PROJECT FINANCING

Banks provide facilities for two purposes. For building up current assets of the borrower, banks provide fund based and non-fund based facilities in the form of working capital. For building up current assets of the borrower, banks can provide project loan and term loan. The basic difference between Project Financing and Term Loan is that in the case of Project Financing, the loan is secured by way of primary 

securities and no collateral securities are available. Besides, the cash flow from the assets financed would only be available to repay the project finance loan.

In the case of term loan, the collateral security is available and other cash flows are also available over and above the cash flows from the primary assets. Since the assessment part is the same in the case of both kinds of financing, we shall be using terminology project financing and term loan interchangeably. Besides banks provide term loan for building up of assets which is other than current assets. So term loan is provided for the following purposes:

• Building up of fixed assets of the borrower

• Building up portion of current assets of the borrower

• Building up other non- current assets of the borrower

Determination of Project Cost & Means of Finance

The first step in any project loan assessment is the determination of project cost. Project cost calculations are different for different categories of term loan. If the term loan is provided only for the capacity expansion of a lower end SME, the project cost would be only the fixed assets cost. However, if we are giving the loan for setting up a new unit the project cost can be composed of three components:

(i) Fixed Asset Cost and Contingencies

(ii) Interest during Construction

(iii) Margin Money for working capital

So we can generalize the concept where the project cost can be defined as:

Project Cost = Fixed Asset Cost and Contingencies (I) + Interest During Construction (II) + Margin Money For Working Capital (III)

Depending on the nature of the borrower, we can exclude second and third component from the determination of project cost. One of the basic principles is that if the risk of the borrower is high then II and III would not be included in the project cost and this amount needs to be funded with equity. Similarly, in the case of existing unit, project cost would not include II and III part as this would be funded purely by the equity part. However, if the borrower is a good borrower and its credibility is high, we can include both II and III.

Fixed Asset Cost determination

First lenders would ask the borrower to submit quotation from reputed suppliers. The fixed asset would consist of the following:

(i) Land

Building

(i) Plant and Machinery 

(ii) Furniture and Fixture 

(iii) Information Technology 

(i) Land: For almost all cases, land would not be financed by the term lender. So term lender would first ask the borrower to submit the land documents. In case land has not been purchased, the lender would not disburse the fund unless proof of land purchase has been shown to the lender by the borrower. 

(ii) Building: In the case of a project where building has to be constructed, the lender would ask the borrower to submit detailed quotation for the building construction. Lender’s engineer should verify the correctness of the quotation and the engineer should give written report in this regard. In case lender’s engineer reduced the cost, the lender would communicate the same to the borrower and borrower has to accept this reduced quotations. While selecting the contractors for the construction of the building, the lender should ensure the following: 

• The capacity of the contractor to execute such job 

• The net worth of the contractor 

• Past track record 

(iii) Plant and Machinery: The borrower should submit multiple quotations and the lender should check the price of the equipment from the market. Lenders must also check about the following aspects of the plant and machinery: 

• Suppliers credibility of the market 

•  Machines performance 

• Comprehensive Maintenance Contract and its provisions 

• Any adverse opinion of the machines being purchased in the recent periods 

(iv) Furniture and Fixture: We shall adopt the same process as in the case of the building. 

(v) Information Technology: In the case of IT, we shall take quotation from renowned vendors. It is advisable that at the time of first purchase, extended warranty period may be included in the quotations and the same to be included in the project cost. 

Once we get all the price of the fixed assets, we determine the time of implementation. Since the implementation period would be spread over time period, the interest incurred during the construction period would be capitalized and the same would be included in the project cost. This interest is called Interest During Construction (IDC). 

Margin Money for Working Capital

In the case of Margin Money for working capital or Net Working Capital calculation, we need to project the current assets. Margin money for working capital is a part of project finance. Without working capital project finance disbursement would not take place. Current asset should always be categorized into three parts: 

• Inventory 
•  Receivable 
•  Other Current Asset 

Inventory level may go up in the initial part of the project. Due to initial teething problem, inventory level would come down as the process stabilizes. This may not be true for receivable. Receivable level would go up in the initial stage if the product has competition in the market. For innovative product, receivable level may not go up in the initial phase. Receivable level may not go down subsequently. Holding level is important for calculation of appropriate working capital. Holding level should be based on a realistic situation. Lender should never assume constant current asset. It must determine the current asset from the holding level. 

Evaluation of the project 

When we decide for undertaking investment in a capital project, the following are the characteristics: 

•  Money is invested at a time i.e. out flow of fund takes place at a time; 

•  Inflow of fund is taking place at different points of time; 

•  So there is time value of money concept involved in analysing the capital investment decision since there is a considerable difference between the inflow and outflow of fund. 

So any good project evaluation criteria must consider this time value of money. However, even today there are certain criteria which do not take into account the time value of money criteria. However, this type of evaluation must not be adopted. 

Based on this, we are making a list of different evaluation criteria. The entire evaluation criterion is divided into two categories: 

Category I (where time value of cash flow is not considered) 

• · Pay Back method 

• · Accounting Rate of return 

• Category II (where time value of cash flow is considered) 

• · Discounted Pay back 

• · Net Present Value 

• · Internal Rate of Return.

• These techniques have already been discussed in greater detail in the paper Financial Management at Intermediate Level. 

• Issues related to Project /Infrastructure Funding 

• Project Financing is a new concept in India. Presently, not much of project financing happens in India except in the infrastructure sector. So issues related to infrastructure funding can be best methodology to analyse the appropriate assessment process of project funding.

• Every infrastructure proposal should have the following sections: 

• · Technical Feasibility 

• · Financial Viability 

• · Bankability 

• · Risk Analysis 

• · Uncertainty Analysis 

• Technical Feasibility 

• Under this section technical feasibility of project is carried out through the Technical Feasibility Report broadly containing following heads: 

• · Approved technical consultant 

• · Coverage area: 

• – Use of technology in previous project 

• – Remaining life cycle of technology 

• · Risks associated with advent of newer technology 

• – Any negative impact of the technology on the environment 

• – Ease of availability of the technology during the operation of the project 

• · Forecasting area: 

• – Sales / revenue prediction 

• – Methodology of sales/revenue prediction 

• – Approval status of the same with the regulatory / other bodies 

• · Past track record: 

• – Back testing of projections and actual 

• – Acceptability criteria 

• Financial Viability 

• Under this section, the viability of the project is carried out. RBI said that bankers should follow the following methods: 

• · Discounted Pay Back 

• · Internal Rate of Return· Net Present Value

• · Adjusted Present Value

Bankers can also follow more advanced methods of evaluation.

Adjusted Present Value (APV): As mentioned earlier first three methods are covered in the paper of Financial Management at Intermediate Level. Let us discuss the APV method here.

Normally financing decisions and investment decisions are handled separately. Since level of gearing adopted by a firm can influence the decision, APV technique offers some advantages over NPV. Accordingly, at the side effect of financing is also considered along with investment decision and accordingly formula for evaluation shall be as follows:

APV = Base NPV + Present Value of Impact of Financing or NPVg = NPVu + PV of tax relief on debt interest

Where, NPVu = Value of ungeared company

Thus, it evaluates the NPV from the perspective of an geared company giving the increase in Vu by considering the benefit to the company of increasing the debt for its funding.

Illustration

XYZ Ltd. is planning to introduce a new product. The initial investment required is ` 48 lacs. Total requirement of ` 48 lacs will be met by, ` 8 lacs from internally generated funds, ` 15 lacs from a right issue and remaining from a long-term loan at 12% p.a. The ratio of loan reflects debt

capacity of the company. Corporate taxes are payable at 40% p.a. on net operating cash flows of the particular year. Risk free rate of interest is 9%, market return is 14% and relevant company assets beta for the investment is estimated to be 1.5. Net operating after tax cash flows from the project is

year 1 = ` 15 lacs.

year 2 = ` 34 lacs;

year 3 = ` 12 lacs.

Besides, these inflows residual value of ` 5 lacs (after all taxes) is also expected at the end of third year. Assuming the principal is repayable at the end of 3 years you are required to estimate APV (Adjusted Present Value) of the investment and decide whether the investment is worth undertaking.

Solution Base NPV:

This is applicable if the project is 100% equity financed.

Rf + (Rm - Rf) b

= 9% + (14% - 9%) 1.5 = 16.5% 

NPV at Cost of Capital of 16.5% = ` (2.4840) lacs 

Impact of Financing: 

Annual Interest ` 25.00 lacs ´ 0.12 = ` 3.00 lacs Annual Tax Saving = ` 3.00 lacs x 0.40 = ` 1.20 lacs Present Value of Tax Shield 

= ` 1.20 lacs ´ 3 year annuity factor of 12% 

= ` 1.20 lacs ´ 2.4018 

= Rs. 2.882 lacs 

Adjusted Present Value 

` lac 

Base NPV 

(2.484) 

Present Value of Impact of Financing 

2.882 

0.398 

The project is therefore marginally acceptable on the basis of APV. 

Bankability of Project 

Bankability means the repayment capacity of the borrower. Bankability is measured by way of: 

– Debt Service Coverage Ratio 

– Interest Service Coverage Ratio 

Risk Analysis 

Under this the following risks may be covered: 

– Construction Risk: 

– Post construction Risk: 

Construction Risk 

Construction carries the risk that the project will not be completed on time, within budget or at all because of technical, labour, and other construction difficulties. 

– Delay in repayment 

– Loss of sale contract

Construction Risk Mitigants: 

· Past track record of the construction agencies 

– Minimum Net worth 

– Minimum Turn Over 

– Successful past experience 

· Obtaining completion guarantees requiring the sponsors to pay all debts and liquidated damages if completion does not occur by the required date. 

· Ensuring that sponsors have a significant financial interest in the success of the project so that they remain committed to it by insisting that sponsors inject equity into the project. 

· Requiring the project to be developed under fixed-price, fixed-time turnkey contracts by reputable and financially sound contractors whose performance is secured by performance bonds or guaranteed by third parties. 

· Obtaining independent experts' reports on the design and construction of the project. 

· Phased draw- down 

· Contingent on completion of milestone 

· Milestones to be verified by: 

– Independent consultant 

– Government bodies 

– Other bodies 

Post Construction Risk 

· The risk here is that for a mining project, rail project, power station or toll road, there are inadequate inputs that can be processed or serviced to produce an adequate return. 

· For example, there is the risk that there are insufficient reserves for a mine, passengers for a railway, fuel for a power station or vehicles for a toll road. 

Post Construction Risk Mitigants: 

· Experts' reports as to the existence of the inputs (e.g. detailed reservoir and engineering reports which classify and quantify the reserves for a mining project) or estimates of public users of the project based on surveys and other empirical evidence (e.g. the number of passengers who will use a railway); 

· Requiring long term supply contracts for inputs to be entered into as protection against shortages or price fluctuations (e.g. fuel supply agreements for a power station); 

· Obtaining guarantees that there will be a minimum level of inputs (e.g. from government that a certain number of vehicles will use a toll road);

· “Take or pay" off-take contacts which require the purchaser to make minimum payments even if the product cannot be delivered.

· Affect the cash-flow of the project by increasing the operating costs or affecting the project’s capacity to continue to generate the quantity and quality of the planned output over the life of the project.

· Operating risks include, for example, the level of experience and resources of the operator, inefficiencies in operations or shortages in the supply of skilled labour.

· Before lending :

– To be operated by a reputable and financially sound operator whose performance is secured by performance bonds.

· During the loan period :

– Provision of detailed reports on the operations of the project

– Controlling cash-flows by requiring the proceeds of the sale of product to be paid into a tightly regulated proceeds account to ensure that funds are used for approved operating costs only.

· Market risk is the risk that a buyer cannot be found for the product at a price sufficient to provide adequate cash-flow to service the debt.

· Risk Mitigants:

– The best mechanism for minimizing market risk before lending takes place is an acceptable forward sales contact entered with a financially sound purchaser.

· Uncertainty Analysis: Uncertainty is captured by way of:

– Sensitivity Analysis

– Scenario Analysis

– Simulation

– Decision Tree Analysis

– Real Option Analysis

For projects where completion uncertainty is not there, we can use Sensitivity Analysis or Simulation Analysis. However, if the project has uncertainty, we have to use Decision Tree Analysis and Real Option analysis along with the above methods.