Project Finance

By
S.CLEMENT

Project Finance -features

1. To finance New, Expansion, Modernization,
Diversification etc
2. High value investment
3. Longer Gestation period break even period is
longer
4. High risk spread over longer time horizon and
future is full of uncertainty
5. Irreversible decision difficult to come out or quit

Project Finance
A funding structure that relies on future cash flow
from a specific development as the primary
source of repayment, with that developments
assets, rights and interest legally held as
collateral security
It looks in to cash flow as compared to
conventional corporate lending which looks to
the balance sheet and income statement.

Project finance - structure

Cost of project
Land & site dev.
Building
Machinery
Other assets
Pre op. exp.
Margin for W.C
Contingencies

Means of finance
Capital
Bank loans
Un sec. loans
Subsidy

Project finance involves

MANGERIAL
FINANCIAL
TECHNICAL
COMMERCIAL
LEGAL
ECONOMICAL

Managerial Appraisal
Most subjective aspect
Types of promoters
Existing companies RIL/Bajaj Auto
First generation E.g. Mr. Narayana
Murthy of Infosys
Government/ PSUs SAIL, ONGC etc
Foreign promoters Pepsi/Coke/Ford
motors. Covered under FDI.

Managerial Appraisal
Managerial
Promoters track record individual /group/ how
group companies are managed.
Qualification technical or otherwise
Composition of board - % of independent
/professional directors
Management structure centralized
/decentralized/ reporting systems
Corporate governance ethics/
/transparency/disclosure
Stake in the business high or low

Financial appraisal
Estimates of profitability, cash-flow and balance
sheet
More emphasize on cash flows
Assumptions underlying profitability projections
Critical assumptions

Installed capacity
Capacity utilization 1st/2nd/3rd year etc
Product mix
Consumption of inputs & prices

-- Sales realization
-- Cash realization

FINANCIAL APPRAISAL
Debt Equity
Cash flows realistic vis--vis to loan
repayment
Breakeven/ cash BE
profitability
DSCR
NPV/IRR
Sensitivity analysis

Financial appraisal
Compare profitability with that of existing firms in
similar line, particularly the PBIDT margin.
NPV/(net present value) IRR (internal rate of
return) method: Considered to be best method for
evaluating the capital investment proposals.
It takes into account time value of money
The sum of money received in future is less valuable
than it is today. Present value of rupee to be
received is less than one. E.g. Re 100 today may
not have the same value after one year.
With Passage of time present value of rupee to be
received in future will go on decreasing
Technique of finding present value of money
through discounting is NPV/IRR method

Financial appraisal
Sensitivity analysis
Effect of adverse variance of critical
elements on viability is examined
Typical tests are
Reducing sales vol./ Price
Increasing cost of inputs
Increase in project cost
Effect of FE fluctuation
Reduction in capacity utilization.

Technical appraisal
Various areas covered are

Locational aspects
Process
Technical arrangements
Raw materials
Utilities
Environmental factors
Manpower
Implementation schedule

Location
Proximity to markets [e.g. perishable products]
Proximity to raw material supplies [resource
based, imported raw material] E.g. Cement/Sugar
Proximity to market E.g. Electronics
Availability of labour [quality, quantity, cost,
relations]
Effluent disposal
Other infrastructure [power, transportation, water
etc]. Stand by arrangement for power, water etc
Governmental Policies [restrictions and sops]

Technical arrangements

Technical collaboration
Licensor of know-how/ basic engineering
Patents/ updation clause
Plant & machinery
Guarantees/ warrantees Collaborator/ P&M
supplier/ Details of engineering contractor
Approach to force majeure conditions
earthquake/storm etc
Termination

Technical arrangements
Technical know-how agreement
Supply/ vetting of basic engineering
Guarantees
Liquidated damages for non-performance
Training of personnel
Royalty
Indemnity

Raw Material
Raw materials & quantity
Sustained availability
Imported/ indigenous
Major suppliers
Prices of raw material
Price volatility E.g. oil
Past trends in growth
Duties customs/excise
Arrangements for supply

IMPLEMENTATION
SCHEDULE
Consequences of delay
Increase in project cost
Funding overrun
Effect on viability
Loss of market
Confidence level of FIs

Commercial

Product profile substitutes,inventions

Customer profile high or low
end/corproates/government/overseas etc
Competitors profile local/international
Demand & supply/market share
Import threat- WTO/ Trade block or CECA
(comprehensive economic cooperation
agreement)
Pricing compatible with market/elasticity of
price change
Marketing/Selling arrangements
Govt. Policy budget/foreign trade policy /FDI

Legal
Title to the property
Object clause in Memorandam
Powers to borrow & create charge

PROJECT STRUCTURE
Sponsor 1

Shareholders Agreement

Construction and
O&M Contractors

Sponsor 2

O&M
Contract

EPC
Contract

Equity
Insurance
Policy

Insurance
Company

Loan & Security

Documents

Project SPV

TRA
Agreement

LENDERS

Lenders

Concession
Agreemen
t

Lenders Engineer
TRA Bank

Government

Risks Analysis Why?

Many projects have:
Large investment outlays
Long periods of project payout
Incomplete sharing of information and technology
especially with foreign investors
Differences in the ability of the parties to bear
risks
Unstable contracts
Projects may be attractive in aggregate, but are
unattractive to one or more parties due to
uncertainties about sharing risks and returns.

Risk analysis
Strategic Risks
Market demand [more often than not the demand
projections have little credibility].
Operating costs [often underestimated].
Unexpected/ unanticipated capital costs.

Financial Risks
Interest rate changes.
Currency/ foreign exchange fluctuations.
Liquidity cashs flow mismatch

Risk analysis
Operational Risks
Supply chain management
Information systems
Key managers

Hazard Risks

Property damage
Legal risks
Workers' compensation
Natural disasters

Risk control
Within Companys Control
Outside Companys Control
Within Lenders Control

WITHIN COMPANYS
CONTROL
Operating Risk Technical
Cost
Management
Participant Risk
Engineering Risk or Design Risk
Completion Risk

OUTSIDE COMPANYS
CONTROL

Supply Risk
Market Risk
Infrastructure Risk
Environmental Risk
Political Risk
Force Majeure Risk Temporary
Permanent
Foreign Exchange Risk

RISK SHARING
SPONSORS

BANKS

SHAREHOLDERS
AGREEMENT

SUPPLIERS

CREDIT
ENHANCEMENT

SUPPLY
AGREEMENTS

PROJECT COMPANY

OPERATOR
LOCAL LAWS
O&M AGREEMENT

GOVERNMENT
AGREEMENTS

EPC CONTRACTOR
EPC CONTRACT

Risk and risk mitigation

Risks
Political
Interest rate
Liquidity
Force Majeure
Exchange rate

Risk mitigation
Arbitration clause
Hedging
Cash flow
arrangement/
standby
* Insurance
* Hedging - FC

Strategy of Reliance Petroleum

Why RPL is the most profitable refinery in
the world?
How RPL can achieve a refining margin of $
9-10/barrel which is one and half times
higher than the global players ?
Singapore refineries can achieve just
$3/barrel.
What is the strategy? What is secret of
success ?

Strategy of Reliance Petroleum

Ability to build larger projects cheaply(37% less
than in US)
Most other refineries sign long term contracts
covering all their needs and tailor made
refinery technology. It assures supply security
but not price security.
RPL opted for highly complex refinery (out of
2300 different configurations) for a) to crack all
low-value fractions (as fuel oil) into higher
value products and b) complex refinery could
refine a wide variety of crude.

Strategy of Reliance Petroleum

Of course, this flexibility came at a price
since complex refinery cost is much more
than stand alone.
How did RPL justify such an expensive and
complex compared to others.?
RPL took huge bet on composition of future
oil supplies i.e. expected that supply low
quality crude will outstrip that of high quality
crude creating widening price discount for
low quality varieties.

Strategy of Reliance Petroleum

This will make it profitable to buy low quality
crude which could not be processed in
efficiently in simple refinery but in complex
refinery.
By tracking, the prices of different crude and
products, RPL could spot opportunities
continuously to buy cheap crude variety.
Simple refinery lacked the flexibility to switch
from one to another crude.
RPL bet that this flexibility would justify high
cost of complex refinery.

Strategy of Reliance Petroleum

RPL strategy is based on opportunism in
selecting profitable crude to import at any
point of time
It does not assure supply security. RPL has
firm contracts for only half its capacity . For
the rest, it scans the market for short term
bargains.
Insecurity of supply can translate in to
security of high profits.

Successful project finance

entails ...
Identification of proper project
Right transaction structure
Proper risk identification, allocation and
mitigation