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SUBMITTED ON: 12TH AUG 2011
Submitted by: Savan shah Soumya roy chowdhary Kirti mishra Sudip kar Suyash saboo
Trambak patnayak Varun sunil p Vishal vishy
Q2. As a result these bonds would fetch a lower investment gin and cause a higher interest drain leading to loss. which would not have its usage then. Through this it can enjoy benefits currently being enjoyed by private equity firms. . PDVSA will preserve its debt capacity and hence have higher flexibility. As a result higher leverage through project finance would be costlier. This would provide higher flexibility for PDVSA and at the same time better distribute the risk. EXCHANGE RATE: the other major risk associated with the Petrozuata project is exchange rate fluctuation. PDVSA is not looking for financing of one deal. but at a chain of many deals which would be a public. HOW SHOULD PDVSA FINANCE THE DEVELOPMENT OF THE ORINOCO BASIN? WHAT ARE THE COSTS AND BENEFITS OF USING PROJECT FINANCE INSTEAD OF TRADITIONAL DEBT FINANCE? PDVSA should go for project financing for the development of the Orinoco basin. The probability of getting a higher investment grade for the project even when the country Venezuela had a rating of B. Hence project financing for the venture is a better option. Through project financing it can approach larger private markets inviting more foreign investments.PETROLERA ZUATA (PETROZUATA) CASE ANALYSIS: Q1. 2. Chances of a negative carry due to inflow of large amount of funds via bond in the start.private partnership between PDVSA and a foreign organization for development and up-scaling of the Orinoco Basin. WHAT ARE PETROZUATA A THREE OR FOUR MOST IMPORTANT RISKS? HOW DOES THE DEAL STRUCTURE ADDRESS THESE RISKS? WHO WOULD BEAR THESE RISKS IF THE PROJECT WERE FINANCED INTERNALLY BY PDVSA INSTEAD? Petrozuata s most important operating risks were: 1. This would increase the expenses and tax Soln. it is important that PDVSA maintains its cash and debt capabilities to address to future uncertainties. providing a lower risk to the home company PDVSA. The costs attached with using project finance instead of traditional debt finance are: 1. Using project financing PDVSA can get into a joint venture which can be private and not public. 3. The benefits associated with project financing instead of traditional debt finance are: 1. Therefore. 4. Soln. 2. High cost of political risk insurance would increase the interest rate associated with debt. POLITICAL RISK: the political risk associated with the downfall of the Venezuelan government and the unpredictability of the Venezuelan government to abruptly change the tax rate or the royalty posed a big risk for the investors. 2. As the Venezuelan economy is developing there is a high risk that that the currency Bolivar would appreciate against dollar.
Payment priority the cash water fall : to account for the high risks. which can be easily achieved. reducing the profitability of the project. This political risk insurance would increase the lending rate by about 300bps over the borrowing rate. 4th priority: to the equity holders. It was only once in the 10 yrs history that the oil price has gone below the $8. and hence the risk of price volatility is very high. EDC and US ExIm bank. This insurance would be given by reputed financial organizations like IFC. the risk of the investors and the project is minimized. 3. is the volatility of the oil prices. Inclusion of the political risk insurance (PRI).14 mark. the deal asked for a substantially low breakeven point of only $8.5% to 11. The oil prices have been fluctuating in a high range varying from $8. The deal structure addresses these risks associated with the petrozuata project through the following clauses: 1. making the net borrowing rate to vary in the range 10. 1st priority: to 90 day operating expense account. even when the average market rate was $14.35X as the bare minimum requirement. To account for the price volatility.14 to $37. Even higher ratio of about 1.liability of the project relative to the sale income which would be in dollar. c.63 mark down to $8. 2.63 per barrel. If the project were financed internally by PDVSA. High debt coverage ratio of 1.27 per barrel. 2nd priority: to project s debt obligations. 3rd priority: to debt service reserve account for 6 months. these risks were to be borne by the home organization PDVSA and the home government. OIL PRICE VOLATILITY: the third major risk associated with the Petrozuata project. 3. . 4. OPIC. d. the deal designed a cash waterfall model with the following priority of payments: a. A part of these risks would also be shared by the banks providing capital to PDVSA. through higher interest rates for the high risk.80X required for attaining an investment grade rating. Hence this way. b.75%.
This recommendation I based on the following findings and reasons: 1. DEBT WILL COMPROMISE OF 60% OF THE FUNDS NEEDED FOR THE PROJECT. Hence.35X. Therefore a lower leverage is not recommended. Also.35X and hence the minimum DSCR is not affected. the DSCR in this case becomes very robust at 2. At a higher leverage of 70%. Hence.Q3. Soln. thereby covering the risk of price volatility and exchange rate volatility. When project leverage is 50%: when the leverage is reduced to 50%. 4. again the minimum DSCR is not affected. the company gains no direct benefit of going for debt finance. Hence the risk associated with price fluctuations is very high.45X in the initial years.06X. When project leverage is 70%: when the project leverage is 70%. 3. at a lower leverage.35X.06X and thereby increasing giving it enough margins to easily get an investment grade rating. much above the minimum required value of 1. WOULD YOU RECOMMEND A HIGHER OR A LOWER LEVERAGE RATIO? WHAT HAPPENS TO THE MINIMUM DSCR AND IRR ON EQUITY AS THE PROJECT LEVERAGE INCREASES TO 70% OF THE PROJECT FUNDS? DECREASES BY 50%? We would recommend that the debt should compromise of the already decided 60% level of the total funds.45X. and there are low chances of getting an investment grade rating for the project. the net IRR is 22% which is comparable to the cost of equity of 21%. At lower leverage of 50%. But at the same time its DSCR suffers and comes down to 1. 2. However. Hence giving a definite 5% benefits over equity investment. the DSCR in the initial years comes down to 1. the company has no benefits of going for project financing. as an equity financing would have earned the same return. at 60% leverage the DSCR is sufficient enough to cover the interest debt expenses in case of any price fluctuations. 5. Therefore the company loses on the advantages of a tax shield and lower cost of debt financing. Hence a higher leverage is not recommended. thereby increasing its default risk and hence making it sub-investment grade project. . But it still remains above the minimum required DSCR of 1. At 60% leverage the firm earns an IRR of 26% which gives it measurable gains when compared to the cost of equity of 21%. At 60% leverage the DSCR for the initial years is around 2. making it very close to the minimum required DSCR of 1. the IRR increases to 32% giving it substantial returns. AS CURRENTLY ENVISIONED. the IRR suffers and comes down to 22% close to its equity cost of capital.
Agency debt: the advantage of getting an agency debt is that they could get a large sum of unsecured loan (without PRI) of about $200mn. Hence a change in any of it could impact the offerings and therefore the risk associated was higher. Public bonds: the major advantage of going for public bonds was that it could provide with huge sum of capital as compared to other means and that it had a much longer maturity. . The reasons for using rule 144A bonds are: 1. However the issues related to the bank debt were : a. 2. However these were dependent on the Venezuelan economic stability and the U.75%. However the major dis advantage was that a majority of the remaining debt would require PRI taking the costs to the ceiling. as compared to the market rates of 7. Soln.Q4.5% to 8. Venezuelan economy was improving and had a better scope for investment. Variable interest rates increasing the volatility and hence the risk d. Short maturity: it posed a serious risk in case of constructional delays and oil price volatility. 3. WHAT KIND OF DEBT SHOULD SPONSER USE TO FUND THE DEAL? WHAT ARE THE ADVANTAGES AND DIS ADVANTAGES OF EACH KIND OF DEBT? the debt sponsors should choose the private bonds (rule 144A bonds) for financing the deal.S bond market. Rule 144A bonds: these were the private bonds and had the advantage that it could be executed very easily and in a short time of only 6 months. Private bonds could provide a requisite high value of debt of $1.4billion.S bond market was heating up and hence a private issue of bonds to this market had a higher chance of getting large fund. 5. However there was a serious issue of the negative carry which could lead to losses. 6. 3. The debt from banks would take a huge time of 18 months to arrange. Restrictive covenants c. 4. They could be underwritten within a short time of only 6 months and require less disclosure. 4.75% The advantages and dis-advantages of various kinds of debts: 1. b. The U. 2. Getting such a high investment in a public bond market for an emerging economy project was highly unlikely. Besides the interest rates charged by the banks is very high of the range of 10. Bank Debt: the advantage of getting the bank debt was that it could draw on its credit lines matching its cash inflows and outflows hence utilizing the best of the cash inflow. And the smaller limited size of it.5% to 11.
89% 20.07% 18.169 631.84 0.333.67 0.169 631.169 631. the cost of equity should be less than the internal rate of return.24 1.07% 19.000 75.17 3.34% 21.07% 19.96% 27. Year Equity Total Debt V/E 1 13.169 631.03 0.222 1.90 1.24 3.086.000 0 .000 75.Q6.73 0.67 0. To be profitable for a shareholder.137 567.169 $0 1. the ratio of equity to value will change over time and hence a single cost of equity cannot give a true picture of the situation.137 449.372.57% 18.000.57% 18.299 1.169 631.80 1.137 669.90 1.59% 23.67 0.22% 27.57% 18.57 1.25% 19.44% 27.40 1.55 2.024.71 1.961 977.169 631.411.169 631.034 134.01 3.01 2.07% 19.57% 70.556 755.6 0.241 252.39% 27.60.88 2.169 631.30 3.450.169 631.57% 18.94 1.57% Soln: 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 79.484 849. WHAT ARE YOUR EXPECTED RETURNS? ASSUME THE ASSET BETA FOR AN INTEGRATED DRILLING.07% 24.169 631.70% 27.137 401.000 1.111 1.11 3.12 1.35 2.035 81.169 631.333 1.01 1.169 631.169 631.14 1.169 631.021 631.67 0.12 1.169 631.46% 19.24% 20.12 1.169 631.12 1. PIPELINE AND REFINING FIRM IS 0.169 631.6 0.41% 25.267.000 75.72 2.64 1.21 1. Since debt is not constant over the years.20 2.63 1.81 1.268.53 1.169 631.169 631.169 631.169 631.41 1.169 631.169 631. AS ONE OF THE SPONSORS. Internal rate of return calculated is coming out to be 26% at 60% leverage ratio.60 8.47% 25.169 631.169 631.856 1.169 631.6 0.187.169 631.614 1.12 1 1 1 1 1 Equity beta 0.87 1.06 1.00% 28.93 0.169 631. Calculation of cost of equity over the years is calculated in the table below.6 Ke 18.34 2.07% 19.22% 23.01% 26.56% 21.689 348.02% 22.32 1.280 1.98 0.80% 25.000 75.55 1.448 75.98 1.67 0.6 0.73 1.62 3.000 1.
57% 18. This shows that if we would have opted for 50% leverage ratio. As seen from the solution to question 6.169 631.169 631. If Conco invest large equity capital.6 0. the equity investment provides a negative return as IRR would be below 22% the estimated cost of equity capital.57% The assumptions made for the calculation of equity beta are given as under.169 631. . Hence on an average the cost of equity for a shareholder will be around 20-22%.6 0.6 5. if Conco invests equity the profitability of the project reduces.6% percent.67% 2.6 18. as compared to the 22% cost of equity that I would be paying. Therefore we would prefer investing in project bonds. the costs of capital averages about 21% with its lower end about 18.10% We can see the cost of equity in the early years due to large amount of debt is high around 2728% which declines over time to around 18-19%.57% 18. We would prefer investing in project bonds because they provide a 26% return.57% 18.169 631. As Conco.6 0. then we would have not generated adequate returns. Also it should be noted that when calculating the internal rate of return for 50% leverage. investing equity capital is not a preferable option. Hence it would provide me a net 4% to 6% relative benefit in investing in project bonds.6 0.57% 18.6 0.169 1 1 1 1 1 1 1 1 0.6 0.169 631. Hence Conco should not invest in equity capital. the debt leverage of the project goes down. If the leverage reduces below 50% due to investment of equity.57% 18.169 631.2027 2028 2029 2030 2031 2032 2033 2034 631.169 631. Q7.57% 18. as a result its IRR goes down.60% 7% 6. the IRR turned out to be 22%. Hence. WOULD YOU INVEST IN PROJECT BONDS? WOULD YOU INVEST IN EQUITY CAPITAL AS CONCO? SOLN.57% 18.6 0. Asset Beta Rf risk premium Country premium Startup premium 0.
PDVSA should go for project financing for the following reasons: 1. it cannot get such high leverage and the leverage would be close to its own capital structure. The projects can get a higher investment grade as compared to PDVSA or the Venezuelan country. PDVSA can go for higher leverage of 60% and 70% via project financing. A joint venture project financing. 4. the project would become a private project and not a public project and hence would not be bound by numerous government regulations. Higher returns can be earned via leveraged project financing. HOW SHOULD PDVSA FINANCE ITS OTHER OILFIELD PROJECTS? PDVSA should finance its other oil field projects using project financing keeping a similar debt ratio of 60%. 3. If it goes for traditional financing. 2. would invite foreign firms to invest thereby inviting liquidity into Venezuela helping improve its financial status. . as compared to the traditional financing.Q8. 5. Soln. By going for a project financing.
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