECT Y
0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s payback period, net present value (NPV), internal rate of return
(IRR), and modified internal rate of return (MIRR).
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. How might a change in the cost of capital produce a conflict between the NPV and IRR
rankings of these two projects? Would this conflict exist if k were 5 percent? (Hint: Plot the
NPV profiles.)

Question 11

B. Davis Industries must choose between a gas-powered and an electric-powered forklift

truck for moving materials in its factory. Since both forklifts perform the same function, the
firm will choose only one. The electric- powered truck will cost more, but it will be less
 66

expensive to operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500.
The cost of capital that applies to both investments is 12 percent. The life for each type of
truck is estimated to be 6 years, during which time the net cash flows for the electric-
powered truck will be $6,290 per year and those for the gas-powered truck will be $5,000
per year. Annual net cash flows include depreciation expenses. Calculate the NPV and IRR
for each type of truck, and decide which to recommend.

Question 12

Kandy Corporation is considering a replacement investment. The machine currently in use

was originally purchased two years ago for $65,000. Tax-allowable depreciation is $13,000
per year for five years. The current market value of this machine is $23,000. The new
machine being considered would cost $140,000, and require $4,000 shipping costs and
$2,000 installation costs. The economic life of the machine is estimated as three years. Tax-
allowable depreciation is $70,000 per year for the first two years. If the new machine is
acquired, the investments in accounts receivable is expected to increase by $9,000, the
inventory by $13,000, and accounts payable by $15,000. The before-tax net operating cash
flow is estimated as $120,000 per year for the next three years with the old machine and
$143,000 per year for the next three years with the new machine. The expected resale value
of the old and new machines in three years’ time would be $4,000 and $6,600, respectively.
The corporate tax rate is 30%.
(a) Calculate the initial investment associated with the proposed replacement decision.
(b) Calculate the incremental operating cash flows of the proposed replacement decision.
(c) Calculate the terminal cash flows associated with the proposed replacement decision.
(d) Compute the NPV of the replacement project assuming a discount rate of 6% per
annum.

(e) What is the proposed investment’s IRR?

Use the computed IRR and NPV results and discuss
 Chapter 5
Optimal Capital Structure for the Deal

 While there are these various sources of financing open to projects,

 Optimality is one key issue that project managers should aim to achieve
 Key questions are :
 Are we using the correct form of capital given the nature of the
project?
 Are we using the right mix of the various forms of capital ?
 Are we generating value for the sponsors of the projects ?
 In most projects, the investor (sponsor) is usually a profit seeking investor
 Therefore value maximisation is key for such investors

Quantifying operating cash flows is crucial for defining the second key aspect of
project finance initiatives: the optimal mix of debt and equity. In fact, financial
models work on the basis of a logical framework that takes trends in operating
cash flows as input; flows corresponding to financial items make up the other
input. In the construction phase, such items consist of the use of bank loans, bond
issues, and sponsor equity, and in the operations phase, reimbursement of the
principal and interest to lenders and payment of dividends to the SPV’s
shareholders.
In Figure 5-5, the two key factors for setting up the optimal capital structure lie at
the center of the diagram. Operating cash flow during the operating life represents
cash available for debt service, while the financial structure and assumptions
regarding
loan repayment define the cash requirement.
During the construction phase the operating cash flow is negative. This results in a
financial requirement to be covered with both share capital from sponsors and, more
importantly, bank loans organized by the arranger. Conversely, during the
postconstructionphase, operating cash flow becomes positive and has to be able to
supportthe debt service (principal and interest), the obligation to create and maintain
reserveaccounts, and reimbursement on capital invested by sponsors. As a
precautionarymeasure, flows relating to the debt service and deposits in a reserve
account aresubtracted from operating cash flow. If residual flows remain, they are
made availableto sponsors as dividends. See Figure 5-6.
As regards the reserve account, we should point out that this is established and
maintained for the entire duration of the financing. The amount of funds to set aside
in this account can be determined in various ways. However, a rather common
practice is to decide on an account balance by applying the following formula:
B ¼ DS n
Cost of
raw
materials
Construction
costs
Operating Costs Sales
revenue
Operating
cash flow
Risk
analysis
Risk
allocation
Financial
structure
Debt service
requirements
Debt service
capacity
Capacity ≤
requirements?
F I G U R E 5-5 Process for Defining a Project’s Capital Structure

Waterfall Structure of Project Cashflows

Waterfall Structure of possible uses of Free Cashflows

Free Net Operating Cashflow
 Less Interest on loans

Less Interset on sub-ordinated loans

Less Senior loan repayments

Less sub-ordinated loans repayment

Less Debt reserves provisions

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