PROJECT FINANCE Project finance does not have a singular universally accepted definition, although available definitions point out that it is a means of financing capital intensive projects. It could be defined as the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself (Pinto, 2017). Typically, project finance is used for capital intensive infrastructure investments that employ established technology and generate stable returns, preferably returns that are denominated or can easily be converted into hard currencies (Gatti, 2008). In earlier times, the financing and construction of major infrastructure project was seemingly dominated by private entrepreneurs, in a way being privately owned. However, in an essay submitted to All Answers Ltd it is reported that private sector involvement dwindled or disappeared after World War 1. It could have been as a result of the economic and financial impact that the war had on investors and the economic state of many countries as well as environmental factors such as geographical location of aspiring projects which require transportation of material. Dating back to at least 1299 A.D. when the English crown financed the exploration and development of the Devon silver mines (Kensinger and Martin, 1993), project financing has evolved through the centuries into primarily a vehicle for assembling a consortium of investors, lenders and other participants to undertake infrastructure projects that would be too large for individual investors to underwrite (Comer, 1996). Governments began to oversee the allocation and financing of projects through public sector borrowing. International lending institutions such as the International Monetary Fund, World Bank Group, and the Asian Development Bank also developed interest and have overtime supported public finance in developing and developed countries alike. Having realised the importance of private sector, governments alongside international lending organisations encourage its involvement through project finance techniques in order to attract new money so as to accelerate economic growth and development. Kleimeier and Megginson (2000) point out that the use of project finance to fund natural resources, electric power, transportation, and other ventures around the world has risen steadily for the past four decades, from its modern beginnings financing development of the North Sea oil fields during the 1970’s (Pinto, 2017). Attributes of project finance Similar to its definition, different researchers have given different views on what are considered as attributes of project finance. Some characteristics or features of include the following. i) Non-recourse financing Considered to be the most visible attribute, non-recourse financing implies that the sponsor holds no obligations to ensure the repayment of the project debt or loan. In other words, if revenues generated from the project are insufficient to repay the loan the sponsor is not personally liable. Expected revenues and assets of the project are considered as collateral for the loan. Fight, 2006, stated that this is important because capital adequacy requirements and credit ratings mean that assuming financial commitments to a large project may adversely impact the company’s financial structure and credit rating (and ability to access funds in the capital markets). This safeguards the private assets and credit score of the sponsor as their involvement in the project is limited. ii) Off balance sheet financing This means that a company does not reflect the project on its balance sheet, instead a Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) is created to isolate financial risk that could result from project failure from the company or owner’s financial condition. Theoretically, the project sponsor may retain some real financial risk in the project as a motivating factor, however, the off balance sheet treatment per se will effectively not affect the company’s investment rating by credit rating analysts (Fight, 2006). 2 iii) Capital intensive Project finance requires huge amounts of money as projects undertaken are costly. Governments are able to raise funds for developmental projects on the international capital markets in form of bonds and other financial instruments. For example, the Kafue flyover bridge in Lusaka which cost approximately $13 million was financed and constructed by AFCON an Indian company. When this happens, it implies that the entity that actually owns the project is not sufficiently creditworthy. iv) Numerous project participants Project finance incorporates both domestic and international participants. This allows project sponsors to add equity investors to the list of project shareholders. This also allows for a vast amount of lenders to be able to provide loans as most of the projects tend to be too large for one lender to issues loans. v) Risk allocation It permits the risks associated with projects to be allocated among a number of parties at levels acceptable to each party (Francis, 2013). This is typically matched with the returns to be paid to each party and is normally based on the equity ratio, that is, the amount the individual parties invest in the project. This creates an atmosphere that allows all participants to incur the same eventful costs; no single party can receive benefits alone without experiencing loss resulting from project failures and vice versa. Furthermore, Pinto (2017) stated that project risks are allocated to parties that are most capable of handling them. vi) Cost of financing The cost of a project could be above its estimated value depending on the host country’s terms of service. It is advisable to seek financial consultancy from both international and indigenous financial advisors on issues such as locales desirable for a project and capital requirements before implementing its construction. It is also important to reduce any and all political risk opposing the project. 3 LEASES A lease can be defined as a contract where one party which uses the assets agrees to pay rent for the use of that asset to the proprietor of that asset (Parikh, 2011). It involves two parties. One of which is the lessor, the owner of the asset or the landlord, and the other is the lessee, the borrower or tenant. There existent a number of leases, but the most commonly discussed or the considerably major types are the finance or capital lease and operating or service lease. i) Finance lease The capital or finance lease is an alternative solution to borrowing in that the lessor purchases the asset and transfers largely all the rights, risks and rewards to the lessee against a periodically fixed rental (Borad, 2018). The lessee has the bargain option purchase price which provides the opportunity to acquire ownership of the asset if so desired. Seemingly more costly than the operating lease, the finance lease enables the lessor to recover a large proportion of if not the entire amount the asset cost in additional to earning interest from the rentals paid the lessee. Termination of the lease before end date by the lessee in most times will attract a penalty charge from the lessor as some sort of compensation. Maintenance and damage repair fall onto the lessee and not the proprietor of the asset. The lease term covers a major part of the economic life of the asset. The leased assets are of a specialised nature such that only the lessee can use them without major modifications being made (ACCA, nd). The most appropriate example of a financial lease could be that of car rental and hire. Traditionally, the company pays for insurance and all other required road fitness costs. In the event that the client has an accident before maturity of the insurance policy, all costs to repair the vehicle fall onto them. The cost of fuel is also covered by the client. ii) Operating lease Also known as the service lease, this is a short term lease of an asset for a limited period of time. A lease payment under such a lease is not enough to cover full cost of 4 equipment (Shodhganga, nd). Typically, with this kind of lease ownership is retained by the lessor during and after the lease term. In short, ownership is at no point transferred to the lessee. Maintenance, taxes and other costs related to the asset are paid for by the proprietor. If they so desire, a lessee can cancel the lease on an asset prior to the expiration date without incurring any penalty charges. The lease is active for a period shorter than the economic life of the asset. Rentals paid for use of the asset do not equal its actual value. For instance, a seamstress decides to open a tailoring shop but does not own a sewing machine could hire or rent one for say a year in order to generate funds to purchase her own machine. In the meantime, the amount she pays for its usage will not be the same value the owner paid for it. If funds are raised before the year is over, the lessee who in this case is the seamstress can cancel the lease without any further charges. It should be noted that terms of an operating vary significantly according to the agreement between the lessor and lessee. Calculation of lease payments Generally, the formula used to determine lease payments is the sum of the depreciation charge, interest rate and the sales tax charge. That is; Total lease payment= depreciation+ interest+ tax Steps in calculating a lease payment i) Depreciation charge Depreciation refers to the drop in the value of a fixed asset such as a car, machine, computer etc. Firstly, the net capitalised cost is calculated Net capitalised asset= negotiated selling price- down payments & other credits+ loan balance Secondly, determine the residue value of the item Residual value= sticker price* residual percentage 5 Thirdly, identify the number of monthly payments on the lease Depreciation fee= (net capitalised cost- residual value)/ number of monthly payments For example, a lease is granted on a new car for 3 years with sticker price $30,000, negotiated purchase price $26,000, cash down payments $1,000, trade in old car for credit $3,000, and residual value 55% of sticker price Net capitalised cost= 26000-1000-3000= $22,000 Residual value=30000*55%= $16,500 Number of monthly payments= 3 years * 12 months= 36 Depreciation fee= 22000-16500/36= $152.78 ii) Interest charge (financing) Additional charge to principal paid for use of item First step is to calculate the money factor MF= interest rate (APR)/2400=6%/2400=0.0025 OR MF= rent charge/(net cap. Cost- residual value*period of lease) 3465/(22000-16500)*36= 0.0025 Next, add the net capitalised cost to the residual value Financing fee= (22000+16500)*0.0025= $96.25 iii) Sales tax charge This is the last step before the final estimation of the lease payment. Consider taxes local sales tax of 5% Sales tax= lease payment* local sales tax 6 Lease payment= dep. fee +finance fee ($152.78+ $96.25)*5%= $12.45 Example two Assume the car you will be leasing has an MSRP (sticker price) of $27,000 and you managed to negotiate the purchase price down to $25,000. There is no down payment and you do not have a trade-in. you will be leasing the car for 36 months. The money factor is 0.0029, and the leasing company has predicted the residual value to be $12, 500 at the end of 36 months. (Example adopted from realcartips.com). Depreciation (25000-12500)/ 36= $347 Interest (25000+12500)* 0.0029=$109 Taxes (347+109)* 7%= $32 (note that 7% is the local sales tax rate) Total lease payment= 347+109+32= $488 monthly 7 REFERENCES Gatti, S. 2008. Project Finance in Theory and Practice: designing, structuring, and financing private and public projects. All Answers Ltd.2018. Concepts of Project Finance. [Online article]. Available from: https://ukdiss.com/examples/origins-of-project-finance.php?vref=1 [accessed on 31 August, 2020] Comer, B. 1996. Project Finance Teaching Note. [Online article]. Available from: https://finance.wharton.upenn.edu [accessed on 1 September, 2020]. Fight, A. 2006. Introduction to Project Finance. n.a. 1999. Project Financing and the International Financial Markets. Springer, Boston. MA. Available from: https://doi.org/10.1007/978-0-585-31561-4_9 [accessed on 31 August, 2020] Francis, A. 2013. Project Management: Characteristics of Project Financing. [online article]. Available from: https://www.mbaknol.com [accessed on 2 September, 2020] Kesinger, J.W and Martin, J.D. “Project Finance: Raising Money the Old-Fashioned Way,” in Donald H. Chew Jr., ed. 1993. The New Corporate Finance: Where Theory Meets Practice. New York: McGraw-Hill, p.326. Pinto, J.M. 2017. Investment Management and Financial Innovations: what is project finance? Catholic University of Portugal. Parikh, V.2011. Features of Operating Lease. [online article]. Available from: https://www.letslearnfinance.com [accessed on 4 September, 2020] Kumar, A. 2016. Finance: Capital Lease. [online article]. Available from: https://efinancemanagement.com [accessed on 2 September, 2020] Shodhganga. nd. Features of Operating leases. https://www.shodhganga.com [accessed on 31 August, 2020] 8 Available from: Borad, S. 2018. Financial Lease: Meaning and definition of Financial Lease. Available from: https://www.readyratios.com [accessed on 4 September, 2020] ACCA. nd. Lease: Operating or Finance. 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