PROJECT FINANCING AND APPRAISAL

September 21, 2006

Project Financing and Appraisal• Project Financing and Project Appraisal are two sides

of the same coin. – Project Financing deals with how one would finance

projects. – Project Appraisal focuses on how does one evaluate projects

to know which projects are worth financing. – The promoter’s view vis a vis the lender’s view: project

finance means financing an investment based on the operating cash flows and assets, generally without sponsor guarantees.

– Corporate finance vs. project finance (recourse and non-recourse)

Project Finance: Macro and the Micro Approach

• One way of posing the project finance question is to ask for instance:– Why did Sub- Saharan Africa attract only 5% of the world’s

investments. – Why did Africa rank last among developing regions in investment

flows to projects, with US$39.4 billion in 1990–2004, far behind Latin America (US$391 billion) and East Asia (US$199 billion).

– Why did South Africa and Nigeria together account for about two third of these flows in 1990–2004.

– Why did South Africa alone manage to receive 50% (US$19 billion) of these flows.

– How does China spend above 10% of GDP on infrastructure and India only around 4%.

The Macro and the Micro Approach

• The other view consists in asking which of the projects is to be the most preferred, which less preferred, in other words ranking projects by comparing their respective cost benefit streams.

• This is the micro view, while the other view is the macro view.

• The micro view corresponds to project appraisal. • The macro view corresponds to project financing.

The Project Finance Question• It would be insufficient to answer the preceding

questions by saying that the projects in Rest of the World are better than the projects in Africa or that projects in South Africa are better than the projects in rest of Africa.

• In this context, project appraisal degenerates into a non-issue. In fact, what one is saying is that no matter how superior the projects in terms of the output or impacts in Africa, the chance of their attracting finance is roughly 1/10th of the project in Latin America.

Project Finance: the Macro View

• The foregoing questions probe the wider realm of economic environment and policy.

• The issues they raise are as to how should one manage the economy so that one attracts higher levels of inflows into the projects in that economy. – But projects are nothing but packets of investments into

identified activities with specific technological outcomes.

• Hence, the issue boils down to how to raise investments in the economy.

Project Financing: Four Phases• Pre-World War II

– The case of Indian Railways but Taj Mahal or pyramids would be a similar story.

• 1950 to 1980– Public Sector as the preferred vehicle– Multilateral Development Banks

• 1980 to 2000– Bringing Private Sector back in

• 2000 onwards– Public Private Partnerships

• Our focus on post world war II years or the post colonial era

Savings and Investments

Much of the post war public sector led investment growth owes itself to the propositions embedded in the Keynesian macroeconomics. The world before Keynes, believed in Say’s Law which says that supply creates its own demand.

• In this system, there is no place for general overproduction or unemployment. However, unemployment in specific sectors is possible. Further, wage rate rigidities may pose problems in adjustment.

• The Great Depression (1929-33) when stock markets crashed, the income levels fell by half and unemployment rose to unprecedented levels could not be explained by Say’s Law.

The Macroeconomics of Depression

• Keynes put forth the argument that if realized investment in a period is more than the planned, then investment is cut back.

• This leads to lower aggregate demand for the output, leading to unemployment on the one hand and excess capacity on the other. Downward wage flexibility does not help, because then the aggregate demand becomes even lower.

• Increasing money supply does not help, because the additional money is simply held as liquidity to avoid capital losses in the event of rise in interest rates.

Dealing with Depression: Fiscal Policy

• Fiscal Policy is about Government spending and taxes– Taxes reduce output– Government spending boosts output

• Entail Keynesian Policy prescription- ‘dig holes and fill them up’ because that boosts aggregate demand.

• It is immaterial how the Government finances its expenditure.

Fiscal Policy for Developing Economies

• In the post world war scenario, with the colonies acquiring independence, development became the key agenda of national governments.

• In a developing country, savings are low due to low incomes. Low savings mean low investments and hence, lower income in the future. This is the vicious circle.

• One way out of the vicious circle is that Government may itself increase investments either through higher taxes or through higher debt.

• This led to the public sector acquiring the commanding heights and adoption of import substituting model of growth. (Why import substituting?)

Why Fiscal Policy may not work in general

• In cases where there is no excess capacity, the increase in Government expenditure would induce inflationary pressure.

• With inflation, the domestic currency may be expected to lose value.

• In inflationary situations, the nominal rate of interest may also rise, which would scare investments.

• In general, increase in fiscal deficits would be self defeating either through explosion in interest payment or through crowding out.

The Swing from Public to Private

• Eventually, the public sector led model began to wear due to resurgence of belief in markets and open economies in the wake of the following events-– Oil Shock – Stagflation– Inefficiencies in the public sector – Growth record of open economies turned out to

be superior to those with closed economies.

Public Private Partnership

• The romance with privatization lasted even less owing perhaps to the following-– The private sector did not move in as big a way as

expected following privatization initiatives. – A series of corporate scandals shook public confidence

in corporate governance. – Nature of risks underlying projects turned out to be more

difficult to deal with e.g. tariff fixation, regulation, etc. • The model now is the Public Private Partnership

Model

Increasing investments in open economy framework

• To finance investments, either one mobilizes domestic savings or attracts savings from abroad.

• Mobilizing domestic savings means mobilizing savings of households, internal accruals of companies and savings by the Government.

• It is only the special case of unemployment and idle resources, and not the general case, where it is possible for Government to boost income by raising expenditure.

Attracting Investments: The new macro policy framework

• Private sector investments are based on expectations of future flows.

• Future flows in developing economies should be more robust than in developed countries. (owing to the marginal return principle)

• The three-fold formula for attracting investments is: – Open economy – Fiscal Prudence– Good institutions to keep transaction costs low

Institutional Framework for Project Finance

• Two broad categories of finance- debt and equity• Both debt and equity can be from domestic or

foreign sources. • Domestic sources often inadequate and less

developed and virtually non-existent for long tenors in developing economies.

• This entails increased emphasis on involvement of international banks, supplier’s credit, multilateral agencies, ECAs and equity funds.

Conceptual Underpinnings of Project Finance

• Project Finance is closely associated with provision of public goods e.g. roads, health.

• Public Goods are defined as those goods where there is non-rivalry and non-excludability.

• Non-rivalry means that consumption of the good by one person does not affect the consumption by others. e.g. parks, roads etc.

• Non-excludability refers to the inability to deprive anyone from consumption of the goods. those which when left to market forces are not produced in sufficient quantity.

Why Markets Fail

• Market Power• Incomplete Information• Externalities• Public Goods

Market

In case of there being some monopoly industries, the monopoly industries will produce an output which is smaller than that of a like competitive industry, therefore, given total employment less resources would go in monopoly and more in competitive industry that what would be the case if all industries were competitive. However, if all industries are monopolies then this result does not hold, which is what theory of second best is all about. Some competition may conceivably be worse than none and monopolies in all industries may conceivably be better than monopoly in some industries.

Incomplete Information: Asymmetric Information: The case of ‘Lemons’

The issue: Why does a six month car old car sells for so much less than a new one?Lemon is a used car constantly subject to mechanical troubles.Some small proportion of used cars are lemons. The seller of used cars knows which car, but the buyer does not. This is asymmetry in information.First inference: Good quality cars are driven out of the market. Second inference: Discounting of the used car price for the reason that some of them are lemons.

Externalities

Externalities arise where there is a difference between private and social costs or private and social benefits. e.g.. A steel plant dumping its waste in the river which affects the catch of the fisherman.

Public Goods

• The consumption of Public Goods is characterized by-– Non-rivalry (no additional cost for use by an

additional consumer e.g. highway)– Non-exclusion (not possible to exclude anyone from

consumption e.g. Law and order)The consequence is free rider problem, whereby one understates the value of the good so that one can enjoy the benefit without having to pay for it.

PPP Framework for Project Financing

• Identification of Value for Money proposition by a public agency- The public good character

• Institutional Structure for PPP- Special Law for PPP – South Africa vs. India

• Competitive bidding and transparency • Financing Options

Models of Long Term Finance• Two broad models

– Market Based- Anglo American– Bank Based- Japan

• Convergence is being noticed as Financial Service Providers embrace the Universal Banking Model.

• Developing Countries did not have deep capital markets. The policy, therefore, was to have a directed regime of ‘priority’ sector based financing by banks and long term project financing by development financial institutions (DFIs).

External Sources of FinanceAS % of Total Sources of Funds

1985-86 to 1990-91

1991-92 to 2000-01

1992-93 to 1996-97

1997-98 to 2000-01

Equity 7 16.1 20.5 12.8

Borrowing 36.2 32 33.2 28.3

Debentrs 10.3 6.2 5.2 6.1

Banks 12.7 10 10.7 9.4

FIs 8.4 9.5 8.3 9.8

Others 22.5 15.9 14.8 15.3

Maturity Profile of Loans (2003-04)Percent

In years Public Sector

Old Pvt. Banks

New Pvt. Banks

Foreign Banks

Up to 1 40 41 35 57

1-3 33 36 31 16

3-5 12 10 13 8

Over 5 15 13 21 19