PRINCIPLES OF PROJECT FINANCING ASSIGNMENT
PRINCIPLES OF PROJECT FINANCING ASSIGNMENT
Project financing refers to the funding of long-term infrastructure developments, industrial undertakings and public services using limited recourse or non-recourse financial arrangements. Under the process, any debt or equity incurred by the project are paid back using the cash flow generated from the completed scheme. Therefore, project financing is simply a loaning structure that depends on the cash flow from a venture for repayment with assets, interests and rights employed as collateral.
The primary purpose of project financing is to structure off-balance-sheet funding for the venture in ways that do not impact the shareholder’s credit or the federal government’s contracting power. Project risk is transferred to the lender to capture the primary focus. However, according to Triantis (2018, p. 13), the lender benefits from higher margins of corporate lending compared to normal borrowing.
|Corporate Financing||Project Financing|
|Introduced when a company is starting up||Derived from the project financier when the company has more than 3 years of operation|
|Financier requires commercial proof of concept, which is the revenues||The financier checks the project’s cash flow to determine whether it is as projected|
|Investor risk is higher than normal||Investor risk is lower than normal|
|High risks means higher Returns on Investment (ROI)||Returns are lower due to payments coming from the cash flow, which has less risk|
|Financier uses the assets of the company as collateral||Financier uses project assets as collateral|
|Investors assess the balance sheet prior to making an investment||Investors look at the cash flow using financial model to base their investment decisions|
The debt ratio is derived by dividing a corporation’s total liabilities with shareholder equity. The ratio is sued to determine the company’s capital structure and is influence by business risk, financial flexibility, tax exposure, market conditions and the upper level management.
|Debt Funds||Equity Funds|
|Money is pooled from people and invested in fixed income projects, such as corporate bonds, government bonds and highly-rated instruments||Money is pooled from people and used in equity-like instruments, such as stocks|
|Have less risk||Have high risk due to the volatility of market conditions|
|Debt funds are taxed 2-% after indexation||Have a flat 12% tax rate after indexation|
|Have steady returns with a consistent range||Possibility of high gains and losses depending on market conditions|
Equity shares have the following properties:
- Equity shares do not create any obligation to pay a fixed rate of dividend.
- Equity shares can be issued without creating any charge over the assets of the company.
- It is a permanent source of capital and the company has to repay it except under liquidation.
- Equity shareholders are the real owners of the company who have the voting rights.
- They don’t have any preferential right in respect of payment of dividend or in the repayment of capital at the time of winding of the company.
- Equity shares are risk bearing shares because they are the actual owners of the company when ever company run into losses they have to bear the losses.
- Equity shares are easily transferred from one person to another at the stock exchange according to the procedure laid down in the article of association of the company.
Contract documents refer to written reports that describe the basis of the agreement including terms and conditions, responsibilities of each party and specifications. The report can contain crucial information for the completion of work.
The requisite elements of any contract are that it must be established to denote the formation of a legally binding agreement. The six elements include the offer, acceptance, consideration, mutuality of obligation, competency and capacity and the writing requirement.
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The significant features of project financing within companies includes:
The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely “non-recourse” to the sponsor. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project (Gatti 2014, p. 7).
Depending upon the structure of a project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor (Gatti 2014, p. 8). Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.
In a project financing, the sponsor typically seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity.
Maximize Tax Benefits
Project financing should be structured to maximize tax benefits and to assure that all available tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle.
- A project may be subject to high risk. An SPV helps the organization to legally isolate the risks by transferring it to the investors via the purchase of the automobile.
- The need to secure loans is another reason why a project should have SPVs. The automobile can be used as collateral allowing investors to have mortgage-based security for loans.
- Companies might face difficulties in transferring certain assets. An SPV can be bought to hold such assets and subsequently sold as part of mergers and acquisitions.
- Given that the taxation rate for property sales it’s greater than capital gains, a company can opt to create SPVs to own features of the sale. The vehicle is sold instead of properties subjecting the company to less taxation and higher capital gains.
When investors acquire security with significant risk, the opportunity for returns must make the investments attractive. With high risk margins, the investor has higher anticipations of returns (Finnerty 2013, p. 158). The relationship between rate of return and cost of capital helps management determine the amount of debt to incur in an investment.
General Economic Conditions
Global conditions determine the demand and supply of capital within individual economies. The economic variable reflects on the risk of rate of return. If demand changes in relation to supply, investors are required to change their rate of return. Basically, the conditions determine amount of debt available and suitability of the loans as determined by the rate of returns.
Operating and Financing Decisions
Debt, as risk, results from decisions made within the company. Risk resulting from these decisions is generally divided into two types: business risk and financial risk. As business risk and financial risk increase or decrease, the investor’s required rate of return (and the cost of capital) will move in the same direction
Amount of Financing
The last factor determining the corporation’s cost of funds is the level of financing that the firm requires. As the financing requirements of the firm become larger, the weighted cost of capital increases for several reasons. Suppliers of capital become hesitant to grant relatively large sums without evidence of management’s capability to absorb this capital into the business. This is typically “too much too soon” (Finnerty 2013, p. 158). Also, as the size of the issue increases, there is greater difficulty in placing it in the market without reducing the price of the security, which also increases the firm’s cost of capital.
Force Majeure describes a clause contained in contracts to eradicate the liability for natural or unexpected disasters that can distort the normal development and activities in a project (Kokorin & Van der Weide 2015, p. 48). The clause is embodied in common law in the U.K. and U.S.A, but to be acceptable, the clause must be explicit about the nature of events that can trigger it. An example is when a mudslide destroys a factory resulting in production delays. The clause protects investors and managers form liability in the event normal disruptions occur from non-human actions.
Project financing comes from a variety of sources. The main sources include federal grants, equity and debt. Equity comes from project sponsors, third-party investors, internally generated revenue and from the government. Equity has a higher rate of return and is subject to higher interests rates compared to debt financing. Lenders of business capital do so in commercial loans, bridge financing, bonds or subordinate loans. Governments have unique mechanisms for the awarding of grants to PPP projects.
Identification of Risk
The project manager and his/her team first uncover risks that might affect the final outcome. Listed threats are documented in a freshly prepared project risk register.
Once risks are identified, the team moves to determine the likelihood and implications of each threat. The objective is for the team to develop basic understanding of the nature of risk and potential implications on the project if the said risks were to occur.
Risk Ranking and Categorization
You evaluate or rank the risk by determining the risk magnitude, which is the combination of likelihood and consequence. You make decisions about whether the risk is acceptable or whether it is serious enough to warrant treatment. These risk rankings are also added to your Project Risk Register.
Treating of the Risk
The process entails the formation of a risk response plan. The highest ranking threats are prioritized and reduced to the least acceptable level. The project team employs risk mitigation strategies including preventive and contingency plans.
Risk Monitoring and Review
This is the step where you take your Project Risk Register and use it to monitor, track and review risks.
Finnerty, J 2013, project financing: Asset-based financial engineering. New York, John Wiley & Sons.
Gatti, S 2014, Project financing in theory and practice: designing, structuring and financing private and public projects. New York, Springer Life.
Kokorin, I & Van der Weide, J 2015, Force majeure and unforeseen change of circumstances: the case of embargoes and currency fluctuations. Russian Law Journal, vol. 3, no. 3, pp. 45-58.
Triantis, E, J 2018, ‘Project finance for business development’, New York, John Wiley & Sons.