Project Financing - Financial Scheme for Long-Term Projects

The process of development of a project consists of 3 stages - pre-bid stage,

contract negotiation stage, and fund-raising stage. Be it a long-term
infrastructure, public services, or industrial project, sourcing funds to implement
and successfully run an undertaking is an integral part of the entire process.
With Project Financing, a company can arrange for a loan based on the cash
flow generated at the end of a project while using the assets, rights, and interests
of the concerned project as collateral. As this scheme provides financial aid off
balance sheet, the credit of the Government contracting authority or the
shareholders is not affected. Since Project Financing shifts part of the risk
associated with the project to the lenders, this financial plan is one of the most
preferred options for private sector companies.
This structured financing technique is implemented mostly by the sectors that
have low technological risks and a predictable market. Therefore, the method of
funding a project using Project Financing is generally employed by companies
in the telecommunication, mining, transportation, and power industries. Sports
and entertainment venue projects also often avail the benefit of this financing
scheme. Project Financing is also preferred by many financial services
organisations because they can earn better margins if a business chooses to opt
this scheme as opposed to any other financing technique.

What is Project Financing?

If you are planning to start an industrial, infrastructure, or public services
project and need funds for the same, Project Financing might be the answer that
you are looking for. Project Financing is a long-term, zero or limited recourse
financing solution that is available to a borrower against the rights, assets, and
interests related to the concerned project. The repayment of this loan can be
done using the cash flow generated once the project is complete instead of the
balance sheets of the sponsors. In case the borrower fails to comply with the
terms of the loan, the lender is entitled to take control of the project.
Additionally, financial companies can earn better margins if a company avails
this scheme while partially shifting the associated project risks. Therefore, this
type loan scheme is highly favoured by sponsors, companies, and lenders alike.
In order to bridge the gap between sponsors and lenders, an intermediary is
formed namely Special Purpose Vehicle (SPV). The main role of the SPV is to
supervise the fund procurement and management to ensure that the project
assets do not succumb to the aftereffects of project failure. Before a lender
decides to finance a project, it is also important that all the risks that might
affect the project are identified and allocated to avoid any future complication.

What Is Special Purpose Vehicle and Why Is It Necessary?

During Project Financing, a Special Purpose Vehicle (SPV) is appointed to
ensure that the project financials are managed properly to avoid non-
performance of assets due to project failure. Since this entity is established
especially for the project, the only asset it has is the project. The appointment of
SPV guarantees the lenders of the sponsors’ commitment by ensuring that the
project is financially stable.

Key Features of Project Financing

Since a project deals with huge amount funds, it is important that you learn
about this structured financial scheme. Below mentioned are the key features of
Project Financing:
Capital Intensive Financing Scheme Project Financing is ideal for ventures
requiring huge amount of equity and debt, and is usually implemented in
developing countries as it leads to economic growth of the country. Being more
expensive than corporate loans, this financing scheme drives costs higher while
reducing liquidity. Additionally, the projects under this plan commonly carry
Emerging Market Risk and Political Risk. To insure the project against these
risks, the project also has to pay expensive premiums.
Risk Allocation Under this financial plan, some of the risks associated with the
project is shifted towards the lender. Therefore, sponsors prefer to avail this
financing scheme since it helps them mitigate some of the risk. On the other
hand, lenders can receive better credit margin with Project Financing.
Multiple Participants Applicable As Project Financing often concerns a large-
scale project, it is possible to allocate numerous parties in the project to take
care of its various aspects. This helps in the seamless operation of the entire
process.
Asset Ownership is Decided at the Completion of Project The Special Purpose
Vehicle is responsible to overview the proceedings of the project while
monitoring the assets related to the project. Once the project is completed, the
project ownership goes to the concerned entity as determined by the terms of
the loan.
Zero or Limited Recourse Financing Solution Since the borrower does not have
ownership of the project until its completion, the lenders do not have to waste
time or resources evaluating the assets and credibility of the borrower. Instead,
the lender can focus on the feasibility of the project. The financial services
company can opt for limited recourse from the sponsors if it deduces that the
project might not be able to generate enough cash flow to repay the loan after
completion.
Loan Repayment With the Project Cash Flow According to the terms of the loan
in Project Financing, the excess cash flow received by the project should be
used to pay off the outstanding debt received by the borrower. As the debt is
gradually paid off, this will reduce the risk exposure of financial services
company.
Better Tax Treatment If Project Financing is implemented, the project and/or
the sponsors can receive the benefit of better tax treatment. Therefore, this
structured financing solution is preferred by sponsors to receive funds for long-
term projects.
Sponsor Credit Has No Impact on Project While this long-term financing plan
maximises the leverage of a project, it also ensures that the credit standings of
the sponsor has no negative impact on the project. Due to this reason, the credit
risk of the project is often better than the credit standings of the sponsor.

What Are the Various Stages of Project Financing?

Pre-Financing Stage
This stage further consists of the following segments:
Identification of the Project Plan - This process includes identifying the
strategic plan of the project and analysing whether its plausible or not. In order
to ensure that the project plan is in line with the goals of the financial services
company, it is crucial for the lender to perform this step.
Recognising and Minimising the Risk - Risk management is one of the key
steps that should be focused on before the project financing venture begins.
Before investing, the lender has every right to check if the project has enough
available resources to avoid any future risks.
Checking Project Feasibility - Before a lender decides to invest on a project, it
is important to check if the concerned project is financially and technically
feasible by analysing all the associated factors.
Financing Stage
Being the most crucial part of Project Financing, this step is further sub-
categorised into the following:
Arrangement of Finances - In order to take care of the finances related to the
project, the sponsor needs to acquire equity or loan from a financial services
organisation whose goals are aligned to that of the project.
Loan or Equity Negotiation - During this step, the borrower and lender
negotiate the loan amount and come to a unanimous decision regarding the
same.
Documentation and Verification - In this step, the terms of the loan are mutually
decided and documented keeping the policies of the project in mind.
Payment - Once the loan documentation is done, the borrower receives the
funds as agreed previously to carry out the operations of the project.
Post-Financing Stage
Timely Project Monitoring - As the project commences, it is the job of the
project manager to monitor the project at regular intervals.
Project Closure - This step signifies the end of the project.
Loan Repayment - After the project has ended, it is imperative to keep track of
the cash flow from its operations as these funds will be, then, utilised to repay
the loan taken to finance the project.
Types of Sponsors in Project Financing
In order to determine the objective of the project and the risks related to it, it is
important to know the type of sponsor associated with the project. Broadly
categorised, there are four types of project sponsors involved in a Project
Financing venture:
Industrial sponsor - This type of sponsors are usually aligned to an upstream or
downstream business in some way.
Public sponsor - The main motive of these sponsors is public service and are
usually associated with the government or a municipal corporation.
Contractual sponsor - The sponsors who are a key player in the development
and running of plants are Contractual sponsors.
Financial sponsor - This type of sponsors often partake in project finance
initiatives and invest in deals with a sizeable amount of return.
Conclusion
Project Financing is a long-term, non-recourse or limited recourse financing
scheme that is used to fund massive projects which can be repaid using the
project cash flow obtained after the completion of the project. This scheme
offers financial aid off balance sheet, therefore, the credit of the shareholder and
Government contracting authority does not get affected. In Project Financing,
multiple participants are allowed to handle the project while the ownership of
the project is entitled according to the terms of the loan only after the project is
completed. This financial scheme offers better credit margin to lenders while
shifting some of the risk from the sponsors to the lenders.
As the Indian Government continues to investment on the infrastructure of the
country, it is expected that there will be massive developments in future in
terms of power, transportation, bridges, dams etc. Most of these projects will be
using the Public Private Partnership (PPP) method indicating a rise in Project
Financing during the upcoming years. This entire cycle will further help
improve the economic condition of India.

Definition of NPV
When the present value of the all the future cash flows generated from a project
is added together (whether they are positive or negative) the result obtained will
be the Net Present Value or NPV. The concept is having great importance in the
field of finance and investment for taking important decisions relating to cash
flows generating over multiple years. NPV constitutes shareholder’s wealth
maximization which is the main purpose of the Financial Management.

NPV shows the actual benefit received over and above from the investment
made in the particular project for the time and risk. Here, one rule of thumb is
followed, accept the project with positive NPV and reject the project with
negative NPV. However, if the NPV is zero, then that will be a situation of
indifference i.e. the total cost and profits of either option will be equal. The
calculation of NPV can be done in the following way:

NPV = Discounted Cash Inflows – Discounted Cash Outflows

Definition of IRR
IRR for a project is the discount rate at which the present value of expected net
cash inflows equates the cash outlays. To put simply, discounted cash inflows
are equal to discounted cash outflows. It can be explained with the following
ratio, (Cash inflows / Cash outflows) = 1.

At IRR, NPV = 0 and PI (Profitability Index) = 1

In this method, the cash inflows and outflows are given. The calculation of the
discount rate, i.e. IRR, is to be made by trial and error method.

The decision rule related to the IRR criterion is: Accept the project in which the
IRR is greater than the required rate of return (cut off rate) because in that case,
the project will reap the surplus over and above the cut-off rate will be obtained.
Reject the project in which the cut-off rate is greater than IRR, as the project,
will incur losses. Moreover, if the IRR and Cut off rate are equal, then this will
be a point of indifference for the company. So, it is at the discretion of the
company, to accept or reject the investment proposal.

Key Differences Between NPV and IRR

The basic differences between NPV and IRR are presented below:
The aggregate of all present value of the cash flows of an asset, immaterial of
positive or negative is known as Net Present Value. Internal Rate of Return is
the discount rate at which NPV = 0.
The calculation of NPV is made in absolute terms as compared to IRR which is
computed in percentage terms.
The purpose of calculation of NPV is to determine the surplus from the project,
whereas IRR represents the state of no profit no loss.
Decision making is easy in NPV but not in the IRR. An example can explain
this, In the case of positive NPV, the project is recommended. However, IRR =
15%, Cost of Capital < 15%, the project can be accepted, but if the Cost of
Capital is equal to 19%, which is higher than 15%, the project will be subject to
rejection.
Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR
such an investment is made at the rate of IRR.
When the timing of cash flows differs, the IRR will be negative, or it will show
multiple IRR which will cause confusion. This is not in the case of NPV.
When the amount of initial investment is high, the NPV will always show large
cash inflows while IRR will represent the profitability of the project irrespective
of the initial invest. So, the IRR will show better results.
Similarities

 Both uses Discounted Cash Flow Method.

 Both takes into consideration the cash flow throughout the life of the
project.
 Both recognize time value of money.

Comparison Chart

BASIS FOR
NPV IRR
COMPARISON

Meaning The total of all the present IRR is described as a rate

values of cash flows (both at which the sum of
positive and negative) of a discounted cash inflows
project is known as Net equates discounted cash
Present Value or NPV. outflows.

Expressed in Absolute terms Percentage terms

What it represents? Surplus from the project Point of no profit no loss

(Break even point)

Decision Making It makes decision making It does not help in

easy. decision making

Rate for reinvestment Cost of capital rate Internal rate of return

of intermediate cash
flows

Variation in the cash Will not affect NPV Will show negative or
outflow timing multiple IRR
Conclusion

Net Present Value and Internal Rate of Return both are the methods of
discounted cash flows, in this way we can say that both considers the time value
of money. Similarly, the two methods, considers all cash flows over the life of
the project.

During the computation of Net Present Value, the discount rate is assumed to be
known, and it remains constant. But, while calculating IRR, the NPV fixed at
‘0’ and the rate which fulfills such a condition is known as IRR.

Payback Period
The payback period is the time required to earn back the amount invested in an
asset from its net cash flows. It is a simple way to evaluate the risk associated
with a proposed project. An investment with a shorter payback period is
considered to be better, since the investor's initial outlay is at risk for a shorter
period of time. The calculation used to derive the payback period is called the
payback method. The payback period is expressed in years and fractions of
years. For example, if a company invests $300,000 in a new production line,
and the production line then produces positive cash flow of $100,000 per year,
then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000
annual payback).

The formula for the payback method is simplistic: Divide the cash outlay
(which is assumed to occur entirely at the beginning of the project) by the
amount of net cash inflow generated by the project per year (which is assumed
to be the same in every year).

Payback Period Example

Alaskan Lumber is considering the purchase of a band saw that costs $50,000
and which will generate $10,000 per year of net cash flow. The payback period
for this capital investment is 5.0 years. Alaskan is also considering the purchase
of a conveyor system for $36,000, which will reduce sawmill transport costs by
$12,000 per year. The payback period for this capital investment is 3.0 years. If
Alaskan only has sufficient funds to invest in one of these projects, and if it
 were only using the payback method as the basis for its investment decision, it
would buy the conveyor system, since it has a shorter payback period.

Payback Method Advantages and Disadvantages

The payback period is useful from a risk analysis perspective, since it gives a
quick picture of the amount of time that the initial investment will be at risk. If
you were to analyze a prospective investment using the payback method, you
would tend to accept those investments having rapid payback periods and reject
those having longer ones. It tends to be more useful in industries where
investments become obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. Though the payback method is widely
used due to its simplicity, it suffers from the following problems:

1. Asset life span. If an asset’s useful life expires immediately after it pays back
the initial investment, then there is no opportunity to generate additional cash
flows. The payback method does not incorporate any assumption regarding
asset life span.
2. Additional cash flows. The concept does not consider the presence of any
additional cash flows that may arise from an investment in the periods after full
payback has been achieved.
3. Cash flow complexity. The formula is too simplistic to account for the multitude
of cash flows that actually arise with a capital investment. For example, cash
investments may be required at several stages, such as cash outlays for periodic
upgrades. Also, cash outflows may change significantly over time, varying with
customer demand and the amount of competition.
4. Profitability. The payback method focuses solely upon the time required to pay
back the initial investment; it does not track the ultimate profitability of a
project at all. Thus, the method may indicate that a project having a short
payback but with no overall profitability is a better investment than a project
requiring a long-term payback but having substantial long-term profitability.
5. Time value of money. The method does not take into account the time value of
money, where cash generated in later periods is worth less than cash earned in
the current period. A variation on the payback period formula, known as the
discounted payback formula, eliminates this concern by incorporating the time
 value of money into the calculation. Other capital budgeting analysis methods
that include the time value of money are the net present value method and the
internal rate of return.
6. Individual asset orientation. Many fixed asset purchases are designed to
improve the efficiency of a single operation, which is completely useless if
there is a process bottleneck located downstream from that operation that
restricts the ability of the business to generate more output. The payback period
formula does not account for the output of the entire system, only a specific
operation. Thus, its use is more at the tactical level than at the strategic level.
7. Incorrect averaging. The denominator of the calculation is based on the average
cash flows from the project over several years - but if the forecasted cash flows
are mostly in the part of the forecast furthest in the future, the calculation will
incorrectly yield a payback period that is too soon. The following example
illustrates the problem.

Conclusion

The payback method should not be used as the sole criterion for approval of a
capital investment. Instead, consider using the net present value or internal rate
of return methods to incorporate the time value of money and more complex
cash flows, and use throughput analysis to see if the investment will actually
boost overall corporate profitability. There are also other considerations in a
capital investment decision, such as whether the same asset model should be
purchased in volume to reduce maintenance costs, and whether lower-cost and
lower-capacity units would make more sense than an expensive "monument"
asset.