FINA 522:
Project Finance and Risk
Analysis
Lecture 1
ELEMENTS
OF
PROJECT FINANCE
PROJECT FINANCE
What is Project Finance?
• No universally accepted definition of the term “Project
Financing” -- different people use it in different senses.
• Project financing refers to a financing in which lenders to a
project look primarily to the cash flow and assets of that project
as the source of payment of their loans.
• Distinct from corporate finance where lenders look to the
company to repay the loan from the cash flow generated by all
of its assets and acquisitions.
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Three Categories of Project Financing
• Full Recourse - lenders look initially to the cash flow and
assets of the project for debt repayment but ultimately can
look to a creditworthy sponsor for any shortfalls.
• Non-Recourse - lenders look solely to the cash flow and
assets of the project for debt repayment. There is no
guarantee that they will be paid.
• Limited Recourse - all financing between full and nonrecourse. Lenders look partially to project cash flow and
assets for debt repayment. In defined circumstances they
look to project sponsors for debt repayment. Two categories:
– Fall away, initially full-recourse then non-recourse (e.g. post-completion)
– True limited recourse - residual risks to sponsors (e.g. market)
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Origins and Development of
Project Finance
• Project financing had its origins in the energy industry in industrialized
countries (oil & gas production loans).
• Later extended to transportation (mainly gas and oil pipelines), mining, utilities
and large industrial projects.
• Scope further expanded to include all kinds of infrastructure projects.
• Today even medium-scale projects (US $5 million) can use project finance.
• The questions asked in the analysis of project finance arrangement may be
quite similar to the ones asked when making small and medium enterprise
(SME) loans. In the case of small business, one needs to look at the cash flow
from benefits financed by the loan. It might be a large proportion of assets of
SME.
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Main Characteristics of Suitable
Investments for Projects Financing
The ideal candidates for project financing are capital
investment projects that
 are capable of functioning as independent
economic units,
 can be completed without undue uncertainty, and
 When completed, will be worth demonstrably more
than they cost to complete.
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Why Project Financing? (cont’d)
• Project Owners’ Perspective
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–
–
–
–
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Achievement of Economics of scale
Risk minimization
Preservation of borrowing capacity and credit rating
Release of free cash flow
Reduce Legal or Regulatory costs
Country specific accounting and/or tax benefits
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Achieving Economies of Scale
• Two or more producers can benefit from joining
together to build a single facility when there are
economies of scale in production.
• For example, two aluminum producers might decide
to build a single aluminum processing plant near a
location where each has a large supply of bauxite.
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Risk Minimization
• A joint venture permits the sponsors to share a project’s
risks.
• If a project’s capital cost is large in relation to the
sponsor’s capitalization, a decision to undertake the
project alone might jeopardize the sponsor’s future.
• Similarly, a project may be too large for the host country
to finance prudently from its treasury.
• To reduce its own risk exposure, the sponsor or host
country can enlist one or more joint-venture partners.
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Expanded Debt Capacity
• Project financing enables a project sponsor to finance the project on someone
else’s credit.
• Often, that someone else is the purchaser(s) of the project’s output.
• If the output purchaser’s credit standing is higher than that of the project
sponsors, the project will be able to borrow funds more cheaply than the project
sponsors could on their own.
• A project can rise funds on the basis of contractual commitments when (1) the
purchasers enter into long-term contracts to buy the project output and (2) the
contract provisions are tight enough to ensure adequate cash flow to the project,
enabling it to service its debt fully under all reasonably foreseeable
circumstances.
• If there are contingencies in which cash flow might be inadequate, supplemental
credit support arrangements will be required to cover these contingencies.
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Size and Cost of Financing for Projects
• Project financing should be pursued when it
will achieve a lower after-tax cost of capital
than conventional financing.
• In an extreme case, the sponsors’ credit may be
so weak that it is unable to obtain sufficient
funds to finance a project at a reasonable cost
on its own.
• Project financing may then offer the only
practical means available for financing the
project.
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Release of Free Cash Flow
• The project entity typically has a finite life.
• Its “dividend policy” is usually specified contractually at the time
any outside equity financing is arranged.
• Cash flow not needed to cover operating expenses, pay debt
service, or make capital improvements-so called free cash flow –
must normally be distributed to the project’s equity investors.
• Thus, under a project financing arrangement, it is the equity
investors, rather than professional managers (as is normally the
case with companies) who get to decide how the project’s free
cash flow will be reinvested.
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Reduced Legal or Regulatory Costs
• Certain types of projects, such as cogeneration projects, involve
legal or regulatory costs that an experienced project operator
can bear more cheaply than an inexperienced sponsor can.
• For example, a chemical company or an oil company that
undertakes a cogeneration project on its own would face
significant costs because of an unfamiliar technology and legal
and regulatory requirements.
Tax and Accountability Issues
– Organizing a project on a project financing basis with a
specific type of organization may lower total tax burden on
project
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Why Project Financing?
• Lenders’ Perspective
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–
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Competitive pressures: other banks are doing
the business
Seeking higher returns
Easier to assess risks in project finance
situation
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Easier to Understand the Nature
of the Project’s Business
• Reduced cost of resolving financial distress problems
• The structure of a project’s liabilities will normally be
less complex than the structure of each sponsor’s
liabilities.
• A project entity’s capital structure typically has just one
to three class of debt, and the number of other potential
claimants is likely to be small.
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Disadvantages of Project Financing
• Project financing will not necessarily lead to a lower cost of capital in all
circumstances.
• Project financings are costly to arrange, and these costs may outweigh the
advantages enumerated above.
• Complexity of Project Financings: Project financing is structured around
a set of contracts that must be negotiated by all the parties to a project.
• Indirect Credit Support: For any given degree of leverage in the capital
structure, the cost of debt is typically higher in a project financing than in a
comparable conventional financing because of the indirect nature of the
credit support. The credit support for a project financing is provided
through contractual commitments rather than through a direct promise to
pay.
• Higher Transaction Cost: Because of their greater complexity, project
financings involve higher transaction costs than comparable conventional
financings.
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Main Characteristics of Project Finance (Summary)
– Project is a distinct legal entity.
– Project assets, project-related contracts, and project cash
flows are separated to a large degree from the sponsors.
– Sponsors provide limited or no recourse to cash flow from
other assets.
– Lenders may have recourse to their funds through other
stakeholders through various types of security
arrangements.
– Two-phase financing is common.
• Construction financing
• Refinancing after the completion is sometimes done in phases as
risk prospects of the project change.
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The Basic Elements of a Project Financing
Investors
Lenders
Equity
Project Finance Debt
Finance
Operator
Operator & Maintenance
Contract
Contractor
Support Agreement
Construction Contract
Project Company
Input Supply Contract
Concession Agreement or License
Offtake Contract
Input Supplier
Offtaker
OR
Government or other
Public Sector
authorities
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Legal Ownership Structures for
Project Financing
(Special Purpose Vehicle (SPV))
• Choice influenced by tax, accounting, regulatory,
risk allocation considerations as well as access to,
and cost of, capital.
• Examples of legal ownership forms are:
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Undivided Joint Interest
Corporation
Partnership
Limited Liability Company
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Undivided Joint Interest
• Liability is several and unlimited
• Each sponsor is responsible for providing its pro rata
share of cost. Advantageous if sponsors have different
credit strengths.
• Tax consequences flow through directly to sponsors.
• Project is not legal entity for accounting purposes –
proportional consolidation of assets and liabilities.
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Partnership
• Can have general partners and limited liability partners
• Must have at least one general partner
• Liability of general partners may be joint or several but liability is
unlimited
• Partnership owns assets and raises equity and debt
• Tax consequences flow through directly to sponsors
• Reflection of project’s assets and liabilities on partner’s balance
sheets depends on ownership share.
• In USA, full consolidation if over 50%, none if less.
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Corporation
• No liability to project owners
• Corporation owns assets and raises equity and debt
• Tax consequences do not flow through directly to sponsors unless there is full
consolidation
• Taxation of income at the corporation and shareholder level, with perhaps
taxation of two or more level.
• Perhaps tax implementation in some countries.
• Reflection of project’s assets and liabilities on partner’s balance sheets
depends on ownership share.
• In USA, full consolidation if over 50%, none if less.
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Limited Liability Company
• No liability to project owners
• Company owns assets and raises equity and debt
• Tax consequences flow through directly to sponsors (deductions
may not include investment tax credits).
• Reflection of project’s assets and liabilities on partner’s balance
sheets depends on ownership share.
• In USA, full consolidation if over 50%, none if less.
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Prerequisites for Project
Financing
• Financial Analysis
• Economic Analysis
• Risk Analysis
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Prerequisites for Project Financing (cont’d)
• Financial Analysis is concerned with:
– project’s overall financial viability and
sustainability--NPV, financial ratios, etc.
– Project’s ability to service its debt--coverage
ratios; and generate sufficient returns--ROA,
ROE.
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Prerequisites for Project Financing (cont’d)
• Economic Analysis is concerned with:
– Economic fundamentals of project
– Economic viability of project
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Prerequisites for Project Financing (cont’d)
• Risk Analysis is concerned with
– identifying the different areas of project risk
– identifying the impact of changes in risky
variables on project’s economic and financial
viability
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