The MM Proposition

The Capital Structure is irrelevant as long as the firms 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.

What is a Project?
High operating margins. Low to medium return on capital. Limited Life. Significant free cash flows. Few diversification opportunities. Asset specificity.

What is a Project?

Projects have unique risks:

Symmetric risks:

Demand, price. Input/supply. Currency, interest rate, inflation. Reserve (stock) or throughput (flow). Environmental. Creeping expropriation. Technology failure. Direct expropriation. Counterparty failure Force majeure Regulatory risk

Asymmetric downside risks:

Binary risks

What Does a Project Need?

Customized capital structure/asset specific governance systems to minimize cash flow volatility and maximize firm value.

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.

Conventional Methods of Financing (1)

Methods of Financing
The two broad choices a firm has for financing an investment project are: 1. Equity financing, and 2. Debt financing

Equity Financing:
It can take one of two forms: - the use of retained earnings otherwise paid to stockholders, - the issuance of stock. Both forms of equity financing use funds invested by the current or new owners of the company.

Conventional Methods of Financing (2)

Debt Financing:

It includes both short-term borrowing from financial institutions and the sale of long-term bonds, wherein money is borrowed from investors for a fixed period. With debt financing, the interest paid on the loans or bonds is treated as an expense for income-tax purposes.

Typical Project Financing Models(1)

The most common structures used to finance projects are:

Project Financing (also known as limited recourse financing), Corporate Financing, and Lease Financing.

Project Financing
The term project finance refers to financing structures wherein the lender has recourse only or primarily to the assets of the project and looks primarily to the cash flows of the project as the source of funds for repayment. The terms limited recourse finance and non-recourse finance are used interchangeably with project finance.

Project Financing Definition

A form of financing projects, primarily based on claims against the financed asset or project rather than on the sponsor of the

project. However, there are varying degrees

of recourse possible. Repayment is based on the future cash flows of the project.

Typical Project Financing Models(2)

Corporate Financing
It involves the use of internal company capital to finance a project directly, or the use of internal company assets as collateral to obtain a loan from a bank or other lender.

Lease Financing
Leasing essentially involves the supplier of an asset financing the use and possibly also the eventual purchase of the asset, on behalf of the project sponsor. Assets which are typically leased include land, buildings, and specialized equipment. A lease may be combined with a contract for operation and maintenance of the asset.

Project Financing

The raising of funds to finance an economically separable capital investment project in which the providers of the fund 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. (Finnerty)

A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan. (Nevitt & Fabozzi)

The financing of long-term infrastructure, industrial projects and public services based upon a nonrecourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. (International Project Finance Association)

A project company is defined as a group of agreements and contracts between lenders, project sponsors, and other interested parties that creates a form of business organization that will issue finite amount of debt on inception; will operate in a focused line of business; and will ask that lenders look only to a specific asset to generate cash flow as the sole source of principal and interest payments and collateral. (Standard & Poors Corporation)

Although none of these definitions uses the term non-recourse debt explicitly (i.e., debt repayment comes from the project company only rather than from any other entity); they all recognize that it is an essential feature of project financing

Project Finance Involves the creation of a legally and economically independent project company financed with nonrecourse debt (and equity from one or more corporate sponsors) for the purpose of financing a single purpose, capital asset usually with a limited life.

Project financing involves raising funds to finance an economically separable capital investment project by issuing securities or incurring bank borrowings that are designed to be serviced and redeemed exclusive out of project cash flow.

Project financing v/s Corporate Financing

It may be termed financing on a firms general credit Conventional direct financing, lenders to the firm look to the firms entire asset portfolio to generate the cash flow to service their loans. The assets and their financing are integrated into the firms asset and liability portfolios. Such loans are not secured by any pledge or collateral.

The project is a distinct legal entity; project assets, project related contract, and project cash flow are segregated to an substantial degree from the sponsoring entity. The financing structure is designed to allocate financial returns and risks more efficiently than a conventional financing structure Project financing, 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 assts, to secure the project loans.

Characteristics of project Finance

Project financing arrangements invariably involve strong contractual relationship among multiple parties Project financing can only work for those projects that can establish such relationships and maintain them at a tolerable cost. To arrange a project financing, there must be a genuine community of interest among the parties involved in the project. For experienced practitioners, the acid test of soundness for a proposed project financing is whether all parties can reasonably expect to benefit under the proposed financing arrangement

Project financing will not necessarily lead to a lower cost of capital in all circumstances. Usually may be more cost-effective than conventional direct financing when:

Permits a higher degree of leverage than the sponsors could achieve on their own Increase in leverage produces tax shield benefits sufficient to offset the higher cost of debts funds, resulting in a lower over all cost of capital for the project.

To arrange financing for a stand-alone project, prospective lender (and prospective outside equity investors, if any) must be convinced that the project is technically feasible and economically viable. And the project will be sufficiently creditworthy if financed on the basis the project sponsors.

That construction can be completed on schedule and within budget and that the project will be able to generate sufficient cash flow so as to cover its overall cost of capital. Establishing creditworthiness requires demonstrating that even under reasonably pessimistic circumstances, the project will be able to generate sufficient revenue both to cover all operating costs and to service project debt in a timely manner.

Lenders to a project will require that they be protected against certain risks. Recent innovations in finance, including currency futures, interest rate swaps and caps, and currency swaps, have provided project sponsors with new vehicles for managing certain types of project related risks cost-effectively.

The term project finance is generally used to refer to a non-recourse or limited recourse financing structure in which debt, equity, and credit enhancement are combined for the construction and operation, or the refinancing, of a particular facility in a capital- intensive industry, in which lenders base credit appraisals on the projected revenues from the operation of the facility, rather than the general assets or the credit of the sponsor of the facility, and rely on the assets of the facility, including any revenueproducing contracts and other cash flow generated by the facility, as collateral for the debt.

The Rationale for Project Financing

Several studies have explored the rationale for project financing. These studies have generally analyzed the issue from the following perspective When a firm is contemplating a capital investment project, three interrelated questions arise:

Should a firm undertake the project as part of its overall asset portfolio and finance the project on its general credit, or should the firm form a separate legal entity to undertake the project? What amount of debt should the separate legal entity incur? How should the debt contract be structured that is, what degree of recourse to the project sponsors should lenders be permitted?