Project Financing - Lecture notes 8-11 PDF

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PROJECT FINANCINGUnit DescriptionThis unit is designed to equip the trainee with knowledge, skills and attitudes that will enable him/her to appraise various forms of financing, prepare financial plans and select the most appropriate forms of financing.Course Outline Introduction to Project Financin...

Description

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PROJECT FINANCING Unit Description This unit is designed to equip the trainee with knowledge, skills and attitudes that will enable him/her to appraise various forms of financing, prepare financial plans and select the most appropriate forms of financing. Course Outline 1. 2. 3. 4. 5. 6. 7.

Introduction to Project Financing Tools of Project Financing Sources of Finance Finance Requirements of a Project Cost of Financing Financial Evaluation Techniques Capital Investment Decisions

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TOPIC ONE: INTRODUCTION TO PROJECT FINANCING A Project is normally a long-term infrastructure, industrial or public services scheme, development or undertaking having 

Large size.

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Intensive capital requirement – Capital Intensive

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Finite and long Life.

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Few diversification opportunities i.e. assets specific.

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Stand-alone entity.

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High operating margins.

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Significant free cash flows

A project consists of a concrete and organized effort motivated by a perceived opportunity when facing a problem, a need, a desire or a source of discomfort (e.g., lack of proper ventilation in a building). It seeks the realization of a unique and innovative deliverable, such as a product, a service, a process, or in some cases, a scientific research. Each project has a beginning and an end, and as such is considered a closed dynamic system. Project Financing is loan arrangement in which the repayment is derived primarily from the project's cash flow on completion, and where the project's assets, rights, and interests are held as collateral. Usually, a project financing structure involves a number of equity investors, known as 'sponsors', a 'syndicate' of banks or other lending institutions that provide loans to the operation. Project Financing is: “The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flows generated by the project.” Project finance is especially attractive to the private sector because they can fund major projects off balance sheet. Importance of Project Financing Financing infrastructure projects through the project finance route offers various benefits such as the opportunity for risk sharing, extending the debt capacity, the release of free cash flows, and maintaining a competitive advantage in a competitive market. Project finance is a useful tool for companies that wish to avoid the issuance of a corporate repayment guarantee, thus preferring to finance the project in an off-balance sheet manner. The project finance route permits the sponsor to extend their debt capacity by enabling the sponsor to finance the project on someone's credit, which could be the purchaser of the project’s outputs. Sponsors can raise funding for the project based simply on the contractual commitments. Project finance also permits the sponsors to share the project risks with other stakeholders. The basic structure of project finance demands that the sponsors spread the risks through a network of security arrangements, contractual agreements, and other supplemental credit support to other 2

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financially capable parties willing to assume the risks. This helps in reducing the risk exposure of the project company. The project finance route empowers the providers of funds to decide how to manage the free cash flow that is left over after paying the operational and maintenance expenses and other statutory payments. In traditional corporate forms of organization, corporate management decides on how to use the free cash flow — whether to invest in new projects or to pay dividends to the shareholders. Similarly, as the capital is returned to the funding agencies, particularly investors, they can decide for themselves how to reinvest it. As the project company has a finite life and its business is confined to the project only, there are no conflicts of interest between investors and the management of the company, as often happens in the case of traditional corporate forms of organization. Financing projects through the project finance route may enable the sponsors to maintain the confidentiality of valuable information about the project and maintain a competitive advantage. This is a benefit of raising equity finance for the project (however, this advantage is quite limited when seeking capital market financing (project bonds). Where equity funds are to be raised (or sold at a later time so as to recycle capital) through market routes (for example, Initial Public Offerings [IPOs]), the project-related information needs to be shared with the capital market, which may include competitors of the project company/sponsors. In the project finance route, the sponsors can share the information with a small group of investors and negotiate the price without revealing proprietary information to the general public. And, since the investors will have a financial stake in the project, it is also in their interest to maintain confidentiality. Other Advantages of Project Financing. 1. Eliminate or reduce the lender’s recourse to the sponsors. 2. Permit an off-balance sheet treatment of the debt financing. 3. Maximize the leverage of a project. 4. Avoid any restrictions or covenants binding the sponsors under their respective financial obligations. 5. Avoid any negative impact of a project on the credit standing of the sponsors. 6. Obtain better financial conditions when the credit risk of the project is better than the credit standing of the sponsors. 7. Allow the lenders to appraise the project on a segregated and stand-alone basis. Obtain a better tax treatment for the benefit of the project, the sponsors or both. The scope of project financing encompasses three core elements: 

calculating the risk involved in financing the project;

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defining the boundaries or scope of the project;

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And carefully forecasting the predicted cash flow resulting from the project or project outcomes.

To do this successfully requires a detailed understanding of the drivers of input costs.

The Agency Theory In an agency relationship, one party, called the agent, makes decisions and acts on behalf of another, called the principal. The agency theory attempts to summarize and solve problems arising from the relationship between a principal and an agent. Agency relationships are common in financial management, due to the nature of the industry. When one person manages another person's financial affairs, an agency relationship exists by default. Understanding the agency theory's application in financial management can give you greater insight as an investor, stockholder or aspiring financial professional.

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TOPIC TWO: TOOLS OF PROJECT FINANCING Ratio Analysis A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.

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Objectives of Ratio Analysis Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils. 1] Measure of Profitability Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of profitability of a firm. The management can use such ratios to find out problem areas and improve upon them. 2] Evaluation of Operational Efficiency Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets. 3] Ensure Suitable Liquidity Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency. 4] Overall Financial Strength There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc. 5] Comparison The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis. Advantages of Ratio Analysis When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers, they draw the management’s attention towards issues needing attention. Let us take a look at some advantages of ratio analysis. Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. They summarize the financial statement into comparative figures, thus helping the 5

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management to compare and evaluate the financial position of the firm and the results of their decisions. It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc. Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems. Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy. Limitations of Ratio Analysis While ratios are very important tools of financial analysis, they’d have some limitations, such as The firm can make some year-end changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing. Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation. Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative) There are no standard definitions of the ratios. So firms may be using different formulas for the ratios. One such example is Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while calculating current ratio And finally, accounting ratios do not resolve any financial problems of the company. They are a means to the end, not the actual solution. 1. Profitability Ratios Profitability ratios are the financial ratios which talk about the profitability of a business with respect to its sales or investments. Since the ratios measure the efficiency of operations of a business with the help of profits, they are called profitability ratios. They are quite useful tools to understand the efficiencies/inefficiencies of a business and thereby assist management and owners to take corrective actions. Purpose and Importance A business (unless a non-government organization) starts with a motto of making a profit and thus one of the most commonly used financial ratios is the profitability ratios. Management and investors calculate these ratios often and they are always present in the annual reports of the company. Since every business wants to generate profit and the investors also want returns on their investments, it is mandatory to showcase how the company is working and generating profit. Thus, profitability ratios analysis is an important evaluation criterion for companies. Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. For all the profit-oriented businesses, the final goal is none other than the profits. Profits are the lifeblood of any business without which a business cannot remain a going concern. Since the profitability ratios deal with the profits, they are as important as the profits.

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The purpose of calculating the profitability ratios is to measure the operating efficiency of a business and returns which the business generates. The different stakeholders of a business are interested in the profitability ratios for different purposes. The stakeholders of a business include owners, management, creditors, lenders etc. Types of Profitability Ratios Profitability ratios are a bunch of financial metrics which measures the profit generated by the company and its performance over a period of time. The profit of the company which is assessed by these ratios can be simply defined or explained as the amount of revenue left after deducting all the expenses and losses which incurred in the similar time period to generate that revenue. Ultimately, these ratios are nothing but a simple comparison of various levels of profits with either SALES or INVESTMENT. So, these ratios can be further classified as Margin Ratios (Sales based Ratios) and Return Ratios (Investment based Ratios). There are different ratios under this profitability ratio category which are as below.

Margin Ratios There are broadly 3 margin ratios, gross profit margin, net profit margin and operating profit margin. Gross Profit Margin This is the ratio which is used to understand how much cost incurred to manufacture a product. It also helps in understanding the efficiency of the company and how is it using its resources to produce the product and then make a profit by passing the cost incurred to the consumers of the product. Read Gross Profit Margin for an enhanced coverage of this ratio. Net Profit Margin It is the most common profitability ratio which is used to measure the profit after deducting all the expenses, losses, provisions for bad debt. It measures how much you are making out of every penny you spent on the business. For example, if you have a net profit margin of 10% then on every 1 rupee that you have invested in the business you earn 10 paise. For an in-depth understanding of this ratio, visit Net Profit Margin. Operating Profit Margin This is the metric which is used to evaluate the operating efficiency of the company. EBIT i.e. earnings before interest and taxes are calculated to understand how much profit the company has 7

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generated from its core operation. Operating profit margin evaluates this EBIT as a percentage of sales to understand the efficiency of the operations of the company. For full coverage, read Operating Margin Ratio. Expense Ratios Expense ratios are a comparison of any particular type of expense with respect to sales. These expense ratios could be as many in numbers as the no. of important expense categories. Say, for example, sales and distribution, administration etc. Return Ratios There are mainly 3 return ratios, return on assets, return on equity and return on capital employed. Return on Assets (ROA) It is the profitability ratio which is used to evaluate the company’s level of efficiency in employing its assets to generate profit. The assets of the company if not used optimally will not be able to make the desired amount of profit and the return will also be lower. Detailed post here at Return on Assets. Return on Equity (ROE) Every equity investor looks for this ratio before investing in any company as it gives the insight into the company’s profit-generating ability to the investors. The potential, as well as existing investors, keep a check on this ratio as it measures the return on the investment made in shares of the company. In general, the higher the ratio, more favorable it is for the investors to invest in the company. Read exclusively about Return on Equity here. Return on Capital Employed (ROCE) This is a third ratio which covers the equity as well as debt part too. In place of equity capital, total capital employed is used as the denominator to calculate this ratio. Read a detailed write up about Return on Capital Employed here. Formula Gross Profit Margin = (Gross profit / Net Sales )*100 Net Profit Margin = (Net Profit / Net Sales)*100 Operating Profit Margin = (Operating Profit / Net Sales)*100 Expense Ratio = Expenses (Ex. Sales and Distribution) / Net Sales Return on Asset = ( Net Income / Assets)*100 Return on Equity = (Net Income / Shareholder’s Equity Investment)*100 Return on Capital Employed = Net Income / Capital Employed Example with Calculation Let us assume Ayur & Co. makes a net profit of Rs 1,00,000 and the gross profit is Rs 1,50,000. Net sales in the year amount to Rs 5,00,000, interest Rs 10,000 and taxes Rs 20,000. The company has 10,00,000 invested in the assets and equity investments or paid up capital is Rs 12,00,000. Therefore; Gross Profit Margin = (Gross profit / Net Sales )*100 = (Rs 1,50,000/ Rs 5,00,000)*100 = 30% Net Profit Margin = (Net Profit / Net Sales)*100 = (Rs 1,00,000/ Rs 5,00,000)*100 =20% 8

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Operating Profit Margin = (Operating Profit / Net Sales)*100 = (EBIT/Net Sales)*100 = ((Rs 1,00,000+Rs 10,000+ Rs 20,000) / Rs 5,00,000)*100 = 26% Return on Asset = ( Net Income / Assets)*100 = (Rs 1,00,000/ Rs. 10,00,000)*100 =10% Return on Equity = (Net Income / Shareholder’s Equity Investment)*100 = (Rs 1,00,000 / Rs 12,00,000)*100 =8.33%. Uses of Profitability Ratios The profitability ratios are used to get an insight of a business. It helps an analyst to get an indication of the sufficiency or adequacy of profits. It finds out the rate of return and makes the business comparable to the industry as well as its own past. These ratios are used by banks and financial institutions while lending to the business as the ratios ensure them about the regular payments of interest and installments. Not only the bankers but owners also look at these ratios to know about the fruits, their investment is going to reap. Management follows and analyses these ratios to spot out the lacuna in their operations and thereby bring about the necessary improvements. Uses of profitability ratios are different to the management and the investors but the motto behind calculating them is to evaluate the profit and performance of the company. Different profitability ratios measure profitability based on different aspects of a business and help the management to work more efficiently to generate more profits. 2. Liquidity Ratios Every organization has some level of cash requirement for keeping its operations functional. Companies that are able to meet its cash requirement from a source with minimum cost, would maximize value for shareholders. Hence, the level of cash and liquidity of assets are very crucial to the survival of any organization. Liquidity is how easily an asset can be converted into cash. Liquidity ratios give an idea about company’s ability to convert its assets into cash and pay its current liabilities with that cash whenever required. In simple language, they ind...