agarwal kaul (1)
TRANSCRIPT
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Project finance
Aditya Agarwal
Sandeep KaulFuqua School of Business
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases
Project Finance: Valuation Issues
The MM Proposition
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases Project Finance: Valuation Issues
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What is a project?
High operating margins.
Low to medium return on capital.
Limited Life. Significant free cash flows.
Few diversification opportunities. Asset
specificity.
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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
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What does a Project need?
Customized capital structure/asset specificgovernance systems to minimize cash flowvolatility and maximize firm value.
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases Project Finance: Valuation Issues
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What is Project Finance?
Project Finance involves a corporatesponsor investing in and owning a single
purpose, industrial asset through a legallyindependent entity financed with non-recourse debt.
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Project Finance An Overview
Outstanding Statistics Over $220bn of capital expenditure using project finance in 2001
$68bn in US capital expenditure
Smaller than the $434bn corporate bonds market, $354bn asset
backed securities market and $242bn leasing market, but largerthan the $38bn IPO and $38bn Venture capital market
Some major deals: $4bn Chad-Cameroon pipeline project
$6bn Iridium global satellite project
$1.4bn aluminum smelter in Mozambique
900m A2 Road project in Poland
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Total Project Finance Investment
0
50
100
150
200
250
Million USD
1997 1998 1999 2000 2001
Years
Total Project Finance Investment
Equity Finance
MLA/ BLA
Bonds
Bank loans
Overall 5-Year CAGR of 18% for private sector investment.
Project Lending 5-Year CAGR of 23%.
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Number of Projects
0
100
200
300
400
500
600
700
Number of
Projects
1997 1998 1999 2000 2001
Years
Number of Projects
Project with Bond Finance
Projects with Bank LoanFinance
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Lending by Type of Debt
Percent Lending by type of debt
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1997 1998 1999 2000 2001
Years
Percentage
Bonds
Bank Loans
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Project Finance Lending by Sector
$-
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
Amount USD
1997 1998 1999 2000 2001
Years
Amount of Project Lending by Sector
Industrial
Leisure
PetrochemicalMining
Telecom
Oil and Gas
Infrastructure
Power
37% of overall lending in Power Projects, 27% in telecom.
5-Year CAGR for Power Projects: 25%, Oil & Gas:21% and
Infrastructure: 22%.
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases Project Finance: Valuation Issues
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Project Structure
Structure highlights
Comparison with other Financing Vehicles
Disadvantages
Motivations
Alternative approach to Risk Mitigation
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Structure Highlights
Independent, single purpose company formed to buildand operate the project.
Extensive contracting As many as 15 parties in upto 1000 contracts.
Contracts govern inputs, off take, construction and operation.
Government contracts/concessions: one off or operate-transfer.
Ancillary contracts include financial hedges, insurance for Force
Majeure, etc.
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Structure Highlights
Highly concentrated equity and debt ownership One to three equity sponsors.
Syndicate of banks and/or financial institutions provide credit.
Governing Board comprised of mainly affiliated directors fromsponsoring firms.
Extremely high debt levels Mean debt of 70% and as high as nearly 100%.
Balance capital provided by sponsors in the form of equity or
quasi equity (subordinated debt). Debt is non-recourse to the sponsors.
Debt service depends exclusively on project revenues.
Has higher spreads than corporate debt.
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Comparison with Other Vehicles
Financing vehicle Similarity Dis-similarity
Secured debt Collaterized with aspecific asset
Recourse tocorporate assets
Subsidiary debt Possible recourse tocorporate balancesheet
Asset backedsecurities
Collaterized and non-recourse
Hold financial, notsingle purpose
industrial asset
LBO / MBO High debt levels No corporate sponsor
Venture backedcompanies
Concentrated equityownership
Lower debt levels;managers are equityholders
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Disadvantages of Project Financing
Takes longer to structure than equivalent sizecorporate finance.
Higher transaction costs due to creation of an
independent entity. Can be up to 60bp Project debt is substantially more expensive (50-
400 basis points) due to its non-recourse nature. Extensive contracting restricts managerial
decision making. Project finance requires greater disclosure of
proprietary information and strategic deals.
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Motivations: Agency Costs
Problems: High levels of
f ree cash f lowdue to few
investmentopportunities.Possiblemanagerialmismanagementthrough wasteful
expendituresand sub optimalinvestments.
Structural solutions: Traditional monitoring mechanisms such as
takeover markets, staged financing,product markets absent.
Reduce free cash flow through high debt
service. Contracting reduces discretion. .Cash Flow Waterfall: Pre existing
mechanism for allocation of cash flows.Covers capex, maintenance expenditures,debt service, reserve accounts,
shareholder distribution.
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Motivations: Agency Costs
Problems: High levels of
f ree cash f lowdue to few
investmentopportunities.Possiblemanagerialmismanagementthrough wasteful
expendituresand sub optimalinvestments.
Structural solutions: Concentrated equity ownership provides
critical monitoring. Bank loans provide credit monitoring. Separate ownership: single cash flow
stream, easier monitoring. Senior bank debt disgorges cash in early
years. They also act as trip wires formanagers.
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Motivations: Agency Costs
Problems: Opportunistic
behavior by
trading partners:ho ld up. Ex-antereduction inexpected returns.
Structural Solutions: Vertical integration is effective in
precluding opportunistic behavior but not
at sharing risk (discussed later). Also,opportunities for vertical integration maybe absent.
Long term contracts such as supply andoff take contracts: these are moreeffective mechanisms than spot market
transactions and long term relationships.
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Motivations: Agency Costs
Problems: Opportunistic
behavior by
trading partners:ho ld up. Ex-antereduction inexpected returns.
Structural Solutions: Joint ownership with related parties to
share asset control and cash flow rights.
This way counterparty incentives arealigned.
Due to high debt level, appropriation offirm value by a partner results in costlydefault and transfer of ownership.
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Motivations: Agency Costs
Problems: Opportunistic
behavior by host
governments:expropr iat ion.Either direct throughasset seizure orcreeping through
increasedtax/royalty. Ex-anteincrease in risk andrequired return.
Structural Solutions: Since company is stand alone, acts of
expropriation against it are highly visible
to the world which detracts futureinvestors.
High leverage forces disgorging ofexcess cash leaving less on the table tobe expropriated.
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Motivations: Agency Costs
Problems: Opportunistic
behavior by host
governments:expropr iat ion.Either direct throughasset seizure orcreeping through
increasedtax/royalty. Ex-anteincrease in risk andrequired return.
Structural Solutions: High leverage also reduces accounting
profits thereby reducing local opposition
to the company. Multilateral lenders involvement
detracts governments fromexpropriating since these agencies aredevelopment lenders and lenders of last
resort. However these agencies onlylend to stand alone projects.
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Motivations: Agency Costs
Problems: Debt/Equity h old er
conf l ic tindistribution of cash
flows, re-investmentand restructuringduring distress.
Structural Solutions: Cash flow waterfall reduces managerial
discretion and thus potential conflicts in
distribution and re-investment. Given the nature of projects, investment
opportunities are few and thus investmentdistortions/conflicts are negligible.
Strong debt covenants allow bothequity/debt holders to better monitormanagement.
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Motivations: Agency Costs
Problems: Debt/Equity holder
conf l ic tin distribution
of cash flows, re-investment andrestructuring duringdistress.
Structural Solutions: To facilitate restructuring, concentrated
debt ownership is preferred, i.e. bank
loans vs. bonds. Also less classes ofdebtors are preferred for speedyresolution. Usually subordinated debtis provided by sponsors: quasi equity.
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Why Corporate Finance cannot Deter
Opportunistic Behavior ? Do not allow joint ownership.
Direct expropriation can occur without triggering default.
Creeping expropriation is difficult to detect and highlight.
Multi lateral lenders which help mitigate sovereign risklend only to project companies.
Non-recourse debt had tougher covenants thancorporate debt and therefore enforces greater discipline.
In the absence of a corporate safety net, the incentive togenerate free cash is higher.
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Motivations: Debt Overhang
Problems: Under investmentin
Positive NPV projects at
the sponsor firm due tolimited corporate debtcapacity. Equity is not avalid option due to agencyor tax reasons. Fresh debtis limited by pre-existing
debt covenants.
Structural Solutions: Non recourse debt in an
independent entity allocates
returns to new capital providerswithout any claims on thesponsors balance sheet.Preserves corporate debt capacity.
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Motivations: Risk Contamination
Problems: A high risk project
can potentially draga healthy
corporation intodistress. Short ofactual failure, therisky project canincrease cash flowvolatility and reducefirm value.Conversely, a failingcorporation can draga healthy projectalong with it.
Structural Solutions: Project financed investment exposes
the corporation to losses only to the
extent of its equity commitment,thereby reducing its distress costs.
Through project financing, sponsorscan share project risk with othersponsors. Pooling of capital reduceseach providers distress cost due to the
relatively smaller size of the investmentand therefore the overall distress costsare reduced. This is an illustration ofhow structuring can enhance overallfirm value. Re: MM Proposition.
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Motivations: Risk Contamination
Problems: A high risk project
can potentially draga healthy
corporation intodistress. Short ofactual failure, therisky project canincrease cash flowvolatility and reducefirm value.Conversely, a failingcorporation can draga healthy projectalong with it.
Structural Solutions: Co-insurance benefits are negative
(increase in risk) when sponsor and
project cash flows are stronglypositively correlated. Separateincorporation eliminates increase inrisk.
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Motivations: Risk Mitigation
Completion and operational risk can bemitigated through extensive contracting. This willreduce cash flow volatility, increase firm value
and increase debt capacity. Project size: very large projects can potentially
destroy the company and thus inducemanagerial risk aversion. Project Finance cancure this (similar to the risk contaminationmotivation).
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Motivations: Other
Tax: An independent company can avail of tax holidays. Location: Large projects in emerging markets cannot be
financed by local equity due to supply constraints.Investment specific equity from foreign investors is eitherhard to get or expensive. Debt is the only option andproject finance is the optimal structure.
Heterogeneous partners: Financially weak partner needs project finance to participate. It bears the cost of providing the project with the benefits of
project finance. The bigger partner if using corporate finance can be seen as
free-riding. The bigger partner is better equipped to negotiate terms with
banks than the smaller partner and hence has to participate inproject finance.
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Alternative Approach to Risk Mitigation
Risk Solution
Completion Risk Contractual guarantees frommanufacturer, selecting vendors of
repute.Price Risk hedging
Resource Risk Keeping adequate cushion inassessment.
Operating Risk Making provisions, insurance.Environmental Risk Insurance
Technology Risk Expert evaluation and retentionaccounts.
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Alternative Approach to Risk Mitigation
Political andSovereign Risk
Externalizing the project company by forming itabroad or using external law or jurisdiction
External accounts for proceeds
Political risk insurance (Expensive)
Export Credit Guarantees
Contractual sharing of political risk between lendersand external project sponsors
Government or regulatory undertaking to coverpolicies on taxes, royalties, prices, monopolies, etc
External guarantees or quasi guaranteesInterest RateRisk
Swaps and Hedging
Insolvency Risk Credit Strength of Sponsor, Competence ofmanagement, good corporate governance
Currency Risk Hedging
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Financing Choice
Portfolio Theory
Options Theory
Equity vs. Debt
Type of Debt
Sequencing
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Financing Choice: Portfolio Theory
Combined cash flow variance (of project and sponsor)with joint financing increases with: Relative size of the project. Project risk. Positive Cash flow correlation between sponsor and project.
Firm value decreases due to cost of financial distresswhich increases with combined variance.
Project finance is preferred when joint financing
(corporate finance) results in increased combinedvariance. Corporate finance is preferred when it results in lower
combined variance due to diversification (co-insurance).
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Financing choice: Options Theory
Downside exposure of the project (underlying asset)can be reduced by buying a put option on the asset(written by the banks in the form of non-recourse debt).
Put premium is paid in the form of higher interest andfees on loans.
The underlying asset (project) and the option provides
a payoff similar to that of call option.
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Financing choice: Options Theory
The put option is valuable only if the Sponsor might beable/willing to exercise the option.
The sponsor may not want to avail of project finance(from an options perspective) because it cannot walk
away from the project because: It is in a pre-completion stage and the sponsor has provided a
completion guarantee.
If the project is part of a larger development.
If the project represents a proprietary asset. If default would damage the firms reputation and ability to raise
future capital.
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Financing Choice: Options Theory
Derivatives are available for symmetric risks but not forbinary risks, (things such as PRI are very expensive).
Project finance (organizational form of risk management)is better equipped to handle such risks.
Companies as sponsors of multiple independent
projects: A portfolio of options is more valuable than anoption on a portfolio.
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Financing Choice: Equity vs. Debt
Reasons for high debt:
Agency costs of equity (managerial discretion,expropriation, etc.) are high.
Agency costs of debt (debt overhang, risk shifting) arelow due to less investment opportunities.
Debt provides a governance mechanism.
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Financing Choice: Type of Debt
Bank Loans: Cheaper to issue. Tighter covenants and better monitoring. Easier to restructure during distress. Lower duration forces managers to disgorge cash early.
Project Bonds: Lower interest rates (given good credit rating). Less covenants and more flexibility for future growth.
Agency Loans: Reduce expropriation risk. Validate social aspects of the project.
Insider debt: Reduce information asymmetry for future capital providers.
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Financing Choice: Sequencing
Starting with equity: eliminate risk shifting, debt overhangand probability of distress (creditors requirement).
Add insider debt (Quasi equity) before debt: reducescost of information asymmetry.
Large chunks vs. incremental debt: lower overalltransaction costs. May result in negative arbitrage.
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases Project Finance: Valuation Issues
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Real World Cases
BP Amoco: Classic project finance
Australia Japan cable: Classic project finance
Polands A2 Motorway: Risk allocationPetrolera Zuata: Risk management
Chad Cameroon: Multiple structures
Calpine Corporation: Hybrid structure
Iridium LLC: Structure and Financing choicesBulong Nickel Mine: Bad execution
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Case : BP Amoco
Background: In 1999, BP-Amoco, the largest shareholder inAIOC, the 11 firm consortium formed to develop the Caspianoilfields in Azerbaijan had to decide the mode of financing for itsshare of the $8bn 2nd phase of the project. The first phase cost$1.9bn.
Issues:
Size of the project: $10bn.
Political risk of investing in Azerbaijan, a new country. Risk of transporting the oil through unstable and hostile countries.
Industry risks: price of oil and estimation of reserves.
Financial risk: Asian crisis and Russian default.
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Case: BP Amoco
Structural highlights:
Risk sharing: Increase the number of participants to 11 anddecrease the relative exposure for each participant. Since partners
are heterogeneous in financial size/capacity, use project finance. Sponsor profile: Get sponsors from major superpowers to detract
hostile neighbors from acting opportunistically. Get IFC and EBRD(multilateral agencies) to participate in loan syndicate and reduceexpropriation risk.
Staged investment: 2nd phase ($8bn) depends on the outcome of the1st phase investment. Improves information availability for thecreditors and decreases cost of debt in the 2nd phase.
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Case : Australia Japan Cable
Background:12,500km cable from Sydney, Australia to Japan viaGuam at a cost of $520m. Key sponsors: Japan Telecom, Telstraand Teleglobe. Asset life of 15 years.
Key Issues: limited growth potential Market risk from fast changing telecom market Risk from project delay Specialized use asset: Need to get buy in from landing stations and
pre-sell capacity to address issue of Hold Up Significant Free Cash Flow
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Case : Australia Japan Cable
Structural highlights: Avoid Hold up Problem through governance structure:
Long term contracts with landing stations.
Joint equity ownership of asset with Telstra and landing stationowners both as sponsors.
High project leverage of 85%
Concentrates ownership and reduces equity investment.
Shares project risk with debt holders.
Enforces contractual agreement by pre-allocating the revenuewaterfall. Enforces Management discipline.
Short term debt allow for early disgorging of cash.
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Case : Polands A2 Motorway
Background:AWSA is an 18 firm consortium with concession tobuild and operate toll road as part of Paris-Berlin-Warsaw-Moscowtransit system. Seeking financing for the 1bn deal (25% equity). Isbeing asked to put in additional 60-90m in equity. Concession dueto expire in 6 weeks.
Key Issues:
Assessment of project risk and allocation of risks.
How can project risk best be managed? Developing a structuring solution given the time pressure.
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Case : Polands A2 Motorway
Structure for allocation of Risk Construction Risk:
Best controlled by builder and government. Fixed priced turnkey contract with reputed builder.
Government responsible for procedural delay and support infrastructure. Insurance against Force Majeure, adequate surplus for contingencies.
Operating Risk: Best controlled by AWSA and the operating company. Multiple analyses by reputable entities for traffic volume and revenue
projections.
Comprehensive insurance against Force Majeure. Experienced operators, road layout deters misuse.
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Case : Polands A2 Motorway
Structure for allocation of Risk Political Risk:
Best controlled by Polish Government and AWSA. Assignment of revenue waterfall to government: Taxes, lease and profit
sharing. Use of UK law, enforceable through Polish courts. Counter guarantees by government against building competing
systems, ending concession.
Financial Risk: Best controlled by Sponsor and lenders.
Contracts in to mitigate exchange rate risk. Low senior debt, adequate reserves and debt coverage, flexible
principle repayment. Control of waterfall by lenders gives better cash control. Limited floating rate debt with interest rate swaps for risk mitigation.
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Case : Petrolera Zuata, Petrozuata C.A.
Background:$2.4bn oil field development project in Venezuelaconsisting of oil wells, two pipelines and a refinery. It is sponsoredby Conoco and Marvan who intend to raise a portion of the $1.5bndebt using project bonds.
Key Issues: What should be the final capital structure to keep the project viable? What is the optimum debt instrument and will the debt remain
investment grade? How can the project structure best address the associated risk?
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Case : Petrolera Zuata, Petrozuata C.A.
Operational Risk Management
Pre Completion Risk Includes resource, technological and completion risk.
Resource and technology not a major factor ( 7.1% of resources consumed andproven technology).
Sponsors guarantee to mitigate completion risk.
Post Completion Risk Market risk and force majeure.
Quantity risk is mitigated by off-take agreement with CONOCO. However pricerisk not addressed due to secure deal fundamentals.
Sovereign Risk Key risk is of expropriation. Exchange rate volatility is a minor consideration.
Fear of retaliatory action on expropriation. Government ownership of PDVSA.
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Case : Petrolera Zuata, Petrozuata C.A.
Financial Risk and Capital Structure Financial Risk:
Optimum leverage at 60% for investment grade rating.
Evaluation of Debt Alternatives
BDA/ MDA: Reduced political insurance, and loan guarantees athigher cost and time delay.
Uncovered Bank Debt: Greater withdrawal flexibility at a fee.Shorter maturity, size and structure restrictions, variable interestrate.
144A bond market: Longer term, fixed interest rates, fewer
restrictions and larger size. Relatively new and negative carry. Equity returns:
Equity can be adjusted within reason to get better rating.
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Case : The Chad Cameroon Project
Background:An oil exploration project sponsored by Exxon-Mobilin Central Africa with two components:
Field system: Oil wells in Chad, cost: $1.5bn. Export System: Pipeline through Chad and Cameroon to the
Atlantic, cost: $2.2bn.
Key Issues: Chad is a very poor country ruled by President Deby, a warlord.
Expropriation risk.
Possibility of hold up by Cameroon. Allocation of proceedsWorld Banks role and RevenueManagement Plan.
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Case : The Chad Cameroon Project
Possible financing Strategies for Exxon-Mobil
Financing Options Field System Export System Total
Investment
Corporate Finance: 1 sponsor, EM
100% owner
$1521m $322m+$1881m=$22
03m
$3723m
Corporate Finance: 3 Sponsors, EM40% Owner
40%*
$1521m = &608m
40%*($2203m) =$881m
$1489m
Hybrid structure: 3 Sponsors, EM 40%
owner
Corp. Finance
40%*
$1521m = $608m
Project Finance
40%*(123+680)=
$321m
$929m
Project Finance: 3 sponsors D/V=60%
EM 40% Owner
16%*$1521m =$243m
16% * ($2203)
=$352m
$596m
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Case : The Chad Cameroon Project
Structural choice: Hybrid structure
Brings in the World Bank to address the issue of
Sovereign Risk. Exxon-Mobil chooses corporate finance for oil fields
since investment size is small. Other means ofmanaging sovereign risk.
Exxon-Mobil chooses project finance for the pipeline todiversify and mitigate risk.
Involves the two nations to prevent post opportunisticbehavior with the export system.
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Case : Calpine Corporation
Options for Project Structure: Corporate Finance:
Public Offering of senior notes.
Project Finance :
Bank loans 100% construction costs to Calpine subsidiaries for eachplant.
At completion 50% to be paid and rest is 3-year term loan.
Revolving credit facility: Creation of Calpine Construction Finance Co. (CCFC) which receives
revolving credit.
Debt Non-recourse to Calpine Corp. High degree of leverage (70%). 4 year loan allowing construction of multiple plants.
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Case : Calpine Corporation
Comparison of Financing Routes: Corporate Finance:
Higher leverage: violates debt covenant for key ratios. Issuance of equity to sustain leverage would dilute equity.
Debt affected by the volatility in the high yield debt market. Project Finance:
Very high transaction costs given size of each plant. Time of execution: potential loss of First Mover advantage.
Hybrid Finance: Best of Corporate and Project Finance. Low transaction costs and shorter execution time. New entity can sustain high debt levels: ability to finance. Non-recourse debt reduces distress cost for Calpine Corp.
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Case : Iridium LLC
Background:A $5.5bn satellite communications project backed byMotorola which went bankrupt in 1999 after just one year ofoperations. Had partners in over 100 countries.
Issues: Scope of the project: 66 satellites, 12 ground stations around the
world and presence in 240 countries.
High technological risk: untested and complex technology.
Construction risk: uncertainty in launch of satellites.
Sovereign risk: presence in 240 countries.
Revolving investment: replace satellites every 5 years.
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Case: Iridium LLC
Structural highlights:
Stand alone entity: Size, scope and risk of the project in comparisonto Motorola. Allows for equity partnerships and risk sharing.
Target D/V ratio of 60%:
Cannot be explained by trade off theory since tax rate is 15% only.
Pecking order theory and Signaling theory also do not explain the highD/V ratio.
Agency theory best explains the D/V: Management holds only 1% ofequity and the project has projected EBITDA of $5bn resulting in high
agency cost of equity. Also, since Iridium has no other investmentoptions, risk shifting and debt overhang do not increase agency costs ofdebt.
Partners participating through equity and quasi equity to deteropportunistic behavior and align partner incentives.
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Case: Iridium LLC
Financing choices: Presence of senior bank loans:
lower issue costs. Act as trip wire.
Easier to restructure. Avoids negative arbitrage (disbursed when required). Duration aligned with life of satellites. Provide external review of the project.
Sequencing of financing: Started with equity during the riskiest stage (research) since debt would
be mispriced due to asymmetric information and risk. In development, brought in more equity, convertible debt and high yield
debt. This portfolio matches the risk profile then. For commercial launch, got bank loans: agency motivations emerge.
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Case: Iridium LLC
Contention: The Structuring and financing of Iridium wasfaulty and partially responsible for its demise.
Reality: Since Iridium was incorporated as an independententity and not corporate financed, its prime sponsorMotorola is still solvent inspite of Iridiums bankruptcy.Moreover, the Bank loan default which seeminglytriggered the bankruptcy also avoided fresh capital from
being ploughed into what was essentially atechnologically doomed project.
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Case : Bulong Nickel Mine
Background:In July 1998 Preston Resources bought the BulongNickel Mine in the pre-completion phase and financed it with abridge loan. The bridge loan was financed with a 10 year projectbond in December 1998. Within one year, Bulong defaulted on thenotes after operational problems.
Issues:
Concentrated and weak equity ownership: Preston Resources.
Cash flows very close to debt service.
Processing technology is unproven.
The output faces severe market risk and currency risk.
The company has exposure to currency risk through forwardcontracts.
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Case: Bulong Nickel Mine
Structural / financing highlights: Project finance: the right choice given the nature of the project and
its size relative to the sponsor. 72% D/V ratio: very high given the projected cash flows of the
project. Severely limits flexibility. Optionality: financial structure resembles an out of the money call
option from the sponsors perspective. Importance of completion guarantees: EPC agency guarantees
commissioning of plant and not ramp up. This misinterpretation ofcompletion guarantee results in project exposure to technology risk.
Project Bonds instead of bank loans: Motivation is flexibility in futureinvestment (Preston has a similar project on the cards which it wantsto facilitate with Bulong cash flows). However bonds limit flexibilityduring restructuring and delays it by 2 years.
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Contents
The MM Proposition
What is a Project?
What is Project Finance? Project Structure
Financing choices
Real World Cases Project Finance: Valuation Issues
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Project Finance: Valuation Issues
Valuation Issues in Projects
Traditional and Non Traditional Approach
Capital Cash Flow Method
Appropriate Discount Rate
Valuing Risky debt
Real Options
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Valuation Issues in Projects
Projects are exposed to non-traditional risks(discussed earlier).
Have high and rapidly changing leverage. Typically have imbedded optionality.
Tax rates are continuously changing.
Projects have early, certain and large negativecash flows followed by uncertain positive cashflows.
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Failure of Traditional Valuation
Usage of Corporate WACC is inappropriate: Different risk profile of the project from the sponsor.
Project has rapidly changing leverage.
Considers promised return on risky debt and notexpected return.
Traditional DCF method is inaccurate: Single discount rate does not account for changing
leverage. Ignores imbedded optionality.
Idiosyncratic risks are usually incorporated in thediscount rate as a fudge factor.
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Non-traditional Approaches
Using Capital Cash Flow method which acknowledgeschanging leverage and uses unlevered cost of capital.
Usage of non CAPM based discount rates especially foremerging markets investments.
Valuation of risky debt as a portfolio of risk free debt andput option.
Incorporation of imbedded Optionality: Valuation of RealOptions.
Usage of Monte Carlo Simulations to incorporateidiosyncratic risks in cash flows and to value RealOptions.
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Capital cash Flow method
Computing capital cash flow: Take Net Income (builds in tax shields directly) Add depreciation and special charges, Add interest Subtract change in NWC and
Subtract incremental investment. Discount capital cash flow with unlevered cost of equity
to arrive at firm value. Equity value can be derived by subtracting risky debt
value. Advantages:
Incorporates effect of changing leverage. Avoids calculation of debt discount rate. Assumes tax shields
are at similar risk as whole firm.
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Discount Rate for Project Finance
Corporate WACC is an inappropriatediscount rate (discussed above).
Incorporate idiosyncratic risks in cashflows and account for systematic risks indiscount rate. Avoid double accounting.
Ensure that discount rate is consistent with
the cash flow: unlevered rate for capitalcash flows.
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Discount Rate in Emerging Markets
This is a major area of concern:
Many mega projects are in emerging markets.
Many of these markets do not have mature equitymarkets. It is very difficult to estimate Beta with theWorld portfolio.
The Beta with the World portfolio is not indicative ofthe sovereign risk of the country (asymmetric
downside risks). E.g. Pakistan has a beta of 0.
Most assumptions of CAPM fail in this environment.
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Playing with the CAPM!
Approaches to calculating the Cost of Capital inEmerging Markets:
World CAPM or Multifactor Model (Sharpe-Ross)
Segmented/Integrated (Bekaert-Harvey) Bayesian (Ibbotson Associates)
CAPM with Skewness (Harvey-Siddique)
Goldman-integrated sovereign yield spread model
Goldman-segmented
Goldman-EHV hybrid CSFB volatility ratio model
CSFB-EHV hybrid
Damodaran
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Playing with the CAPM!
Most CAPM based methods fail to accuratelycalculate cost of capital in emerging markets dueto one or more of the following:
Method does not incorporate all risks in the project.Assume that the only risk is variance. Fail in capturing
asymmetric downside risks.Assume markets are integrated and efficient.Arbitrary adjustments which either over or
underestimate risk. Use sovereign bond returns as a proxy for cost of
equity.
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The Country Risk rating Model
Erb, Harvey and Viskanta (1995)
Credit rating a good ex ante measure of risk
Impressive fit to data
Explores risk surrogates: Political Risk,
Economic Risk,
Financial Risk and
Country Credit Ratings
Fits developed and emerging markets (nearly 136countries)
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The Country Risk rating Model
Sources
Political Risk Services International Country Risk Guide
Institutional Investors Country Credit Rating
Euromoneys Country Credit Rating
Moodys
S&P
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The Country Risk rating Model
Returns and Institutional Investor Country Credit
Ratings from 1990
R2
= 0.2976
-0.1
0
0.1
0.2
0.3
0.4
0.5
0 20 40 60 80 100
Rating
Averagereturn
s
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The Country Risk rating Model
Steps: Cost of Capital = risk free + intercept - slopexLog(IICCR)
Where Log(IICCR) is the natural logarithm of the Institutional
Investor Country Credit RatingGives the cost of capital of an average project in the country.
If cash flows are in local currency, then add forward premium lesssovereign risk of the currency to the cost of capital.
Adjust for global industry beta of the project.
Adjust for deviations in the project from the average level of a givenrisk in the country (Risk management will have a downward effect).
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The Country Risk rating Model
Risks incorporated in cash flows:
Pre-completion: technology, resource, completion.
Post-completion: market, supply/input, throughput.
Risks incorporated in discount rate:
Sovereign risk: macroeconomic, legal, political, forcemajeure.
Financial risk.
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Valuing Risky Debt
Differentiate between expected yield andpromised yield.
Options approach: Face value of corporate debt: k (strike price)
Underlying assets of the firm: S
Equity value: C(k) (call value with strike price = k)
Riskless debt: PV (k,r) (r: risk free rate of interest)
Put option: P(k) (put value with strike price = k)
By Put-Call Parity: S = C(k) + PV (k,r) P(k)
Value of risky debt, V(D): PV (k,r) P(k)
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Valuing Multiple Classes of Risky Debt
Senior debt: face value = D1; strike price, k1 = D1.
Junior debt: face value = D2; strike price, k2 = D1+D2.
Value of senior debt, V(D1) = V(riskless,D1) P(k1)
Value of junior debt, V(D2) = V(riskless,k2) P(k2)V(D1)
Value of total debt, V(D) = V(D1) + V(D2)
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Effect of Covenants on Debt Value
Management actions that result in risk shifting, increaseequity value (call) and decrease debt value (put): "Bet the firm" on a new technology that may have a small chance
of success.
Pay out large current dividends to shareholders. The futurecollateral of the firm will be reduced.
Get new debt at the same seniority level and repurchase shares.
Bank covenants to deal with such actions: New investment decisions need prior lender approval.
Cash Waterfall: Pre-determine distribution of cash flows. Limitations on new debt and distribution to debtholders.
Bank covenants limit managerial discretion and preservevalue of debt.
O G
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Real Options: Generic Types
R l O ti i P j t Fi
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Real Options in Project Finance
Scale up: Are usually in the form of replication.These also include contractual real options inthe form of leases etc. Affects project NPV.
Switch up: Affects project NPV.
Scope up: Affects value of Sponsorsinvolvement.
Study/start: Affects project NPV. Critical for
stock type projects where precise estimation ofreserves is critical to success.
R l O ti i P j t Fi
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Real Options in Project Finance
Scale down: Mostly applicable in the pre-completion stage. Scale down is rarely an optionpost-completion since projects are valuablealmost exclusively as going concerns. Affects
project NPV. Switch down: Rarely an option for a project.
Scope down: Similar to the scale down option.
Flexibility option: The option to switch input oroutput mix is key to projects and can helpreduce cash flow volatility. Affects project NPV.
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Real Options: Industry Examples
Automobile: Recently GM delayed its investment in anew Cavalier and switched its resources into producingmore SUVs.
Aircraft Manufacturers: Parallel development of cargoplane designs created the option to choose the more
profitable design at a later date. Oil & Gas: Oil leases, exploration, and development are
options on future production; Refineries have the optionto change their mix of outputs among heating oil, diesel,unleaded gasoline and petrochemicals depending on
their individual sale prices. Telecom: Lay down extra fiber as option on futurebandwidth needs
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Real Options: Industry Examples
Real Estate: Multipurpose buildings (hotels, apartments,etc.) that can be easily reconfigured create the option tobenefit from changes in real estate trends.
Utilities: Developing generating plants fired by oil & coalcreates the option to reduce input costs by switching tolower cost inputs.
Airlines: Aircraft manufacturers may grant the airlinescontractual options to deliver aircraft. These contractsspecify short lead times for delivery (once the option is
exercised) and fixed purchase prices.
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Real Options: Valuation Approaches
Black Scholes formula: The PV of cash flows is asset price and the variation in returns is
volatility. It is difficult to find real world situations which fulfill assumptions
underlying the BSM.
Binomial Option Pricing model: The most illustrative method. Have to incorporate varying risks of cash flows at each decision
node. It is better to risk adjust the cash flows and use a risk freerate.
Monte Carlo Simulation: The most robust and accurate method. Easy to integrate multiple and interacting real options. Can be used to accurately value an option when multiple options
are present by comparing the analysis results with and withoutthe option.
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The MM PropositionM&M premise ofStructure irrelevance
No transaction Costs
No taxes
No cost of FinancialDistress
No agency conflict
No asymmetricInformation
Real World situations
Very high transaction costs that canaffect the investment decision.
Taxes are mostly positive and highand results in valuable tax shields.
Capital and governance structuredecreases risk thereby decreasingcost of distress.
Behavior of various parties can be
controlled through structure. Type and sequence of financing
can improve information.
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The MM proposition
Since real world situations do not alwaysfulfill the assumptions of the MM
Proposition, structure does affect firmvalue in reality.
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Acknowledgements
The content of this presentation has been derived primarily from the:
Project Financecourse taught by Benjamin Esty at the HarvardBusiness School.
Emerging markets Corporate Financecourse taught by CampbellHarvey at the Fuqua School of Business.
Ad vanced Corporate Financecourse taught by Gordon Phillips at theFuqua School of Business.
We thank the above for their contribution to this effort. We also acknowledgethe usage of content from Project Finance Internat ionaland Journ al ofAppl ied Corporate Finance. We thank them for access to their databases.