Summary of Project Finance and Risk Management till 26/03/2014Submitted By: Abhi Krishna Shrestha, Akhilesh Sthapit, Shishir BajracharyaFoundation of Project Finance

In project finance measures are based on Cash flow. All investments are based on future cash flow. Improving financial value: Improve IRR and minimize WACC Cash-flow should be measured after tax How the project is taxed affects the IRR of the project. Cash-flow should be adjusted for changes in working capital

Working Capital = Current Assets Current LiabilitiesAccount receivablesInventoryAccount receivables

Concept of circular debt 3 sources of cash flow (investment, operations, financing) Interest is tax deductible, expense Dividend is distribution of profit Cash-flow is distributed in 3 parts, tax, debt service and dividend

NATCF = EBIT(1-T) + Depreciation Working Capital Factors affecting NPV and IRR, scenario analysis Borrowing capacity is the amount of debt a project can fully service during a loan repayment period for a given set of project and loan parameters. Hence, looking just the IRR and NPV cannot determine the amount of money that need to be paid to meet the debt service requirement. Hence Debt Service Coverage Ratio (DSCR) should be high in order to meet the payment of debt to meet the debt service requirement within the given loan period.

Key Financial DecisionsInvestment (Where to put the money)-Net Present Value > 0-Internal Rate of return > WACCDependent on Cash-flowDividends (How to distribute surplus)-Managing Cash-Enough for reinvestment-Minimize risk by dividend payout-Avoid cash pile upFinancing (Where to get the money)-Weighted Average Cost of Capital

Investment Decision:IRR and NPV can be calculated on the basis of different stakeholders. So there will not be single IRR or NPV. This is because there are multiple stakeholders all the stakeholders try to pull in their favor Hence, these IRR and NPV is used for the source of negotiation. The perspective is very important

Financing Decision:Calculating WACCRF: Driven by economyRM: Driven by investors perception of the market: Driven by the project, project sensitivity to economyKe= RF+(RM-RF): Cost of equityKd= Cost of debt from lender (1 tax rate)Ratio= Equity : Debt = E:DWACC: E*Ke+D*Kd

Debt is cheaper source of financing (Riskier) Equity is expensive source of financing (Safer)

Dividend Decision: The main criteria to have a dividend policies is to avoid the cash pile up. Mange the risk There are many risk for the investors the risk of converting the money. Liquidity risk, currency risk etc. Also we have to bring in the element of risk. Risk is investor specific as well as project specific.

Borrowing Capacity:Borrowing capacity is the amount of debt a project can fully service during a loan repayment period for a given set of project and loan parameters. Hence, looking just the IRR and NPV cannot determine the amount of money that need to be paid to meet the debt service requirement. Hence Debt Service Coverage Ratio (DSCR) should be high in order to meet the payment of debt to meet the debt service requirement within the given loan period.Parameters that affect the Project are Revenues, Expenses, Growth Rate, Tax Rate. All of these are captured in a Project Companys Credit Rating. These rating determine the borrow rate. The project has to decide when to drawn down there is some charge of commitment fee which can be huge. That fee has to be paid even if we dont draw cash. There are two ways that the project finance can be drawn down i) Under full drawdown,Maximum loan amount (D) = present value of project cash flow/target cash flow coverage ratio(n)

ii) Under periodic drawdown,D = PV/(n*(1+i)^m),Maximum Loan Amount(D)=Present Value of Project Cash Flows/(target cash flow coverage ratio*(1+i)^time between initial drawdown and cash flows into the project)

Key characteristics of Project Finance:

Independent project company with specific purpose oriented Raising of funds on a limited recourse or a non-recourse basis Providers of funds look primarily to the cash flow from the project as the source of fund to service their loans and the return on equity invested in the project Off balance sheet financing since the assets and liabilities will be off the balance sheet of sponsors Contractual arrangements redistribute project related risk High information, contracting and transaction costs By contract, free cash flow must be distributed to equity investors Debt contracts are tailored to the specific characteristics of the project. Highly leveraging potential.

Criteria for financial modeling Debt service coverage ratio must reflect the margin of safety (eg. Above 2) Payment to limited partners must be reasonable (IRR>WACC, NPV>0), considering shareholder optimization, after tax income Payment to general partners must include incentives to operate, considers before and after tax income. Consistent in currency invested and currency in return. Repayment of debt should be done before the project ends with some time margin. Use of short term and guaranteed financing during construction period. Use of long term, non-recourse financing after construction.

2 Key InputsCapital BudgetingNATCF (Net After Tax Cash Flow)-Working Capital subtracted from EBIT(1-t)- Depreciation added to EBIT(1-t)WACC

Keep in mind, NPV is probabilistic, so try different scenarios and analyze on the worst and best case scenario. Project finance cash flows are agreement based and negotiable Debt to equity ratio is decided by sponsors, but is approved only if DSCR is reasonable for lenders.

Stage 1-Pre-construction-Research Phase-Permit-License-Official matters-Feasibility StudyProject FinanceStage 2-Construction-Short-term loan-Recourse-May get stuckStage 3-Post Construction-Long-term loan-In Operation Stages in Project Financing

ShareholdersLimited Partners-Passive Investors-Only Invest-Limited Liability-No management authorityGeneral Partners-Active investors-Invest and operate-Unlimited liability-Management authority

Extracts from Cases

Chad-Cameroon CaseComment by com01: Bullet points do not convey the key learning. For e.g. when you say Corporate Structure of project, I am not clear what you mean. Same comment applies to all cases. Assessing the structure of the project Assessing vested interests of different stake holders Difference in asset types Corporate structure of the project Leverage used in the project Recourse and limited recourse in Corporate finance and Project finance respectively. Different share holders and their vested interest Exposure of risk to different stakeholders Cashflow distribution discretion to different parties (Reasons behind it)

Airbus Case Introduction of new project and its valuation Understanding the market Necessity of margin of safety while estimating cash inflow Concept of perpetuity revised Predicting future demand estimating from competitors product Involvement of superior power (governments) in a project

Tate & Lyle Case Need of ERR in decision making for government and development supporting organizations Difficulties in changing trade culture in a market Role of infrastructure in trade Comparative analysis with alternatives Cost and benefit analysis due to a change in market Value addition or loss to all stakeholders involved.