T4 PF Pgpfin01 2021

Project Finance
Term IV –PGPFin01 Batch
Pankaj Baag
Faculty Block 01, Room No 22
Mob: 8943716269
Ph (O): 0495-2809121
Ext. 121
Email: baagpankaj@iimk.ac.in
Session 1-2
1
article-8.jpg
(III Components):
I – Class Participation & Assignment : 30%
II - Project: 35%
III - End Term Exam : (open book) : 35%
•
-- MFS2017
LMS code--?
2
Group Formation
• Distribution of case assignment,
Readings, CP and dates
• Distribution of Projects and dates
3
Date: July 06/07 (4+4 groups)
Time 20 min --Class participation –Readings & notes and cases
Topic Group presenting Group questioning Random 3 Q
HBR case 1 6 5+
2CD 8 10
3LM 7 4
HBR case 15, 16 1 2
and the note
Must send the ppts including links before the beginning of the class
The file should mention your gr number
There should be a question on learnings from your presentation along with the answer
Bring in addl. theory/current happenings/trends on the topic
Case 1--Note: An overview of project finance and infrastructure finance- 2014 –use all the three versions
Case 15 , 16 and the related NOTE. Hamilton Real Estate including the note
4
HBR case 19, 20 9 8
(Uploaded as addl
case)
4BR 5 1
5DA 2 6
HBR case 11 3 7
The file should mention yr gr number
There should be a question on learnings from yr presentation along with the answer
Bring in theory/current happenings/trends on the topic
Case 11--Economic Framework for Assessing Development Impact

5
HBR case 6 4 3
HBR case 14 10 9
Case 6--Basel II: Assessing the Default and Loss Characteristics of Project Finance Loans --both A & B
Case 14--Equator Principles: An Industry Approach to Managing Environmental and Social Risks
6
Date: July 20/21 (4 +4 groups)
Time 20 min Case presentation
Topic Group presenting Group questioning +R3Q
Case 2 (all parts) 6 10
Case 3 8 5
Case 4 (all parts) 7 2
Case 5 1 4
7
Date: July 21/23 (4 + 4 groups)

Topic Group presenting Group questioning+R3Q
Case 7 9 1
Case 8 5 8
Case 9 (all parts + 2 7
materials)
Case 10 (+ addl note) 3 6
There should be a question on learnings from yr presentation along
with the answer
8
Date: July 23/27 (2 + 2 groups)

Topic Group presenting Group questioning+R3Q
Case 12 4 9
Case 13 10 3
There should be a question on learnings from yr presentation along
with the answer
9
Date: Aug 3/4
Time 10 min
Project proposal -1st stage
You will send the ppts

before the start of the class
with yr group name as file
name
10
Date: Aug 10/11 (3 groups)
Time 25 min
Project presentation
Group –3;4;8
There should be a question on learnings from yr presentation along with
the answer
Bring in theory/current happenings/trends on the topic wherever needed
11
Time 25 min
Group --10;1;2
the answer
12
Time 25 min
Group --9;6;5;7
the answer
13
• http://edbodmer.com/project-finance-model-collection/
14
What is project
15
The MM Proposition
“The Capital Structure is irrelevant as long as the firm’s investment
decisions are taken as given”
Then why do corporations:

• Set up independent companies to undertake mega projects and incur
substantial transaction costs, e.g. Motorola-Iridium.
• Finance these companies with over 70% debt even though the projects
typically have substantial risks and minimal tax shields, e.g. Iridium:
very high technology risk and 15% marginal tax rate.
16
What is a Project?
• High operating margins.
• Low to medium return on capital.
• Limited Life.
• Significant free cash flows.
• Few diversification opportunities.
• Asset specificity.
17
What is a Project?
• Projects have unique risks:
– Symmetric risks:
• Demand, price.
• Input/supply.
• Currency, interest rate, inflation.
• Reserve (stock) or throughput (flow).
– Asymmetric downside risks:

• Environmental.
• Creeping expropriation.
– Binary risks
• Technology failure.
• Direct expropriation.
• Counterparty failure
• Force majeure
• Regulatory risk 18
What Does a Project Need?
Customized capital structure/asset specific

governance systems to minimize cash flow
volatility and maximize firm value.
19
What is Project Finance?
Project Finance involves a corporate sponsor investing in and
owning a single purpose, industrial asset through a legally
independent entity financed with non-recourse debt.
20
“Project Finance involves one or more corporate sponsors
investing in and owning a single purpose, industrial asset
through a legally independent project company
financed with limited or non-recourse debt.”
A relevant question to investigate:
SPONSOR + PROJECT? Finance separately with non-recourse

debt? (Project Finance)
Finance jointly with corporate funds?

(Corporate Finance)
21
Factors……
1. Project financing can be arranged when a particular facility or a related set of
assets is capable of functioning profitably as an independent economic unit.
2. The sponsor(s) of such a unit may find it advantageous to form a new legal
entity to construct, own, and operate the project.
3. If sufficient profit is predicted, the project company can finance construction of

the project on a project basis, which involves the issuance of equity securities
(generally to the sponsors of the project) and of debt securities that are designed
to be self-liquidating from the revenues derived from project operations.
22
• But this means.. financing on a project basis ----necessarily involves tailoring the financing
package to the circumstances of a particular project.
• Expert financial engineering is often just as critical to the success of a large project as are the
traditional forms of engineering.
• Project financing is a well-established financing technique.
• About 10 percent of large projects cost $1 billion or more.

• Looking forward, today countries face enormous infrastructure financing requirements.
• Project financing is a technique that could be applied to many of these projects.
23
• Project financing may be defined as the raising of funds on a
limited-recourse or non-recourse
basis to finance an
economically separable
capital investment project in which the providers of the funds look primarily to the
cash flow from the project as the source of funds
to
service their loans and provide the return
of and a return on their equity invested in the project.
24
• The terms of the debt and equity securities are tailored to the cash flow characteristics of the
project.
• For their security, the project debt securities depend mainly on the profitability of the project
and on the collateral value of the project's assets.
25
• Project financings typically include the following basic features:
1. An agreement by financially responsible parties to complete the project and, toward that
end, to make available to the project the funds necessary to achieve completion.
2. An agreement by financially responsible parties (typically taking the form of a contract for the
purchase of project output) that, when project completion occurs and operations commence, the
project will generate sufficient cash flow to enable it to meet all its operating expenses and debt
service requirements under all reasonably foreseeable circumstances.
3. Assurances by financially responsible parties that, in the event a disruption in operation occurs
and funds are required to restore the project to operating condition, the necessary funds will be
made available through insurance recoveries, advances against future deliveries, or some other
means.
26
What is the ………..Conventional direct financing or financing on a firm's
general credit–
• Lenders to the firm look to the firm's entire asset portfolio to generate the cash flow to service
their loans.
• The assets and their financing are integrated into the firm's asset and liability portfolios.
• Usually such loans are not secured by any pledge of collateral.
27
But……….Critical distinguishing feature of a project financing---
• The project is a distinct legal entity;
• Project assets, project-related contracts, and project cash flow are segregated to
a substantial degree from the sponsoring entity.
• The financing structure is designed to allocate financial returns and risks more
efficiently than a conventional financing structure.
• The sponsors provide, at most, limited recourse to cash flows from their other
assets that are not part of the project.
• They typically pledge the project assets, but none of their other assets, to secure
the project loans.
28
• It is important to understand -what the term does not mean.
• 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.
• Project financing is not a means of financing a project that cannot be financed on a

conventional basis.
• In fact------A project financing requires careful financial engineering to allocate the risks and
rewards among the involved parties in a manner that is mutually acceptable.
29
The basic elements in a capital investment that is financed on a project basis .
30
• Class 2
31
• At the center is a discrete asset, a separate facility, or a related set of assets that has
a specific purpose.
• This facility or group of assets must be capable of standing alone as an independent

economic unit.
• The operations, supported by a variety of contractual arrangements, must be

organized so that the project has the unquestioned ability to generate sufficient cash
flow to repay its debts.
• A project must include all the facilities that are necessary to constitute an
economically independent, viable operating entity.
32
• Therefore, a project cannot be an integral part of another facility.
• If the project will rely on any assets owned by others for any stage in its operating cycle, the
project's unconditional access to these facilities must be contractually assured at all times,
regardless of events.
• Project financing can be beneficial to a company with a proposed project when

(1) The project's output would be in such strong demand that purchasers would be willing to
enter into long-term purchase contracts and
(2) And, this contracts would have strong enough provisions that banks would be willing to
advance funds to finance construction on the basis of the contracts.
33
• Project financing can be beneficial to lenders –
--when it reduces the risk of project failure,
--leads to tighter covenant packages, or
--facilitates a lower cost of resolving financial distress.
• For example, project financing can be advantageous to a developing

country when it has a valuable resource deposit, other responsible
parties would like to develop the deposit, and the host country lacks
the financial resources to proceed with the project on its own.
• Where we find that this has gone wrong…………
34
So……developing on the major characteristics:
• Economically and legally independent project company
– Founded extensively on a series of legal contracts that unite parties from input suppliers to output
purchaser
– Project assets/liabilities, cash flows, and contracts are separated from those of the sponsors,
conditional on what accounting rules permit
– Investors and creditors have a clear claim on project assets and cash flows, independent from
sponsors’ financial condition
– Debt is either limited (via completion guarantees) or non-recourse to the sponsors
35
Major characteristics….contd…
• Highly leveraged project company with concentrated equity ownership

– Partly due to firms’ need for flexibility and excess debt capacity to invest in attractive opportunities
whenever they arise
– Syndicate of banks and/or financial institutions provide debt
– Typical D/V ratio as high as 70% and above
– Debt has higher spreads than corporate debt
– One to three equity sponsors
– Sponsors provide capital in the form of equity or quasi-equity (subordinated debt)

36
Major characteristics….contd….
• Historically formed to finance large-scale projects
– Industrial projects: mines, pipelines, oil fields
– Infrastructure projects: toll roads, power plants, telecommunications systems
– Significant financial, developmental, and social returns
• Examples of project-financed investments

– $4bn Chad-Cameroon pipeline project (case 2)
– $6bn Iridium global satellite project (case 5)

– $1.4bn aluminum smelter in Mozambique
– €900m A2 Road project in Poland (case 8)
37
A simplified project structure example:
A “nexus
of
contracts”
that aids
the sharing
of risks,
returns,
and
control
38
Source: Esty, B., “An Overview of Project Finance – 2014Update: Typical project structure for an independent power producer”
Major project contracts: • Input Supply Contract:
– The Offtake Contract for the

• The Offtake Contract: input supplier
– A framework under which – Provides the Project Company

the company either takes Project Company obtains
revenues the security of input supplies
the product from the
on a pre-agreed pricing basis
supplier or pays the
supplier a penalty. – Provides the “offtaker”
(purchaser) with a secure – The terms of the Input Supply
supply of project output, and Contract are usually crafted to
the Project Company with the
ability to sell the output on a match those of the Offtake
pre-agreed basis Contract (such as input
volume, length of contract,
force majeure, etc.)
– Can take various forms, such
as “Take or Pay” Contract:
• “Power Purchase
Agreement” (PPA)
39
Major project contracts:
• Permits:
• Construction Contract:
– Contracts that ensure permits
– A contract defining the
and other rights for
“turnkey” responsibility to construction and operation of
deliver a complete project the project, as well as for
ready for operation (a.k.a. investing in and financing of
Engineering, Procurement, the Project Company
Construction (EPC) Contract)
– May be provided by central

• Operation and Maintenance governments and/or local
Contracts: authorities
– Ensures that the operating
and maintenance costs stay
within budget, and project • Government Support
operates as planned. Agreements:
– Provisions may include
guarantees on usage of public
utilities, compensation for
expropriation, tax exemptions,
and litigation of disputes in an
agreed jurisdiction
40
A Historical Perspective
• Project financing is not a new financing technique.
• Venture-by-venture financing of finite life projects has a long history; it was, in fact, the rule in commerce until
the seventeenth century.
• For example, in 1299-more than 700 years ago-the English Crown negotiated a loan from the Frescobaldi (a
leading Italian merchant bank of that period) to develop the Devon silver mines.
• The loan contract provided that the lender would be entitled to control the operation of the mines for one year.
• The lender could take as much unrefined ore as it could extract during that year, but it had to pay all costs of
operating the mines.
• There was no provision for interest.
• The English Crown did not provide any guarantees (nor did anyone else) concerning the quantity or quality of
silver that could be extracted during that period.
• Such a loan arrangement was a forebearer of what is known today as a production payment loan.
41
Drawbacks of Using Project Finance Structure:
• Takes longer to structure and

execute than equivalent size
corporate finance
Still, the combination
of organizational,
• Higher transaction costs due to
creation of an independent entity financial, and
and complex contractual structure contractual features
may offer an
• Non-recourse project debt is opportunity to reduce
more expensive due to greater net cost of financing
risk and high leverage and improve
performance
• High leverage and extensive
contracting restricts managerial
flexibility
• Project finance requires greater

disclosure of proprietary Structure matters, contrary to
information to lenders MM Proposition!
42
Why does structure matter?
Structural decisions may affect the existence and magnitude of costs

due to market perfections:
* Agency conflicts
* Financial distress
* Structuring and executing transactions
* Asymmetric information between parties involved
* Taxes
Value Creation
Organizational Structure Governance Structure
Contractual Structure
43
How Does It Create Value?
• Value creation by Project Finance
– Organizational structure
• Agency costs, debt overhang, risk contamination, risk mitigation
– Contractual structure
• Structuring the project contracts to allocate risk, return, and control
– Governance structure
• Benefits of debt-based governance
• Case examples to value creation
44
Value creation by organizational structure:
Agency Costs Structural Solutions:
Problems
• Concentrated equity ownership and single cash flow stream provides
critical monitoring
1. Agency conflicts between
sponsors (owners) and management • Strong debt covenants allow both sponsors and creditors to better
(control) monitor management
• High levels of free cash • High debt service reduces the free cash flow exposed to discretion
flow leading to
overinvestment in
negative NPV projects • Extensive contracting reduces managerial discretion
• Risk shifting/debt • “Cash Flow Waterfall” mechanism facilitates the management and
shifting by managers to allocation of cash flows, reducing managerial discretion.
invest in high risk,
negative NPV projects
to recoup past losses
• Covers capex, debt service, reserve accounts, and distribution of
residual income to shareholders
• Refusal to make
additional investment • Given the projects are defined within narrow boundaries with limited
investment opportunities, moral hazard (risk shifting, debt shifting,
reluctance to invest) is minimized
45
Problems • “Cash Flow Waterfall” mechanism reduces potential conflicts in

distribution and re-investment of project revenues
2. Agency conflicts between
sponsors and creditors: • Legally/economically separate project company eliminates potential for
risk shifting and debt shifting
– Distribution of cash flows,
re-investment, and • Concentrated debt ownership is preferred (i.e. bank loans vs. bonds) to
restructuring during distress facilitate the restructuring and speedy resolutions
– Moral hazard (such as risk
shifting and debt shifting) • Usually subordinated debt (quasi equity) is provided by sponsors
encouraged by full recourse
nature of debt to sponsor • Strong debt covenants allow better monitoring
• Single cash flow stream and separate ownership provides easier

monitoring
46
Problems • Vertical integration is effective in precluding opportunistic

behavior but not at sharing risk.
• Conflicts between sponsors • Also, opportunities for vertical integration may be absent.
and other parties
(purchasers, suppliers, etc.) • Long term contracts such as supply and off take contracts:
these are more effective mechanisms than spot market
transactions and long term relationships.
• Joint ownership with related parties to share asset control and

cash flow rights.
• This way counterparty incentives are aligned.
47
Problems • Since project is large scale and the company is stand alone, acts
of expropriation are highly visible in the international arena which
• Conflicts between sponsors detracts future investors
and government:
Expropriation through either • High leverage leaves less on the table to be expropriated
asset seizure, diversion, or
creeping • Multilateral lenders’ involvement detracts governments from
expropriation since these agencies are development lenders and
lenders of last resort. However these agencies only lend to stand
alone projects.
• High leverage also reduces accounting profits thereby reducing

the potential of local opposition to the company.
48
• Drawbacks of using Project Finance
49
Debt Overhang Structural Solutions:
• Non-recourse debt in an
Problems
independent entity allocates
• Sponsor’s under-investment in returns to capital providers
positive NPV projects when without any claim on the
sponsor has: sponsor’s balance sheet.
– limited corporate debt capacity • Preserves corporate debt
– agency or tax reasons that capacity.
exclude equity as a valid option
– pre-existing debt covenants • The fact that non-recourse debt
that limit possibility of new debt is backed by project assets/cash
flows and not by the sponsor’s
balance sheet increases the
chances of an already highly
leveraged sponsor to separately
finance a viable project
Debt overhang is a debt burden that is so large that an entity cannot take on additional debt to finance future projects.
50
This includes entities that are profitable enough to be able to reduce indebtedness over time.
Risk Contamination Structural Solutions:
Problems • Project financed investment exposes the sponsor to

• A high risk project may losses only to the extent of its equity commitment,
potentially drag a healthy thereby reducing its distress costs
sponsor into distress, by
increasing cash flow volatility
and reducing firm value. • Through project financing, sponsors can share
• Conversely, a failing sponsor project risk with other sponsors:
can drag a healthy project along – Pooling of capital reduces each provider’s distress cost
with itself. due to the relatively smaller size of the investment and
therefore the overall distress costs are reduced.
• Very large projects can
potentially destroy the
sponsor’s balance sheet and • Separate incorporation eliminates potential increase
lead to managerial risk aversion
in risk when financing a project strongly correlated
• Benefit from portfolio to sponsor’s existing asset portfolio.
diversification is negative (risk
is higher) when sponsor and
project cash flows are strongly
positively correlated.
51
Other motivations Structural Solutions:
Problems
• Joint venture projects with • The stronger partner is better equipped to negotiate terms
heterogeneous partners: with banks than the weaker partner and hence participates in
Financially weaker partner project finance even if it can finance its share via corporate
cannot finance its share of financing
investment through corporate
borrowings, and needs project
finance to participate
• Location: Large projects in

emerging markets usually
cannot be financed by local • Debt may be the only option and project finance the optimal
equity due to supply structure.
constraints. Investment specific
equity from foreign investors is
either hard to get or expensive. • Besides, host government may grant the project “tax
holiday”, which provides sponsors exemptions from taxation
52
53
Value creation by contractual structure:
• An introduction to risk management
– Risk management defined

– Sources of risks
– Who bears risk?
– Mechanisms for reducing cost of risk
• Contractual structure in Project Finance to reduce cost of risk and

create value
54
An Introduction to Risk Management
Risk Management:
The process of identification, assessment, mitigation, and allocation of risks to reduce

cost of risk and improve incentives
Sources of risk:
– External:
• Markets: Availability and quality of products, inputs, and services used
• Financial markets
• Government policy
• Natural resource availability and quality
• Natural disasters, politics
– Internal:
• Incentive problems during construction and operation stages
• Relationships between management, sponsors, lenders, workers, suppliers,
government
(some addressed in the previous slides under “value creation by organizational structure”)
55
Who bears risk?
• Sponsors bear the residual gains and losses, and make key investment decisions.
In simple terms,
Return to equity = Revenues – Material / service costs – Labor costs - Depreciation – Interest expenses – Taxes
Variability in RHS variables lead to changes in return to equity
• Other earners of net income (or net value added) from investment can also share risk:
Net Value added
= Return to equity + Interest expenses + Taxes + Labor costs
= Revenues – Material / service costs – Depreciation
Profit sharing mechanisms or tax incentives may change how variability in income is shared among sponsors, lenders, government, and labor
• Output purchasers and input suppliers can also share the risks as they experience variability in their markets
56
How are costs of risk reduced?
• Some risks can be reduced by spreading the burden across many participants; some other risks cannot
be spread, but can be shifted or reallocated
• Different stakeholders in a project may have different preferences, and hence different willingness and
capacity to bear risks
– Cost of risk is lower to those with greater capacity and willingness to bear risk
– Risk-return trade-offs may enable integrative (not necessarily competitive) negotiations among
different stakeholders and may create value in a project setting
• Gains in economic efficiency can be achieved if overall cost of risk declines through risk shifting and
reallocating:
– The same risk will have a lower cost if born by parties better capable and willing to do so
57
Mechanisms to reduce cost of risk:
• Capital, financial, and futures markets:

– Mix of debt and equity (capital structure) and probability of default
– Risk spreading / pooling
– Risk diversification
– Insurance markets (for residual risks)
– Derivative financial instruments (not available for asymmetric risks)
– Futures markets
• Real options: Design flexibility into project to allow for responses of new information or market changes
• Project design itself for risk mitigation (elements of production process, technology used, etc.)
• Project Finance mechanism: complex contractual arrangements involving all mechanisms of
contractual risk allocation and reduction to deal with risk in large scale investments
58
Contracting and Project Finance to reduce cost of risk
• Generally well developed capital, financial, and futures markets may not always be available
• Special contractual arrangements are often required to manage risk to make projects viable
• The aim of extensive contracting is to reduce cash flow volatility, increase firm value and debt
capacity in a cost-effective way
• Guarantees and insurance for those risks that cannot be handled through contracting
Elements of contracting:
• General form:
– Exchange risk (x) for return (y)
• Additional considerations:
– Participation or partial transfer of ownership
– Timing of x and y
– Contingency of x and y (under what circumstances)
– Penalties on non-performance
– Bonus on performance
59
Contracting criteria:
• Contract with lowest cost not necessarily best contract
• Effective contracts may provide:

– Better risk shifting: better distributions of cost
– Better incentives: higher project returns or lower total project risk as a result of incentives
• Change the incentive structure to change the probabilities of different outcomes  stakeholders have
incentives to increase probability of success and reduce probability of failure in project
• “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives

– Cost focus is implicitly a zero sum perspective: one stakeholder gains and the other stakeholder
loses
– Integrative focus is explicitly a positive sum perspective: By crafting the right contract, one
stakeholder can gain without necessarily costing to the other one (due to differences between
perceived values, preferences, and risk bearing capacity)  contracts that create increased value
through risk sharing and /or improved incentives 60
Sources of contracting benefits:
• Stakeholders’ differing risk preferences
• Differing capability to diversify
• Differing capability to manage risks
• Differing information or predictions regarding future
• Differing ability to influence project outcomes
Risks manageable via contractual structure or other mechanisms in Project Finance:
• Pre-completion risks: Resource, technological, timing, and completion risks

• Post-completion risks: Market risk, supply risk, operating cost risk, and force
majeure
• Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk, expropriation
• Financial risks: Default risk
61
Pre-completion risks:
Risk Solution
•Site acquisition and access, permits •A government support agreement
•Risks related to contractor: •Reputation, references for similar projects and technology being used
–Is it competent to do the work? •Experience with the country, good relationships with local subcontractors
•Similar references for the subcontractors
–Is it also one of project’s •Contract supervision by the project company’s other personnel not directly
sponsors? (Conflict of interest) related to the contractor
–The contractor’s credit standing? •Careful review of contractor’s credit standing
If the contractor’s wider business •Careful review of the project scale in relation to the size of contractor’s
gets into difficulty, the project is overall business
likely to suffer •If project too big for the contractor to handle alone, a joint venture approach
with a larger contractor
•Guarantees of obligations by the contractor's parent company
62
Risk Solution
•Construction cost overruns: reduce equity •Pre-agreed overrun funding (contingency finding)
returns, and DSCR •Fixed (real) price contract, as the EPC contract is normally the largest cost item
in budget (60-70%)
•Engineering, Procurement, Construction and is a prominent form of contracting agreement in the
construction industry. •Contractor takes junior debt and/or equity stake in operations (BOT or BOO)
•Delay in completion: failure to meet the •Completion guarantees, date-certain EPC contract
milestones increase costs, reduce equity returns, •Performance bonds
and reduce DSCR •Completion bonuses/penalties
–Financing costs, especially as debt will be •Reputable contractor
outstanding longer •Close monitoring / testing of project execution (operational, financial, etc.) for
–Revenues from operating the project will be
early detection of problems
lost or deferred (significant risk also especially •Careful definition of “completion” in all the contracts (EPC contract, input
if part of financing depends on early
supplier contracts, off-taker contract, etc) so that it is acceptable and
revenues)
manageable by all parties involved
–Penalties may be payable under contract to
input suppliers or off-taker
•Process failures •Process / Equipment warranties

•Tested technology
63
Risk Solution
•Nonperformance on completion: due to poor •Debt recourse to sponsors (from lenders’

design, inadequate technology perspective)
•Performance LDs (liquidated damages): Pre-
agreed level of loss to be born by the contractor.
Covers the NPV of loss due to nonperformance over
the life of the project
• The Project Company should be aware of the
uncertainty regarding the LDs and should allow a
margin when negotiating the calculations with the
contractor
•Natural resource risk •Independent reserve certification
64
Risk Solution
•Third party risks: •If the third party is not otherwise involved in the project,
–The contractor may be dependent on third parties incentive mechanisms to keep the timetable
such as suppliers of utilities to complete the project •If the third party is involved with a project contract, the
contract should include terms such that the third party should
be held responsible for the delay losses
•Contractor’s good relationships and experience with the third
–The project may be dependent on completion of parties may be a plus
another project – worst type of third party risk
especially when the project financing is dependent on •Financing the projects as one package may be examined as a
it. potential solution, as long as the sponsors’ interests on both
sides can be aligned
•Sponsor-related risks (Lenders’ perspective): •Require lower D/E ratio

–Sponsor commitment to the project •Starting with equity: eliminate risk shifting, debt overhang and
–Financially weak sponsor probability of distress (lenders’ requirement).
•Add insider debt (Quasi equity) before debt: reduces cost of
information asymmetry.
•Attain third party credit support for weak sponsor (letter of credit)
•Cross default to other sponsors
65
Post-completion risks:
Risk Solution
•Market risk: Uncertainty •Long term off-take contract with creditworthy buyers:
regarding the future price –take and pay, take or pay, take if delivered contracts:
and demand for the output •Price floors
–Volume risk: •A fixed price growth path
cannot sell entire •An undertaking to pay a long-run average price
output
•Specific price escalator clauses that would maintain the competitiveness of the product, such
–Price: cannot sell
as indexing price to the price of a close substitute or cost of major input
output at profit
•Hedging contracts
•Operating cost risk: •Risk sharing contracts to increase correlation between revenue and some cost items:
Uncertainty regarding the –If there is an off-take contract, linking input supply price to it:
changes in the operating •Basing the product price under the off-take contract on the cost of the input supplies
cost throughout the life of (more likely if input supply is a widely traded commodity like oil)
the project •Basing the input supply price to product price under the off-take contract: (more likely
if the input is a specialized commodity, or if there is no off-take contract and risk is
passed to the input supplier)
–Price ceilings
–Profit sharing contract with labor
–Output or cost target related pay
66
Post-completion risks:
Risk Solution
•Input supply risk: Uncertainty regarding the •If there is an off-take contract, linking the terms of the output contract with input
availability of the input supplies throughout the supply contracts such as the length of contract, volume, or force majeure
life of the project •If there is no off-take contract, making the input supply contract run for at least the
term of debt
•An input supply contract is off-take contract for the supplier
•Organizational risks: Incentive problems •Profit sharing / stock options
relating to management or workers •Output or cost target related pay for workers
•Operating risk: operating difficulties due to •Performance warranties on equipment

technology (being degraded or obsolescent), •Expert evaluation and retention accounts
processes used, or incapacity of operator team •Proven technology
leads to inefficiencies and insufficient cash flow •Experienced operator/management team
•Operating/maintenance contracts to ensure operational efficiency
•Allowances for service / upgrade built into equipment supply contracts
•Insurance to guarantee minimum operating cash
•Force majeure risk: Likelihood of occurrence •Insurance for natural disasters

of events like wars, labor strikes, terrorism, or 67
nonpolitical events such as earthquakes, etc.
Sovereign risks:
Risk Solution
•Exchange rate changes: Uncertainty regarding the changes •Revenues, costs, and debt in same currency (indexing if they are
in the exchange rate throughout the life of the project not in the same currency)
•Implications of a sudden major local currency devaluation in •Market-based hedging of currency risks (though not widely used)
cases where the project revenue is in local currency and debt •For protection from a sudden major devaluation, a revolving
in foreign currency liquidity facility can be utilized to cover the time lapse between the
devaluation and the subsequent increase in inflation that should
compensate the project company for debt payments
•Currency convertibility / transferability risk: As it is often •Government Support Agreement: Government guarantee of
not possible to raise funding in local currency in developing foreign exchange availability: However, if the host country gets into
countries, revenues earned in local currencies need to be financial difficulty and runs out of foreign currency reserves, then the
converted into foreign currency amounts needed by offshore government may forbid either the conversion of local currency
investors/lenders, and then need to be transferred outside the amounts to foreign currency, or the transmission of these amounts
country to pay for them. Additionally, foreign currency may be abroad  The support agreement may become invalid
needed to import materials, equipment, etc. •Enclave projects: If the project revenues are paid from a source
outside the host country, the project can be insulated from foreign
exchange and transfer risks (Example: sales of oil, gas across
borders)
•Offshore debt service reserve accounts 68
Sovereign risks:
Risk Solution
•Hyperinflation risk: Relative changes in the price of inputs and output •Indexing the output price (in the long term sales contract) against the CPI
may adversely affect the project and or industry price indices in the host country where the relevant costs are
incurred (Indexing means increasing over time against agreed, published
economic indices)
•Expropriation: Direct, diversion, creeping •Government guarantees or regulatory undertakings to cover taxes, royalites,
•Government’s breach of contract and court decisions prices, monopolies, etc.
•Involvement of multilateral/bilateral agencies
•Offshore accounts for proceeds
•Government’s equity ownership
•Using external law or jurisdiction
•Legal system: •Government support agreement

–Unclear and/or inconsistent legal/regulatory framework for project’s •Using external law or jurisdiction
operations •Involvement of multilateral/bilateral agencies
–Insufficient protection of private investment and private ownership/control of
project •A general principle is that the party who is paying for the output under a
–Bureaucratic hurdles project contract should pay for the losses incurred due to changes in law
–Changes in law, such as imposition of new environmental/health/safety specific to the industry, because such change is reflected in the entire
requirements, price controls, import duties/controls, increase in taxes, industry and any extra costs will normally be passed on to end users;
royalties, deregulation, amendment or withdrawal of project’s permits, therefore an offtaker who does not bear this risk would earn extra profits at
changing the control of company the expense of the project company
69
Sovereign risks:
Risk Solution
•Political risks: Likelihood of occurrence of political •Political risk insurance

events like wars, labor strikes, terrorism, etc. •Involvement of multilateral agencies (WB/IFC) (structuring
legal/financial documents, mediation in negotiations,
sovereign deterrence, “halo effect”)
•Bilateral agencies: Export credits
•The private insurance market
•Contractual sharing of political risks between sponsors and
lenders
70
Financial risks:
Risk Solution
•Default risk: •Ensure sufficient debt service coverage

•Decrease debt/equity ratio
•Match term of loan to productive life of assets
•Match repayment schedule to expected cash flows
•Bonds with interest rates indexed to product sales price
•Match currency of loans to currency of revenues
•Interest rate risk: •Interest rate swaps and hedging

•Interest rate caps
71
72
Value creation by governance structure:
– Tighter covenants limit managerial discretion and enforces greater discipline via
better monitoring
– High leverage reduces free cash flow exposed to discretion
– High leverage reduces expropriation risk
– High leverage also reduces accounting profits thereby reducing the potential of
local opposition to the company
– Tax shields
73
2. How Does It Create Value?
• Costs and benefits of debt-based governance
74
Case examples to value creation
Australia-Japan Cable – Structuring a Project Company:
Background:
The project included a 12,500 km submarine telecommunications system between Australia and
Japan via Guam at a cost of $ 520M.
The project would use Telstra’s two landing stations at Australia.
In Japan, it needed to either obtain permit from the government for building new stations, or contract
or partner with other companies to obtain access to the existing ones.
Japanese Government seemed not likely to approve building of a new landing station.
Most significant risks were market and completion risks.
The lead sponsor, Telstra, has to structure the project company, selecting an ownership, financial,
and governance structure.
75
Issues:
1. Selection of strategic sponsors who would bring the most value to the project
2. Mitigation of market risk: Growing demand and capacity shortfall that triggers
competition, rapid improvements in cable technology and resulting price decline
necessitates moving very quickly
3. Completion risk: Potential delays due to environmental approvals and other

permits
4. Management of possible agency conflicts between:

1. sponsors and management
2. sponsors and other parties (capacity buyers (purchasers), suppliers, etc.)
3. sponsors and creditors - decision of how many and which banks to invite to
participate
76
How project structure may help:
1. Telstra partnered with Japan Telecom (who would bring its landing station in Japan
and was interested in buying capacity) and Teleglobe (a major carrier who would
bring significant volume) as sponsors (reducing cash flow variability)
2. Other equity investors to be selected would be high rated sponsors who were also
capacity buyers. They would be made to sign presale capacity agreements (
reducing variability).
3. Capacity agreements with high rated sponsors would also be instrumental in raising
debt with favorable conditions
77
4. Contemplated on concentrated equity ownership to maintain more effective

management and monitoring
5. As for an interim management team, sponsors would also be made equal partners
in control, regardless of individual ownership shares
6. A permanent management team was discussed, that would work exclusively for the
project:
• Management compensation package was easier to craft, since it was a single
purpose company with limited and well-defined growth opportunities
• Single cash flow easier to monitor
78
7. Decided on high leverage and project finance structure to help:

• limit the amount of equity they needed to invest to an acceptable size
• share the project risk with debt holders
• enforce management discipline by reduced free cash flow and contractual
agreements
8. Bank debt with a small banking group was preferred rather than project bonds to
have flexibility
• The initial tranche of bank debt would be secured and repaid in 5 years with
presale commitments
• The second tranche would also be repaid in 5 years, but from future sales,
acting as “trip wires” for the management team
79
Calpine Corporation
Background:
Calpine, a small power generator with high leverage (~80%), sub-

investment grade rating, and little debt capacity, has to decide how to
finance its aggressive growth strategy, facing increasing pressure for
speed, efficiency, and flexibility in a soon-to-be competitive commodity
market.
The growth strategy includes building and operating a “power system”
consisting of multiple power plants.
Project financing and corporate financing alternatives are considered.
80
Issues:
1. Speed was very important to gain first mover advantage
2. Necessity to be a low-cost producer in a commodity market
3. Operating a system of power plants to gain scale economies and also the
flexibility to switch between the plants to offer uninterrupted service
81
Issues:
4. Using corporate finance as the financing method:

• Benefits:
– Issuing high yield bonds would not require collateral and reduce legal fees
– Bonds would leave Calpine free to switch between plants in the power
system
• Costs:
– The high-yield market was thinner and more volatile compared to

investment grade market, creating pricing and availability risk
– As a firm with high leverage and sub-investment grade rating, the high cost
of corporate financing might lead Calpine to miss the opportunity to invest in
a positive NPV growth project (Debt Overhang)
– A large debt issue might further jeopardize Calpine’s debt rating 82
Issues:
5. Using project finance as the financing method:
• Benefits:
– Opportunity to finance the growth strategy even if Calpine had low

investment ratings and limited debt capacity
• Costs:
– Time consuming and expensive to set-up and execute individual deals

– Limited size and absorption capacity of the project finance market
– Possible restrictions to flexibly switch between the plants in the power
83
system if each plant would be collateralized separately
A hybrid structure was crafted that combined elements of both project and corporate finance:
1. Project Finance:
i. Calpine project financed a portfolio of plants rather than a single plant. This reduced legal and
other fees, transaction costs, and saved time.
ii. Project finance allowed raising a large amount of debt on a non-recourse basis, which was
impossible at the parent level
2. Corporate Finance:
i. The structure gave Calpine flexibility to build the plants using equity, and manage them flexibly
as part of a power system (which would be impossible with separately project financing the
individual plants)
84
BP Amoco
Background:
A large and well-capitalized company, BP Amoco tries to decide on the best way to
finance its share in the $8 billion development project of Caspian oil fields,
undertaken by a consortium of 11 companies.
Each of the partners had a choice in how to finance its share of the total investment.
Of these companies, 5 formed a Mutual Interest Group (MIG) to obtain project loan
with assistance of IFC and EBRD.
The alternatives BP Amoco considered for its share were corporate financing,
project financing, or a hybrid structure.
85
Issues:
1. Project Risks: The project had considerable political, financial, industrial (price and
reserve volatility), and transportation related risks largely due to the unique region it
was located.
2. Risk management: Protection of BP Amoco’s balance sheet from risk

contamination or distress costs from investing in a risky asset
3. Involvement of multilateral organizations: Increased capacity to raise capital
86
Using corporate finance as the financing method:

• Benefits:
– Financially strong enough to support a corporate funding strategy with favorable terms
– Easier to set up and less costly
• Costs:
– Project might create additional risks in BP Amoco’s current asset portfolio  Risk contamination
– BP Amoco’s absence in the IFC/EBRD finance deal for the MIG would make it harder for the
weaker partners to negotiate good terms, reducing flexibility in operations and management
– BP Amoco’s using corporate funding while at least some of the other partners’ using the
IFC/EBRD deal might potentially create disagreements
– Other partners might accuse BP Amoco as free rider, since BP Amoco would benefit at no cost
from the political risk protection IFC/EBRD deal would have provided
– How they funded the initial phase would change possibilities of financing for the coming stages
87
Using project finance as the financing method:

• Benefits:
– Reducing project’s potential negative impact on the balance sheet: The project
was very large and posed too many risks which BP Amoco could not bear alone,
meaning a potentially huge negative impact on the balance sheet if financed
solely by internal funding
– More protection from the many project risks due to risk sharing
– Accommodating the financially weaker partners in the consortium to negotiate
better deals with creditors for the sake of future managerial and operational
flexibility
– Benefiting from IFC/EBRD’s existence to shield from possible conflicts with the
host governments
• Costs:
– Harder, costlier, and more time consuming to set up
– Less flexibility compared to corporate finance alternative 88
Recent Uses of Project Financing
• Project financing has long been used to fund large-scale natural resource projects.
(Appendix B provides thumbnail sketches of several noteworthy project financings, including a variety of natural resource
projects –already uploaded)
• One of the more notable of these projects is the Trans-Alaska Pipeline System (TAPS) Project,
which was developed between 1969 and 1977.
• TAPS was a joint venture of eight of the world's largest oil companies. It involved the
construction of an 800-mile pipeline, at a cost of $7.7 billion, to transport crude oil and
natural gas liquids from the North Slope of Alaska to the port of Valdez in southern Alaska.
• TAPS involved a greater capital commitment than all the other pipelines previously built in the
continental United States combined.
89
• More recently, in 1988, five major oil and gas companies formed Hibernia Oil Field Partners to
develop a major oil field off the coast of Newfoundland.
• The projected capital cost was originally $4.1 billion.
• Production of 110,000 barrels of oil per day was initially projected to start in 1995.
• Production commenced in 1997 and increased to 220,000 barrels per day in 2003.
• Production is expected to last between 16 and 20 years.
• The Hibernia Oil Field Project is a good example of public sector-private sector cooperation to
finance a large project.
90
The Impact of PURPA
• Project financing in the United States was given a boost in 1978 with passage of the Public Utility Regulatory
Policy Act (PURPA).
• Under PURPA, local electric utility companies are required to purchase all the electric output of qualified
independent power producers under long-term contracts.
• The purchase price for the electricity must equal the electric utility's its marginal cost-of generating electricity.
• This provision of PURPA established a foundation for long-term contractual obligations sufficiently strong to
support non-recourse project financing to fund construction costs.
• The growth of the independent power industry in the United States can be attributed directly to passage of
PURPA.
91
• Project financing for manufacturing facilities is another area
• In 1988, General Electric Capital Corporation (GECC) announced that it would expand its
project finance group to specialize in financing the construction and operation of industrial
facilities.
• It initiated this effort by providing $105 million of limited-recourse project financing for Bev-
Pak Inc. to build a beverage container plant in Monticello, Indiana.
• The plant was owned independently; no beverage producers held ownership stakes.
• Upon completion, the plant had two state-of-the-art production lines with a combined
capacity of 3,200 steel beverage cans per minute.
• A third production line, added in October 1989, expanded Bev-Pak's capacity to 2 billion cans
per year.
• This output represented about 40 percent of the total steel beverage can output in the United
States.
92
• BevPak arranged contracts with Coca-Cola and PepsiCo to supply as much as 20 percent of
their can requirements.
• It also arranged a contract with Miller Brewing Company.
• Bev-Pak enjoyed a competitive advantage:
Its state-of-the-art automation enabled it to sell its tinplated steel cans at a lower price than
aluminium cans. Moreover, to reduce its economic risk, Bev-Pak retained the flexibility to switch
to aluminium can production if the price of aluminium cans were to drop.
• Financing a large, highly automated plant involves uncertainty about whether the plant will be able to operate at
full capacity. Independent ownership enables the plant to enter into arm's-length agreements to supply
competing beverage makers.
• It thus diversifies its operating risk; it is not dependent on any single brand's success. Moreover, because of
economies of scale, entering into a long-term purchase agreement for a portion of the output from a large-scale
plant is more cost effective than building a smaller plant in house.
• Finally, long-term contracts with creditworthy entities furnish the credit strength that supports project financing.
93
• Infrastructure is another area for innovation--The formation of public-private partnerships to
finance generating stations, transportation facilities, and other infrastructure projects. (ch 16 -ppp
uploaded)
• Governments and multilateral agencies have recognized the need to attract private financing
for such projects.
• How private financing was arranged for two toll roads in Mexico (ch-18-uploaded)
• In the past, projects of this type have been financed by the public sector.
94

T4 PF Pgpfin01 2021

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

T4 PF Pgpfin01 2021

Uploaded by

Copyright:

Available Formats

Project Finance

Term IV –PGPFin01 Batch

• Distribution of Projects and dates

Case 11--Economic Framework for Assessing Development Impact

Time 20 min Case presentation

Time 20 min Case presentation

You will send the ppts

Then why do corporations:

– Asymmetric downside risks:

Customized capital structure/asset specific

A relevant question to investigate:

SPONSOR + PROJECT? Finance separately with non-recourse

Finance jointly with corporate funds?

3. If sufficient profit is predicted, the project company can finance construction of

• Project financing is a well-established financing technique.

• About 10 percent of large projects cost $1 billion or more.

• Project financing is not a means of financing a project that cannot be financed on a

• This facility or group of assets must be capable of standing alone as an independent

• The operations, supported by a variety of contractual arrangements, must be

• Project financing can be beneficial to a company with a proposed project when

• For example, project financing can be advantageous to a developing

• Where we find that this has gone wrong…………

• Economically and legally independent project company

– Debt is either limited (via completion guarantees) or non-recourse to the sponsors

• Highly leveraged project company with concentrated equity ownership

– Syndicate of banks and/or financial institutions provide debt

– Typical D/V ratio as high as 70% and above

– Debt has higher spreads than corporate debt

– One to three equity sponsors

– Sponsors provide capital in the form of equity or quasi-equity (subordinated debt)

– Industrial projects: mines, pipelines, oil fields

– Infrastructure projects: toll roads, power plants, telecommunications systems

– Significant financial, developmental, and social returns

• Examples of project-financed investments

– $6bn Iridium global satellite project (case 5)

– The Offtake Contract for the

– A framework under which – Provides the Project Company

– May be provided by central

• Takes longer to structure and

• Project finance requires greater

Structural decisions may affect the existence and magnitude of costs

Organizational Structure Governance Structure

Problems • “Cash Flow Waterfall” mechanism reduces potential conflicts in

• Single cash flow stream and separate ownership provides easier

Problems • Vertical integration is effective in precluding opportunistic

• Joint ownership with related parties to share asset control and

• This way counterparty incentives are aligned.

• High leverage also reduces accounting profits thereby reducing

Problems • Project financed investment exposes the sponsor to

• Location: Large projects in

– Risk management defined

• Contractual structure in Project Finance to reduce cost of risk and

The process of identification, assessment, mitigation, and allocation of risks to reduce

Variability in RHS variables lead to changes in return to equity

• Capital, financial, and futures markets:

• Contract with lowest cost not necessarily best contract

• Effective contracts may provide:

• “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives

• Pre-completion risks: Resource, technological, timing, and completion risks

•Site acquisition and access, permits •A government support agreement

•Process failures •Process / Equipment warranties

•Nonperformance on completion: due to poor •Debt recourse to sponsors (from lenders’

•Sponsor-related risks (Lenders’ perspective): •Require lower D/E ratio