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Project Finance is the long term financing of infrastructure and industrial projects based upon the
projected cash flow of the project rather than the balance sheets of the project sponsors.
It is the financing of a particular economic unit in which a lender is satisfied to look initially to the
cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid
and to the assets of the economic unit as collateral for the loan.
Usually, a project financing structure involves a number of equity investors, known as sponsors, as
well as a syndicate of banks that provide loans to the operation. The loans are most commonly non-
recourse loans, which are secured by the project assets and paid entirely from cash flow, rather than
from the general assets or creditworthiness of the project sponsors, a decision in part supported by
financial modelling. The financing is typically secured by all of the project assets, including the
revenue producing contracts. Project lenders are given a lien on all of these assets, and are able to
assume control of a project if the project company has difficulties complying with the loan terms.
Assets that have been financed on a project basis include pipelines, refineries, electric generating
facilities, hydroelectric projects, dock facilities, mines, toll roads, and mineral processing facilities.

It is the method of financing very large capital intensive project, with long term gestation period,
where the lenders rely on the assets created for the project as security and the cash flow
generated by the project as source of funds for repaying their dues.

Project financing discipline includes understanding the rationale for the project financing, how to
prepare the financial plan, assess the risks, design the financing mix, and raise the funds. In addition,
one must understand the cogent analyses of why some project financing plans have succeeded while
others have failed. A knowledge base is required regarding the design of contractual arrangements
to support project financing; issue for the host government legislative provisions, public/private
infrastructure partnerships, public/private financing structures; credit requirements of lenders, and
how to determine the projects borrowing capacity; how to prepare cash flow projections and use
them to measure expected rates of return; tax and accounting considerations; and analytical
techniques to validate the project’s feasibility.

The following are the characteristics of the project financing:
 A separate project entry is created that receives loan from lenders and equity from
 The component of debt is very high in project financing. Thus project financing is a highly
leveraged financing.
 The project financing and all its other cash flows are separated from the parent company’s
balance sheet.
 Debt services and repayments entirely depend on the project’s cash flows. Project assets are
used as collateral for loan repayments.
 Project financier’s risks are not entirely covered by the sponsor’s guarantee.
 Third parties like suppliers, customers, government and sponsors commit to share the risk of
the project.

Project financing is most appropriate for those projects which requires large amount of capital
expenditure and involve high risk. It is used by companies to reduce their own risk by allocating
the risk to a number of parties. It allows sponsors to:
 Finance large projects than the company’s credit and financial capabilities would permit.
 Insulate the company’s balance sheet from the impact of the project.
 Use high degree of leverage to benefit the equity owners.

Project financing is not a means of raising funds to finance a project that is so weak economically
that it may not be able to service its debt or provide an acceptable rate of return to equity
investors. In other words, it is not a means of financing a project that cannot be financed on a
conventional basis.

 Favourable tax treatment: - project financing is often driven by tax efficient consideration.
Tax allowances and tax breaks for capital investment etc. can stimulate the adoption of
project finance. Projects that contract to provide a service to state equity cab use these tax
breaks to inflate the profitability of such ventures.
 Favourable financing term:- project financing structure can enhance the credit risk profile
and therefore obtain more favourable pricing than that obtained purely from the project
sponsor’s credit risk profile.
 Political risk diversification: - establishing SPV’s (special purpose vehicles) for project in
specific countries quarantines the project risk and shields the sponsor from adverse
 Risk sharing:- allocating risk in a project financing structure enables the sponsor to spread
risk over all the project participants, including the lender. The diffusion of risk can improve
the possibility of project success since each project participants accepts certain risks;
however the multiplicity of participating entities can result in increased cost which mush be
borne by the sponsor and passed on to the end consumer-often consumers that would be
better served by public services.
 Collateral limited to project assets:- non recourse project finance loans are based on the
premise that collateral comes only from the project assets. While this is generally the case,
limited recourse to the assets of the project sponsor is sometimes required as a way of
incentivizing the sponsor.
 Lenders are more likely to participate in a workout than foreclose: - the non-course or
limited recourse nature of project financing means that collateral has limited valuein
liquidation scenario. Therefore, if the project is experiencing difficulties the best chance of
success lies in finding a workout solution rather than foreclosing. Lenders will therefore
more likely to cooperate in a workout scenario to minimize losses.
 Expansion of the sponsor’s debt capacity:- financing on a project basis can expand the debt
capacity of the project sponsors. First, it is often possible to structure a project so that the
project debt is not a direct obligation of the sponsors and does not appear on the face of the
sponsors’ balance sheets. In addition, the sponsors’ contractual obligation with respect to
the project may not come within the definition of indebtedness for the purpose of debt
limitation contained in the sponsors’ bond agreement or note agreements. Second, because
of the contractual arrangements that provide credit support for project borrowings, the
project company can usually achieve significantly higher financial leverage that the sponsors
would feel comfortable with if it financed the project entirely on its own balance sheet. The
initial leverage ratio is substantially greater that the typical corporate leverage ratio. The
amount of leverage a project can achieve depends on the project’s profitability, the nature
and magnitude of project risks, the strength of the project’s security arrangements, and the
creditworthiness of the parties committed under those security arrangements.

Therefore we understand project financing as an activity that involves raising funds on a limited-
recourse or nonrecourse basis to finance an economically separable capital investment project
by issuing securities (or incurring bank borrowings) that are designed to be serviced and
redeemed exclusively out of project cash flow. The terms of the debt and equity securities are
tailored to the characteristics of the project. For their security, the project debt securities
depend mainly on the profitability of the project and on collateral value of the project’s assets.
Depending on the project’s profitability and on the proportion or debt financing desired,
additional sources of credit support may be required. A project financing required careful
financial engineering to achieve a mutually acceptable allocation of the risk and rewards among
the various parties involved in a project.

PROJECT FINANCE is worthy of study because of the size and complexity of the projects that can be
financed using this technique. Project financing typically accounts for between 10% and 15% of total
capital investment in new projects worldwide and for more than half the capital investment in very
large projects all over the world. It has proven to be a very useful financing technique throughout
the world and across a broad range of industry sectors. It is likely to be increasingly important in the
years ahead as emerging economies increasingly rely on it to exploit their resource deposits and
develop their infrastructure.

Studying project finance is interesting because it requires the application of all the tools in the
corporate finance tool kit. It will also help improve the understanding of how firms choose their
capital structures, how contracts affect managerial decision making and firm behaviour, and how
organizational choice can affect firm value. As project financing typically involves very high leverage,
70% or more debt initially on average, it is a potentially fruitful area for investigating the financial
consequences of high leverage.
To arrange financing for a stand-alone project, prospective lenders (and prospective outside equity investors, if
any) must be convinced that the project is technically feasible and economically viable and that the project will be
sufficiently creditworthy if financed on the basis the project sponsors propose. Establishing technical feasibility
requires demonstrating, to lender’s satisfaction, that construction can be completed on schedule and within
budget and that the project will be able to operate at its design capacity following completion. Establishing
economic viability requires demonstrating that the project will be able to generate sufficient cash flow so as to
cover its overall cost of capital. Establishing creditworthiness requires demonstrating that even under reasonably
pessimistic circumstances; the project will be able to generate sufficient revenue both to cover all operating costs
and to service project debt in a timely manner. The loan terms-in particular the debt amortization schedule
lenders require –will have a significant impact on how much debt the project can incur and still remain
creditworthy. We understand these concepts in detail as follows.
Prior to the start of construction, the project sponsor(s) must undertake extensive engineering work to verify the
technological processes and design of the proposed facility. If the project requires new or unproven technology,
test facilities or a pilot plant will normally have to be constructed to test the feasibility of the processes involved
and to optimize the design of the full scale facilities. Even if the technology is proven, the scale envisioned for the
project may be significantly larger than existing facilities that utilize the same technology. A well executed design
will accommodate future expansion of the project; often, expansion beyond the initial operating capacity is
planned at the outset. The related capital cost and the impact of project expansion on operating efficiency are
then reflected in the original design specifications and the financial projections.
The design, and ultimately the technical feasibility, of a project may be influenced by environmental factors that
may affect construction or operation. Project sponsors often retain outside engineering consultants to assist with
design work and to provide an independent opinion concerning the project’s technological feasibility. It is not
unusual for long-term lenders to require confirming opinions from independent experts that
 The project facilities can be constructed within the time schedule proposed;
 Upon completion of construction, the facilities will be capable of operating as planned;
 The constructions cost estimates, together with appropriate contingencies for cost escalation, will prove
adequate for completion of the project.
The project’s financial adviser must be apprised fully of any technological uncertainties and their potential impact
on the project’s financing requirements, operational characteristics, and profitability.
The critical issue concerning economic viability is whether the project’s expected net present value is positive. It
will be positive only if the expected present value of the future free cash flows exceeds the expected present
value of the project’s construction costs. All the factors that can affect project cash flows are important in making
this determination.
Assuming that the project is completed on schedule and within budget ,its economic viability will depend primarily
on the marketability of the project’s output(price and volume).To evaluate marketability, the sponsors arrange for
a study of projected supply and demand conditions over the expected life of the project. The marketing study is
designed to confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb
the planned output of the project at a price that will cover the full cost of production, enable the project to service
its debt, and provide an acceptable rate of return to equity investors. The marketing study generally includes
 A review of competitive products and their relative cost of production;
 An analysis of the expected life cycle for project output, expected sales volume, and projected prices;
 An analysis of the potential impact of technological obsolescence. The study is usually performed by an
independent firm of experts.
If the project will operate within a regulated industry, the potential impact of regulatory decisions on production
levels and prices-and, ultimately, on the profitability of the project-must also be considered.
A project has no operating history at the time of its initial debt financing (unless its construction was financed
on an equity basis and the project debt financing funds out some portion of the constructing
financing).Consequently, the amount of debt the project can raise is a function of the project’s expected
capacity to service debt from project cash flow-or, more simply, its credit strength. In general, a project’s credit
strength derives from the following:-
 The inherent value of the assets included in the project,
 The expected profitability of the project,
 The amount of equity project sponsors have at risk(after the debt financing is completed),and,
 The pledges of creditworthy third parties or sponsors involved in the project.
Lenders will generally not lend funds to a project if their loans would be exposed to business or economic risks.
Lenders are typically willing to bear some financial risk but they will insist on being compensated for bearing such
risk. A critical aspect of financial engineering for a large project involves identifying all significant project project
risks and then crafting contractual arrangements to allocate those risks (among the parties who are willing to
bear them) at the lowest ultimate cost to the project. Recent innovations in finance, including currency futures,
interest rate swaps and caps, and currency swaps, have provided project sponsors with new vehicles for
managing certain types of project-related risks cost-effectively.
We will try and understand some of the major risks and its repercussions in the following section. The major risk
can be categorized as follows.
1. Completion Risk.
2. Technological Risk.
3. Raw Material Supply Risk.
4. Economic Risk.
5. Financial Risk.
6. Currency Risk.
7. Political Risk.
8. Environmental Risk.
9. Force Majeure Risk.

The credit rating agencies in India offer varied services like mutual consulting services, which comprises of
operation up gradation, risk management. They have special sections to carry on research and development
work of the industries. They provide training to the employees and executives of the companies for better
management. They examine the risk involved in a new project, chalk out plans to fight with the problem
successfully and thus ameliorate the percentage of risk to a great extent. For this they carry on thorough
research into the respective industry. They have started offering services to the mutual fund sector through the
application of fund utilization services. The major industries currently graded by credit rating agencies include
agriculture, health care industry, infrastructure, and maritime industry.
The Securities and Exchange Board of India (credit rating agencies) Regulations, 1999 offers various guidelines
with regard to the registration and functioning of the credit rating agencies in India. The registration procedure
includes application for the establishment of a credit rating agency, matching the eligibility criteria and providing
all the details required. They have to undergo the strict examination procedure with regard to the details
furnished by them. They are required to prepare internal procedures, abidance with circulars. They are offered
guidelines regarding the credit rating procedure, by the Act. The credit rating agencies are provided with
compliance officers. They are required to show their accounting records.
In India, at present, there are four credit Rating Agencies:
1. Credit Rating and Information Services Of India limited (CRISIL).
2. Investment information and Credit Rating Agency of India Limited (ICRA).
3. Credit Analysis and Research Limited (CARE).
4. Duff and Phelps Credit Rating of India (Pvt.) Ltd.
CRISIL: This was set up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the
instruments are being used. CRISIL’s market share is around 75%. It has launched innovative products for credit
risks assessments viz., counter party ratings and bank loan ratings. CRISIL rates debentures, fixed deposits,
commercial papers, preference shares and structured obligations. Of the total value of instruments rated,
debentures’ accounted for 3 1.196, fixed deposits for 42.3% and commercial paper 6.6%. CRISIL publishes
CRISIL rating in SCAN that is a quarterly publication in Hindi and Gujarati, besides English.
CRISIL evaluation is carried out by professionally qualified persons and includes data collection, analysis and
meeting with key personnel in the company to discuss strategies, plans and other issues that may effect,
evaluation of the company. The rating, process ensures confidentially, once- The company decides to use rating;
CRISIL is obligated to monitor the rating over the life of the debt instrument.
1996-97, ICRA rated 261 debt instruments of manufacturing companies, finance companies and financial
institutions equivalent to Rs.12,850 crore as compared to 293 instruments covering debt volume of Rs.75,742
crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the
total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for
debentures (including long term instruments), 49.4% for Fixed Deposit programme (including medium-term
instruments), and 22.1% for Commercial Paper Programme (including short term investments).The
corresponding figures of amount involved for these three broad rated categories was 23.8% for debentures,
52.2% for fixed deposits, and 24.0% for Commercial Paper.
The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. The inherent
protective factors, marketing strategies, competitive edge, competence and effectiveness of management,
human resource development policies and practices, hedging of risks, trends in cash flows and potential liquidity,
financial flexibility, asset quality and past record of servicing of debt as well as government policies affecting the
industry are examined. Besides determining the credit risk associated with a debt instrument, ICRA has also
formed a group under Earnings Prospectus and Risk Analysis (EPRA). Its goal is to provide authentic information
on the relative quality of the equity. This requires examination of almost all parameters pertaining to the
fundamentals of the company including relevant sectoral perspectives. This qualitative analysis is reinforced and
completed by way of the unbiased opinion and informed perspective of one analyst and wealth of judgment of
committee members. ICRA opinions help the issuing company to broaden the market for their equity. As the
name recognition is replaced by objective opinion, the lesser know companies are also able to access the equity
CARE: CARE is a credit rating and information services company promoted by IDBI jointly with investment
institutions, banks and finance companies. The company commenced its operations in October 1993. ‘in January
1994, CARE commenced publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the
rationale of all accepted ratings, CAREVIEW often carries special features of interest to issuers of debt
instruments, investors and other market players.
Credit Rating Agencies rate an instrument by assigning a definite symbol. Each symbol has a definite meaning.
These symbols have been explained in descending order of safety or in ascending order of risk of non-payment.
For example, CRISIL has prescribed the following symbols of debentures

AAA indicates highest safety of timely payment of interest and principal.
AA indicates high safety of timely payment of interest and principal
A indicates adequate safety of timely payment of interest and payment.
BBB offers sufficient safety of payment of interest and principal for the present.
B indicates great susceptibility to default.
C indicates vulnerability to default. Timely payment of interest and payment is possible-only if favourable
circumstances continue.
D indicates that the debenture is in default in payment of arrears of interest or principal or is expected to default
on maturity.
You will note that as the value of symbol is reduced say from AAA to AA, the safety of timely payment of interest
and principal is decreased. While AAA indicates highest safety of timely repayment, D indicates actual default or
expected default on maturity. Different symbols indicate different degrees of risk of repayment of principal and