Unit3: Project Financing

Project Cost Estimation

What is project cost estimation?
• Cost estimating, by definition, is the practice of predicting the final
total cost of a project that has an outlined scope project cost
estimation.
• The process of project cost estimation is central to setting up the
foundation for making key decisions, taking initiatives, budgeting
activities and controlling expenditures.
• The approximate project cost is then being referred to as a cost
estimate or a planned price.
• Cost forecasts and projections are used to establish a set of metrics
against which project success will be measured, and to communicate
work progress to the stakeholders at any given point in time
Why project cost estimation is important
• Cost estimate reflects if the project is financially viable.
• First things first, an accurate cost estimate is essential for deciding if the
project is feasible or not for the company at the moment.
• In this light, a cost estimate answers if the project can be completed with
available resources in the given time period and still bring value to the
organization.
• Cost estimation helps to stay on schedule and on track.
• At the end of the day, sound project estimates are important to ensure that
actual effort, once the project is in progress, matches the estimated targets
that were set at the beginning of the project to the greatest possible extent.
• Thus estimates are one of the foundational pillars for safeguarding client
expectations and your company’s bottom line.
Principles of Cost Estimating
• Integrity
• Any cost estimate should be produced with a high standard of ethical integrity and by
following an open and transparent process.
• Any uncertainties and vagueness associated with the estimate should be explained in an
easy-to-understand manner and in laymen’s terms.
• This principle allows avoiding false precision and rash decisions by integrating all people
involved in the process into a team which works as a single mechanism and uses the same
sources of information.
• Information Accuracy and Relevance
• The development of cost estimates should be based only on the best information available.
• When a planner develops an estimate, engineering judgement and technical advice should be
applied to any assumption made at that estimate.
• By following this principle, all information used for developing estimates can be thoroughly
considered, filtered and refined in order to get the most accurate and relevant pieces of that
information.
Principles of Cost Estimating
• Uncertainty and Risk
• Any type of project cost should be identified and included in an estimate considering
uncertainty and risk.
• For this purpose an exhaustive method of assessing and re-assessing project risks and
uncertainties should be employed.
• We should consider risks by producing accurate contingencies in cost estimates that may be
used later on for developing a risk management plan.
• Expert Team
• This principle assumes that only a skilled, interdisciplinary team should produce cost
predictions and make calculations.
• Project cost estimation sheets should be developed utilizing a clearly defined statement of
work.
• The expert team needs to use methodological tools and approaches to develop their
expenditure forecasts.
• The team can be composed of project team members, experienced personnel of the
performing organization, as well as experts from outside qualified agencies.
• Technical, managerial, and communication skills are required for the candidates. They should
also be able to identify and evaluate critical issues and risks.
Principles of Cost Estimating
• Validation
• The expert and unbiased team should validate cost predictions.
• First, the project manger develops initial estimates and submits them to the team for
validation.
• A second independent judgment will help then make the estimates more correct and capture
different perspectives on the estimating process.
• This principle becomes more important to complex projects which require producing large
estimates.
• Release and Use
• It assumes that while cost estimates might have been developed for a specific purpose, they
can be used improperly by those people who do not understand the real context.
• Until the expert team has been thoroughly reviewed the estimates and validated their
content, these estimates shouldn’t be released to the project team and stakeholders in order
to avoid misuse and misunderstanding.
• This approach allows the estimates to be consistent with the project scope and accurate
indicators of the real expenses.
Project Cost Types
• Variable and Fixed
1. Fixed Cost refers to as a cost which is not to be changed throughout the project
lifecycle. It doesn’t change an increase or reduction of the work amount. Examples
are setup cost, rental cost, cost for hiring of equipment, etc.
2. Variable Cost refers to as any chargeable amount that can be changed with the
amount of project work. An increase or reduction of project scope causes the
respective change in variable cost. Examples are production materials expenses,
remuneration of project team, cost of power and water.
• Direct and Indirect
1. Direct Cost is directly associated with particular tasks or/and activities. Examples
are team wages and expense on materials used.
2. Indirect Cost is expenses on overhead items (overheads). It doesn’t refer to as the
project value. Examples are corporate tax, fringe benefit tax.
Project Cost Estimation Techniques
Estimation technique Definition Recommendations
Best for estimating projects with defined
Assigning costs to the individual elements of
Bottom-up expectations and specific requirements in
the project plan, such as tasks, milestones, or
estimation line with stakeholders who won’t expect
phases, and putting the bucks together
major changes in the scope

Figuring out the project’s total price and Commonly used to estimate elements on
Top-down
determining the scope of work that can be fixed price projects when the price is initially
estimation
done specified by the client
Analogous Relying on data from previous similar Recommended when there’s limited
estimation projects to forecast the cost information about the project
Taking specific cost variables and data points
Parametric Usually called in for use when the previous
from other projects to figure out the
estimation project data you have is scalable
ultimate project cost
Three-point Doing the average from the best, worst, and Well-advised when the risk of going over
estimation most likely case estimations budget is high
Types of Cost Estimates
• There are 2 types of cost estimates:
1. Rough order of magnitude (ROM) with an accuracy of -25% to + 75% (other
frameworks quote a range of +/-50%) and
2. Definitive estimate with an accuracy range of -5% to +10%.
Rough Order of Magnitude vs. Definitive Estimate
• The obvious difference between these 2 types of estimates is the accuracy:
the ROM is rather inaccurate with a broad range of possible outcomes.
• It is therefore typically used in project initiation phases where a ballpark
figure is sufficient to get a project started.
• The definitive estimate is determined in the course of the project when more
information and resources for accurate estimates are available
Reasons for Inaccurate Project Cost Estimates
• Farsighted predictions.
• Seasoned project managers know that every estimate is a premature estimate if it’s
made a long time in advance, let’s say to predict the budget three years ahead. It
immediately turns into a guess estimate that will hardly be relevant then.
• Shortage of expertise on similar projects.
• There is no denial of the fact that better cost estimates come with experience on
comparable initiatives. Analogous projects inform your next estimation decisions by
giving you a clearer understanding of how the new project can be better scoped out
and which milestones take longer than usual.
• Lack of requirements.
• Having an idea what the project is all about is not enough. To provide an accurate
estimate, every element in the project should be specified per client’s request.
Staying on the same page with the client will help you break the project down into
manageable chunks of work and ensure that you don't miss out on anyone’s
expectations.
Reasons for Inaccurate Project Cost Estimates
• Splitting one task across multiple resources.
• When more than one person works on a task, clear processes should be set in
place, which in turn requires additional planning and management time,
often not taken into account. Not only does it make the task last longer, but it
also increases chances of overshot deadlines and estimates. In the end, one
task divided between multiple team members turns out to be more costly
than you initially thought.
• Expecting that resources will work at full battery.
• Total efficiency at workplace is a utopia we all want to believe in. There will
always be “dead time” or unexpected non-billable work. A more reasonable
number to target would be 70-80%. Don’t forget to include that when scoping
your next project.
Project Financing
Project Financing
• Project Financing is a long-term, zero or limited recourse financing
solution that is available to a borrower against the rights, assets, and
interests related to the concerned project.
• Project finance refers to the funding of long-term projects, such as
public infrastructure or services, industrial projects, and others
through a specific financial structure.
• Finances can consist of a mix of debt and equity.
• The cash flows from the project enable servicing of the debt and
repayment of debt and equity.
What is Project Finance?
• Project finance is a means of funding projects that are typically
infrastructure heavy, capital-intensive or related to public utilities.
During its lifetime, these projects are treated as distinct entities from
its parent.
• A project finance venture undertaken is completely an off-balance
sheet item for the parent.
• Therefore, all financing this entity avails, must be repaid exclusively
out of its own cash flow and subject to its own assets.
• The assets of the parent cannot encroach for payback of its
subordinate’s liabilities even if the venture fails
Types of Project Financing
• Sources of project financing will depend on the structuring of the project (which is
heavily impacted by project risks).
• There are many financial products in the market to pay for construction costs. The cost
(interest rates and fees) of each financial product will depend on the type of asset and
risk profile.
1. Private Debt
• Debt that is raised by investment banks
• Cheaper cost of capital than equity financing since debt holders will be repaid first
2. Public Debt
• Debt that is raised by the government under advisement of an investment bank or advisor
• Cheapest cost of capital since it is a government sponsored program used to spur infrastructure
development
3. Equity Financing
• Equity that is raised by a developer or private equity fund
• Highest cost of capital since equity is repaid last and rates of return must reflect the riskiness of
investment
Sources of Project Financing
• Business Angels
• Business Angels have a vast experience in the industry they operate in. Private
investors may invest in a company for a capital gain. The investment is for a place on
board or an equity stake.
• Venture Capital
• Venture capitalists invest in a project for a non-executive position on the board. They
provide capital in exchange of an equity share or a position at a strategic level. Once
the value of shares increase, they may sell those for a profit.
• Loan for Business
• Apart from secured lending, a company can choose unsecured business loan that
comes for a fixed tenure with a repayment plan. The cost of loan is determined by
estimating the returns from the project. The interest payment is tax deductible in
some cases. An agreement is made between the financial institution and the
borrower for a specific loan amount and tenure.
Sources of Project Financing
• Overdrafts
• Overdrafts are ideal for a short-term finance. The period of overdraft facility is for a year or less.
The interest is only charged on the amount spent from the person’s account. Such financing can be
arranged quickly like business loans.
• Share Capital
• The shareholders get profits from dividend. This share of profit is derived from ordinary shares
(owned by business owners who can share profits of an organization from dividends) or
preference shares (does not belong to company owners but a third-party). Capital gain is expected
from selling the shares in future. It is the company shareholders who raise the Share Capital.
• Debentures
• Debenture loans come with a fixed or a floating rate and provided against an organization’s assets.
The debenture holders receive payment of interest before the shareholders receive their dividend
payment. If the business fails, then these holders are liable as preferential creditors.
• A project loan offers a great opportunity to fund-providers and investors to be a part of
the company’s growth process and share its profits.
• The above-mentioned sources for project financing are crucial for new companies. Apart
from these sources, a few others to mention are project grants and government
funding.
Key Features of Project Financing
• Capital Intensive Financing Scheme:
• Project Financing is ideal for ventures requiring huge amount of equity and debt, and is
usually implemented in developing countries as it leads to economic growth of the country.
Being more expensive than corporate loans, this financing scheme drives costs higher while
reducing liquidity. Additionally, the projects under this plan commonly carry Emerging Market
Risk and Political Risk. To insure the project against these risks, the project also has to pay
expensive premiums.
• Risk Allocation:
• Under this financial plan, some of the risks associated with the project is shifted towards the
lender. Therefore, sponsors prefer to avail this financing scheme since it helps them mitigate
some of the risk. On the other hand, lenders can receive better credit margin with Project
Financing.
• Multiple Participants Applicable:
• As Project Financing often concerns a large-scale project, it is possible to allocate numerous
parties in the project to take care of its various aspects. This helps in the seamless operation
of the entire process.
Key Features of Project Financing
• Asset Ownership is Decided at the Completion of Project:
• The Special Purpose Vehicle is responsible to overview the proceedings of the project while
monitoring the assets related to the project. Once the project is completed, the project
ownership goes to the concerned entity as determined by the terms of the loan.
• Zero or Limited Recourse Financing Solution:
• Since the borrower does not have ownership of the project until its completion, the lenders
do not have to waste time or resources evaluating the assets and credibility of the borrower.
Instead, the lender can focus on the feasibility of the project. The financial services company
can opt for limited recourse from the sponsors if it deduces that the project might not be
able to generate enough cash flow to repay the loan after completion.
• Loan Repayment With Project Cash Flow:
• According to the terms of the loan in Project Financing, the excess cash flow received by the
project should be used to pay off the outstanding debt received by the borrower. As the debt
is gradually paid off, this will reduce the risk exposure of financial services company.
Key Features of Project Financing
• Better Tax Treatment:
• If Project Financing is implemented, the project and/or the sponsors can
receive the benefit of better tax treatment. Therefore, this structured
financing solution is preferred by sponsors to receive funds for long-term
projects.
• Sponsor Credit Has No Impact on Project:
• While this long-term financing plan maximises the leverage of a project, it
also ensures that the credit standings of the sponsor has no negative impact
on the project. Due to this reason, the credit risk of the project is often better
than the credit standings of the sponsor.
Stages of Project Financing
1. Pre-Financing Stage
2. Financing Stage
3. Post-Financing Stage
Pre-Financing Stage
• Identification of the Project Plan - This process includes identifying the
strategic plan of the project and analysing whether its plausible or not. In
order to ensure that the project plan is in line with the goals of the
financial services company, it is crucial for the lender to perform this step.
• Recognising and Minimising the Risk - Risk management is one of the key
steps that should be focused on before the project financing venture
begins. Before investing, the lender has every right to check if the project
has enough available resources to avoid any future risks.
• Checking Project Feasibility - Before a lender decides to invest on a
project, it is important to check if the concerned project is financially and
technically feasible by analysing all the associated factors.
Financing Stage
• Arrangement of Finances - In order to take care of the finances related to
the project, the sponsor needs to acquire equity or loan from a financial
services organisation whose goals are aligned to that of the project
• Loan or Equity Negotiation - During this step, the borrower and lender
negotiate the loan amount and come to a unanimous decision regarding
the same.
• Documentation and Verification - In this step, the terms of the loan are
mutually decided and documented keeping the policies of the project in
mind.
• Payment - Once the loan documentation is done, the borrower receives
the funds as agreed previously to carry out the operations of the project.
Post-Financing Stage
• Timely Project Monitoring - As the project commences, it is the job
of the project manager to monitor the project at regular intervals.
• Project Closure - This step signifies the end of the project.
• Loan Repayment - After the project has ended, it is imperative to
keep track of the cash flow from its operations as these funds will be,
then, utilized to repay the loan taken to finance the project.
Types of Sponsors in Project Financing
1. Industrial sponsor - These type of sponsors are usually aligned to
an upstream or downstream business in some way.
2. Public sponsor - The main motive of these sponsors is public service
and are usually associated with the government or a municipal
corporation.
3. Contractual sponsor - The sponsors who are a key player in the
development and running of plants are Contractual sponsors.
4. Financial sponsor - These type of sponsors often partake in project
finance initiatives and invest in deals with a sizeable amount of
return.
Transaction Flow in Project Finance
Parties Involved in Project Finance
• Sponsors
• They are usually the equity share capital holders of the parent company who wish to
seek project finance. Two or more entities may also join hands to float an SPV.
Instances of this phenomenon occur when two organizations create synergy for one
another or are likely to mutually benefit from the underlying SPV. They are the equity
providers of the SPV. Before floating an SPV, they must obtain authorization from the
shareholders of the parent company via a shareholder’s agreement (SHA).
• Banks/Financial Institutions
• It may be a single lender or a consortium of financial institutions. They are the
providers of senior debt and hold precedence over debt extended (if any) by the
sponsors. The loan is secured strictly against the cash flows and assets of the SPV
only. Therefore, sufficient due diligence is performed before the grant of any credit.
Parties Involved in Project Finance
• Special Purpose Vehicle (SPV)
• It is a separate legal entity floated by the sponsors of the project. The project
finance obtained is directed exclusively only towards this SPV. The SPV acts as
a corporate veil between the lenders and the parent company preventing
seepage of credit and attachment of property between the two parties.
• Host Government
• Refers to the government of the home country where the SPV is located. The
SPV must be incorporated in accordance with the government’s rules and
regulations. It also often acts as a guardian angel in providing various tax
concessions, subsidies, and rebates
Parties Involved in Project Finance
• Off Takers
• Off-takers are bound via an off-take agreement to mandatorily purchase a
certain minimum quantity of produce from the selling party. An off-take
agreement is a frequently resorted to in mining, construction and other
industries of mass significance. The vendor (SPV) incurs a huge amount of
capital expenditure. An off-take agreement ensures the seller of the existence
of a market upon completion.
• Suppliers & Contractors
• As in any construction job, suppliers and contractors are necessary for the
execution of a contract. They are the key suppliers of raw material. They also
perform crucial functions such as design and build (D&B), operations and
maintenance (O&M), etc
Advantages of Project Finance
• Effective Debt Allocation
• Project finance enables the sponsors to raise debt over and above the capacity of the parent.
• This borrowing can be viewed in an individual capacity and is not impacted by the credit reputation of its sponsors.
• Therefore, more beneficial and flexible terms of credit can be negotiated depending solely on the merit and potential of the
project under review.
• Risk Management
• As already discussed, what makes project finance truly special is the separation of the legal identity of the parents and SPV.
This provides enormous diversification and dilution of the risk element.
• The shareholders of the parent company are immune against the fluctuations in the fate of the project. The liability is limited
to the amount of equity contributed by the sponsors.
• Additionally, the risk is also reduced upon involve of multiple entities. More than one companies may often form a joint
venture to form a single SPV. Thus, the same amount of risk when distributed among a larger number of participants reduces
each party’s exposure.
• Economies of Scale
• An SPV, when floated by more than one parent, is very likely to demonstrate economies of scale.
• Two contemporary organizations will only agree to come together for a common goal when they see a significant benefit
flowing from the association.
• Vertical synergies will come into play. Both entities will be able to achieve the scale and profits they could not have achieved in
their individual capacity.
• Also, they will also hold better bargaining power with vendors as well as buyers.
Disadvantages of Project Finance
• Complexity
• Project finance is based upon several contracts between multiple parties, each of them involving complex negotiations.
• It may be difficult to maintain a record of the flow of funds among the parties involved if proper discretion is not
exercised.
• Also, an imaginary entity(SPV) is used to route all transactions. Therefore, it becomes important to have dedicated
resources that monitor the flow of exchanges at all times.
• Compliance and Documentation
• At all stops, setting up an SPV faces resistance. Banks and financial institutions perform extreme due diligence and checks
before extending even a penny of credit. This is mainly for the reason that an SPV holds separate legal status. The bank
can make recoveries only against the asset and cash flows of the SPV.
• All these checks are time-consuming and expensive. Obviously, the SPV and its sponsors have to bear the brunt of this
excruciating process.
• Also, a project finance venture sets off the radars of the government. The government is extremely vigilant when it comes
to sanctioning the creation of an SPV.
• Constant Expert Assistance
• Project finance involves complex transactions and multiple parties.
• Therefore, availing the services of professionals and experts is inevitable. S
• Setting up a dynamic model for availing credit and conducting business involves huge cost.