PROJECT FINANCING

7/7/2011

BY: A.ARULDOSS VITHAKAN

PROJECT INTRODUCTION
    

Project: Definition Series of actions to achieve a result Single occurrence a unique, non- rptitive activity Time limitations with a pre-defined start date and end date of delivery or commencement. Clear purpose specified from one or more goals (well defined, measurable and realistic), do not mix project goals and effect goals




A low volume and high variety activity

A unique set of coordinated activities

A temporary Endeavour to create an unique product

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PROJECT INTRODUCTION
Unpredictable structure it consists of a number of complex activities with mutual interdependencies Own organisation e.g. Not in the original line of work  Procurer internal or external acquirer that has expectations on the result  A project is an investment made on a package of interrelated time bound activities.  A project has 2 phases- 1: Preparation and construction and 2-operation

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PROJECT S & DEVLOPMENTDEVLOPMENTCONCEPTS

 

What is a project plan? The aim of a project plan is to go through, document and agree upon important issues that define the work in the project


1.

Project management control include:Programmed objectives

2.
3.

Policy restrictions.
Resource constraints.

4.
5.

Government regulations.
Process implementation.

6.
7.

Review of output.
Feed back system.

8.

Revision of objectives.
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Project Management: concepts

 

SYSTEM THEORY PROJECT TRIANGLE

TIME

COST

QUALITY

 

WORK-BREAK DOWN STRUCTURE(WBS) GANTT -SCHEME

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Project Classification Elements

There are a number of factors, which combine to define the project classification:  Project Focus Business Processes or Information Technology Project Risks Low, Medium or High  All projects have risks associated with them. Understanding the degree of risk and the nature of these risks is important to the selection of the methodology elements.  The methodology identifies project risks at three levels Low, Medium and High.

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Project Classification Elements

       

Total Investment Size Project size is measured in the overall investment, in the following bands: Under Rs.5 crore Enhancement Rs.5 to 20 crores Small project Rs. 20 to 50 crores Medium project Rs.50 to 100 crores Large project Rs.100 crores or more Very large project The larger the investment involved in the project the more stringent the governance
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Project Classification Elements

     

Communication Complexity There are three aspects to complexity: 1. The number of people who are actively involved in the project 2. Geographical/temporal distribution of the project activities 3. Cultural distribution of the project team Low Complexity - The team is small, located within the same geographic area andlargely homogeneous. Projects of this nature are well suited to low-ceremony largely verbal communications, with an expectation that the team will talk to each other frequently.
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Project Classification Elements



Medium Complexity - Any two of the three factors are present that will prevent the team from communicating effectively at all times. Perhaps there are groups within the project team that are co-located but other team members are off-site, or the total team is too large to get together at one time. Project of medium communications complexity will require more formal, written communication than a low complexity project, but there will still be some reliance on verbal informal communication.

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Project Classification Elements

High Complexity - Large teams, outsource/offshore development activities and distributed multi-cultural teams will require much more formal communication channels and will necessitate reliance on formal, written artifacts, with rigorous review and sign-off procedures.  These projects will by definition take longer and run higher risk of misunderstood requirements.  Team members are encouraged to talk to each other frequently and build relationships to reduce the risk involved in having to rely on explicit communications channels.

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WHITE ELEPHANTS
ONE OF THE ILLS OF PROJETS IS COST OVERRUNS  Ministry of project Implementation , Government of India carry alarming information on this issue- approximately 60% t0 70% of all-both mega and medium ongoing projects have huge cost overruns  Such massive cost overruns cause not only erode financial outlays on development projects but also has serious impact on industrial and infrastructural development.  In India almost every project in infrastructural sector has been delayed for one reason or another

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External causes of delay

                

Indian Government policies Import regulations. Resource constraints. Taxation Defense expenditure. Inflation Non-development expenditure Budgetary deficits. Economic stagnation Natural calamities. Labour unrest Law and order problems Political situation. Social turmoil Unscheduled mid-term elections. Global recession Interferences from unexpected quarters.

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Internal causes of delay

             

Inappropriate choice of site. Disputes with local agencies. Inadequacy of foreign collaboration agreements. Monopoly of technology Technical incompetence Lack of skilled workers. Inadequate project planning preparation Cange of scope due to government regulation or for any other reasons. Alteration due to, demand fluctuation. Resource constraints. Vendor delivery problems. Inferior quality of inputs Foreign exchange curbs Lack of infrastructure like power, water, communication roads etc.
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Internal causes of delay

          

Labour unrest Low motivation of project team. Inadequacy of basic conceptual and technical inputs Zero date being specified Lack of coordination / cohesion among team members. Frequent transfer of project manager and other key personnel Late clearance of project schedules bt various agencies. Price escalation Delay in obtaining import licenses. Inadequate and improper liaison with Customs, Excise, Sales Tax, Income tax and other agencies.poor monitoring and control. Infrequent monitoring and review.
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Other cause for delay.

         

Delay in receiving information on changes, clarifications, finalisation of tenders, rework and inspection results. Unavoidable statutory controls. Over ambitious scheduling targets. Frequent changes in design, technological upgardation that hold up project execution. Inadequate consideration in choice of technology. Weak monitoring and control. Force majeure conditions- not having plans to overcome such threats. Resistance to innovative techniques and management practices. Allowing project duration to expand Inability to differentiate between critical and non-critical activities.
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Cost Overruns- How to avoid ? Overruns      

Detailed planning and implementation schedule. Effective MIS and monitoring. Resource planning Rewards and incentive schemes for the project staff. Effective and suitable technology choice. Listing engineering parameters and design Mobilizing community participation.
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Effective and quick decision making Effective and quicker communication Adequate training Minimize managerial lapses. Clarity on scope and objectives of the project Regular follow up/ review for effective management of project to achieve desired progress.
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Development Methodology
For projects which have an information technology component there is another set of choices to be made which lifecycle model is being used. The three models are:  1. Waterfall sequential development based on clearly understood and fixed requirements where change is not expected. Only suited to very short lifecycle projects (Six months or less)  2. Iterative & Incremental an approach based on learning and adapting as the project proceeds in discretely defined steps and phases, with effective change management and requirements

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prioritization guidelines. Change is expected but is carefully managed to ensure project goals and objectives are met.  3. Agile an approach based on emergent requirements, suited to collocated teams addressing  specific business problems with short time windows and uncertain requirements in volatile areas of the business


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Project planning
Probably the most time-consuming project management activity.  Continuous activity from initial concept through to system delivery. Plans must be regularly revised as new information becomes available.  Various different types of plan may be developed to support the main software project plan that is concerned with schedule and budget.


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Types of project plan

Plan Quality Plan Validation plan Configuration management plan Maintenance Plan Staff Development Plan Description Describes the quality plans and standards to be used in the project Describes the approach , resources and schedule used for the project Describes the configuration management procedure and system to be used. Predicts the system maintenance requirements and costs and effort required. Describes as to how the skills and experience of the project team will be developed.

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Project planning process

             

Establish the project constraints Make initial assessments of the project parameters Define project milestones and deliverables while project has not been completed or cancelled loop Draw up project schedule Initiate activities according to schedule Wait ( for a while ) Review project progress Revise estimates of project parameters Update the project schedule Re-negotiate project constraints and deliverables if ( problems arise ) then Initiate technical review and possible revision end if end loop
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The project plan

 The

project plan sets out:

The resources available to the project; The work breakdown; A schedule for the work.

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Project plan structure

      

Introduction. Project organisation. Risk analysis. Hardware and software resource requirements. Work breakdown. Project schedule. Monitoring and reporting mechanisms

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Activity organization
Activities in a project should be organised to produce tangible outputs for management to judge progress.  Milestones are the end-point of a process activity.  Deliverables are project results delivered to customers.  The waterfall process allows for the straightforward definition of progress milestones.


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Project scheduling
Split project into tasks and estimate time and resources required to complete each task.  Organize tasks concurrently to make optimal use of workforce.  Minimize task dependencies to avoid delays caused by one task waiting for another to complete.  Dependent on project managers intuition and experience.


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The project scheduling process

IDENTIFY ACTIVITIES

IDENTIFY ACTIVITY DEPARTME NT

ESTIMATE RESOURCE S REQUIRE

ALLOCATE PEOPLE

CREATE PROJECT CHARTS

SOFTWAREE REQUIREMENTS

ACTIVITY CHARTS BAR CHARTS

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Scheduling problems
Estimating the difficulty of problems and hence the cost of developing a solution is hard.  Productivity is not proportional to the number of people working on a task.  Adding people to a late project makes it later because of communication overheads.  The unexpected always happens. Always allow contingency in planning.


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Bar charts and activity network

Graphical notations used to illustrate the project schedule.  Show project breakdown into tasks. Tasks should not be too small. They should take about a week or two.  Activity charts show task dependencies and the the critical path.  Bar charts show schedule against calendar time.


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STRATEGIC PROJECT VARIABLES

STRATEGIC PROJECT VARIABLES

OPERATING VARIABLES

ECONOMIC VARIABLES

SOCIO-POLITICAL

VRIABLES

OTHERS

PURPOSE & OBJECTIVES TECHNOLOGICAL CHANGE VOLUME 7/7/2011 CAPACITY

MARKET INDICATORS INDUSTRY FORECAST

CONSIDERATION OF PUBLIC POLICY CHANGES IN PATTERNS OF SOCIETY

DESIGN LOCATION SCHEDULE CETRTAINTY

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STRATEGIC PROJECT VARIABLES

      

CONTRACTUAL/LEGAL ENGINEERING/TECHNOLOGY FINANCIAL & ECONOMICAL POST COMMENCING OPERATIONS SOCIAL & HUMAN ASPECTS MATERIAL PROBLEMS PROJECT FORMATION CHECK LIST.

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PROJECT FORMULATION CHECKLIST

       

DEMAND ESTIMATION -AGGREGATE-REGIONALSECTIONAL TO BE MET BY PROJECT. PRODUCT/SERVICE MIX PHYSICAL/SERICE UNITS SELLING PRICE/UNIT REVENUE SUMMARY OF PROJECT TARGET SUPPLY POTENTIAL AND ALTERNATIVES. SUPPLY ALTERNATIVES SIZES AND SCALES OF PRODUCTION
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PROJECT FORMULATION CHECKLIST

      

PROJECT LOCATIONS PROJECT TIMING CAPITAL INPUTS INPUTS FOR IMPLEMENTATION OPERATING INPUTS MANPOWER AND ORGANISATIONAL REQUIREMENTS. INFRASTRUCTURAL REQUIREMENTS

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PROJECT FORMULATION CHECKLIST

     

PERFORMANCE NORMS AND STRTEGY SELECTION PHYSICAL/TECHNICAL FINANCIAL ECONOMIC WEIGHETD CRITERIA FOR SELECTION OF OPTIONAL STRATEGY. RECONSIDERATION OF OPTIONAL STRATEGY.

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GENERATION AND SCREENING OF PROJECT IDEAS

  
1. 2.

To establish a successful venture the first step is to search for promising project ideas. Key to success is the right business at rift time. However this is easier to say but difficult to achieve. this can be achieved through:Identification of opportunities through imagination; Sensitivity to environment changes and realistic assessment of what the firm can do with convergent thinking process and objective evaluation of quantitative factors and subjective evaluation of qualitative factors

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Generation of ideas


  

Truly new ideas are generated though significant technological break through ( Atomic Powe, use of laaser ofr eye treatment)r) All other ideas are generated through combination of existing technologies or variants of existing products / services. ( digital communications, Tele check-ins,ECS, SWIFT transfer of funds in international transactions) Stimulating the flow of Ideas: SWOT analysis Cost articulation of objectives- cost reduction: Productivity improvement; Increase in capacity utilisation; improvement of contribution margins andexpansion into promising fields
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Generation of ideas
Conducive organsational climate to encourage the employees to be creative and proactive . Will enable the firm to harness their abilities to the best advantage of the firm.  Monitoring the environment: Business Environment


ECONOMIC GOVERNMENT SCETOR SECTOR *State of Policies Economy Programme *growth Projects *Trade Tax *Cyclical Subsidy Changes EXIM POLICY *BOP Financial Sector

TECHNOLOGY SECTOR Emergence Access Receptiveness

SOCIAL COMPETITION SECTOR SECTOR Population No of firms Age shifts market share Cost in population quality Income Dist. Price Literacy technology Employment Attitude

SSUPPLIE SECTOR Availability Reliability

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TOOLS FOR IDENTIFYING INESTMENT OPPORTUNITIES



PORTER MODEL: PROFIT POTENTIAL OF INDUSTRIES: The combined strength of the following 5 basic competitive factors will decide the profitability of a company or an industry:

1.

Threat of new entrants.-add capacity; inflate costs; push prices

down; and reduce profitability Threat from new entrants are low if entry barriers are high due to: substantial investments ; economies of scale are enjoyed by the industry; distribution control by existing firms; switching costs of customers-one time cost- are high and the government policy. 2.Rivalry among existing firms. 3.Pressure from substitute oroducts. 4.Bargaining power of buyers. 5.Bargaining power of sellers

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LIFE CYCLE APPROACH

PIONEERING/ INTRODUCTI ON

R & D/ NEW PRODUCT

RAPID GROWTH

DECLI NE

MATURITY/STA BILISATION

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THE EXPERIENCE CURVE

FOR LONG TERM SURVIVAL AND PROFITABILITY ONE OF THE ESSENTIAL FACTOR TO CONSIDER IS REDUCED COST  EXPERIENCE CURVE SHOWS HOW THE COST PER UNIT

BEHAVES

KEY FACTORS:  LEARNING EFFECTS  TECHNOLOGICAL IMPROVEMENTS  ECONOMIES OF SCALE



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90 80 70 60 50 40 30 20 10 0 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr East West North

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SCOUTING FORPROJECT IDEAS Analyze the performance of existing industries. Examine the inputs and outputs of various industries. Review imports and exports. Study plan outlays and government guidelines. Look at the suggestions of the financial institutions. Investigate local materials and resources. Analyze economic and social trends. Study new technological developments. Explore the possibilities of reviving sick units. Identify unfulfilled psychological needs Attend trade fairs Stimulate creativity for idea generation Hope that chance factor will favour you.
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PRELIMINARY SCREENING
     

CMPATABILITY WITH THE PROMOTERS. CONSISTENT WITH GOVERNMENT POLICIES. AVAILABILITY OF INPUTS AVAILABILTY OF MARKET RAESONABLENES OF COST. ACCEPTABILITY OF RISK LEVEL.

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PROJECT RATING INDEX- CONSTRUCTION. INDEXFACTOR FACTOR WEIGHT RATING FACTOR SCORE

VG- G 5 4 Input availability Technology Reasonableness of cost Adequacy of market Complimentary relationship y with other products Stability Dependences on firms strength Consistence with government policies RATING INDEX
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A 3

P 2

VP 1 1.00 0.40

0.25 0.10 0.05 0.15 0.05 Y 0.10 0.20 0.10 Y

Y Y Y Y

0.15 0.60 0.05

Y Y

0.40 0.80 0.50 3.90

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SOURCES OF POSITIVE NET PRESENT VALUE

Economies of scale.  Product differentiation  Cost advantage  Marketing reach  Technological edge  Government policy. A good entrepreneur need to ask:  Are my goals well defined/  Do I have the right strategy?  Can I execute the strategy?  Am I willing to make sacrifices and take the risk/

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A good entrepreneur need to ask:

Do I have effective leadership qualities or willing to delegate and control through an effective leader?  Can I be decisive and have confidence in the project?  Do I have a strong ego to sustain ups and down in the enterprise performance and of operating results ?is it possible to have strong marketing orientation for new venture?


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HOW TO ESTIMATE RISK TOLERANCE

QUESTION 1 POINT 2 POINTS 3 POINTS 4 POINTS

I plan on using the money I am investing

Within 6 months

Within next 3 years

Between 3-6 years

no sooner than 7 years from now < 25%

My investments make up the > 75% share of assets (including House) I expect my future income to decrease

50% -< 75% Remain the same or grow slowly -

25%25%<50%

Grow Grow faster than quickly the rate of inflation Yes but< I Yes would like to have
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I have emergency savings

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No

QUESTION I have invested in stocks and stock mutual fund My most important investment goal is to

1 point -

2 points Yes but uneasy about it

3 points

4 points

No but I look Yes & forward to it comfortable

Preserve my original investment

Receive some growth and provide income

Grow faster than inflation but still provides some income

Grow as fast as possible. Income is not important today

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Assessment of risk tolerance

Points scored Between 25 and 28 points Between 20 and Between 15 and 19 Risk exposure Aggressive investor Above average risk tolerance Moderate investor- willing to investoraccept some risk for a potentially higher return Conservative investor Very conservative investor.

Less than 15 Less than 10

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ASSIGNMENT 1 TO BE SUBMITTED ON29TH October 2009



1. 2. 3. 4.

Generate a project idea from current business environment, develop and screen the idea for implementation by preparing a summary Project Report containing : Objective and scope Cost estimates for all inputs including manpower, technology , materials, funds etc. Organisation structure Time schedule specify strategic variables in your project

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FINANCIAL EVALUATION OF PROJECTS

INVESTMENT CRITERIA

DISCOUNTING CRITERIA

NON-DISCOUNTING CRITERIA

NPV

BENEFIT COST RATIO

IRR

PAY BACK PERIOD

ACCOUNTING RATE OF RETURN

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1. 2.

3.

Pay back period: it is the length of time required to recover the initial cash outflow in a project. Advantages: It si simple both in concept and application but with hidden assumptions It helps in weeding out risky projects- it consider projects which generates substantial cash flows in earlier years and not favour projects with substantial cash flows in later years ( It si true that future cash flows are more uncertain since risk is generally considerable on long term . Since it favours earlier cash flows problems of liquidity is mangeable.
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Consider two project with initial cash out lays of Rs.10,00,000

year Project A Project B

0 1 2 3 4 5 6
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( 10.00.000) 2,00,000 2,75,000 3,00,000 2.25.000 1,25,000 11,25,000

(10.00.000) 1.00.000 1,25,000 1.50,000 2,00,000 2,50,000 3,00,000 11,25,000

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Discounted Pay Back Period

year 0 1 2 3 4 5 6
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Cash flow (10000)3000 3000 3000 4000 4000 5000 2000 3000

Discounting factor@10% 1.000 0.909 0.826 0.751 0.683 0.621 0.565 0.515

Present value (10000) 2727 2478 3004 2732 3105 1130 1539

Cumulative NPV After discounting 10000 -7273 -4795 -1791 941

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Pay back period is simple in concept and application It favors projects which generates substantial cash flows initially than later period . It measure only capital recovery Not suitable for longer gestation period projects Ignores time value of money.

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SOCIAL COST-BENEFIT ANALYSIS COSTRATIIONALE FOR SCBA:  Market imperfections- when market is imperfect market price do not reflect social values. When a consumer pays for a product through rationing system the price paid is generally less than price in a competitive market.  Externalities- for example road width may benefit neighboring areas. Such benefits are considered in SCBA. Similarly cost of pollution is relevant in SCBA  Taxes and subsidies- from private l point of view taxes are definite monetary cost and subsidy is definite monetary gains. But in social point of view taxes and subsidies are transfer payments and hence considered irrelevant.

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SOCIAL COST-BENEFIT ANALYSIS COSTConcern for savings- a private firm does not differentially value consumption and savings. But from social point of view, division between consumption and savings ( which leads to investment) is relevant especially ia a developing country.  Concern for redistribution- A private form is not concerned how he benefits are distributed among various groups in the society. But SCBA is concerned with equitable distribution of benefits across the entire population.  Merit wants- for example the Government may want to promote adult education programme orbalanced nutrition for, school going children though consumer do no demand in the market place.

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APPROACHES TO SCBA
 
1. 2. 3. 4. 5.

There are two approaches : (1)UNIDO approach and (2)LittleMirrless approach Unido approach has 5 stages: Calculate financial profitability of the project measuring at market prices. Obtaining net benefits of the project in terms of economic ( efficiency) prices (also known as shadow prices) Adjustment for the impact of the project on savings and investment. Adjustment for the impact of the project on income distribution Adjustment for the impact of the project on merit goods and demerit goods whose social values differ from their economic values.
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SHADOW PRICING-ECONOMIC (EFFICIENCY) PRICING PRICING

Basic issues in shadow pricing:

1.

Choice of Numeraire: (Unit of account in which value of inputs or outputs are expressed)

-Choice of currency (domestic or foreign) to be used to express benefits or costs. -do we measure cost and benefits at current value or present value, -what use the income project is proposed to be used/ -with reference to which group the income of the project be measured? 1. Choice of tradability: Tradable goods international price is the opportunity cost because domestic goods produced can be substituted by import or import can be substituted by domestic production or export can be substituted by consumption.
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1.

Sources of shadow prices- UNIDO approach suggests three sources of shadow prices:- (i) increase or decrease in total consumption in the economy ; (ii) increase or decrease in production in the economy ;; (iii) increase or decrease in imports and (iv) increase or decrease in exports. If the Impact of Project Consequence is on
Consumption Production International
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Basis for shadow price is consumer willingness to pay Basis is cost of production Basis is Foreign exchange value
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TAXES; UNIDO guidelines : 1. Include taxes when a project results in diversion of non-traded inputs which are in fixed supply from other producers or addition to non traded consumer goods 2. Exclude taxes when a project augments production by other producers Consumer buying D S1 Supply schedule First unit P E OP- Price per unit is willing S D1 To pay OD O Q ODEQ- willingness to pay by consumers OPEQ what actually they pay 61 Difference between ODEQ and OPEQ is consumer surplus (DEP)


SHADOW PRICING OF SPECIFIC RESOURCES

  

 

TRADABLE INPUTS AND OUTPUTS- border price translated in market exchange rate to domestic currency NON-TRADABLE INPUTS AND OUTPUTS.- Import cost Export price EXTERNALITIES: Also referred to as external effect, is special class of goods which is not deliberately produced but incidental outcome of legitimate economic activity ; (ii)it is beyond the control of person who are affected by it, for better or worse and (iii)it is not traded in the market place CAPITAL INPUTS FOREIGN EXCHANGE

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FINANCIAL PROJECTIONS
Balance Sheet Cash Flow Statement

Means of Fiance Interest Loan repayment Estimate Working results W/Capita Advance Interest On WCA Tax Factor

Cost & Time

Depreciatio n

Cost of Production

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W/C Needs

Production Plan

Production Sales

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COST OF Project
Material Land & Site Development Buildings & Civil works Plant & Machinery Other fixed assets Pre operative requirements Non-Material Technology Engineering services Consultants Training Capital Issue Expenses Preliminary expenses Initial cash loss Margin money for WC Advance Cost of finance

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MEANS OF FINANCE
Share capital  Term loans  Debenture capital  Deferred credit  Incentive sources  Miscellaneous sources Planning the means of finance  Norms of regulatory bodies and financial institutions  Key business considerations- cost; risk; control; flexibility


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ESTIMATION OF SALES AND PRODUCTION


1. 2.

3. 4.

The following considerations need to be borne in mind: Do not assume to have high capacity utilization. It is not necessary to adjust stocks. It will be advisable to assume production is equal to sales based on effective market survey. Selling price realsiasble should be net of taxes like excise duty, sales tax Selling price should be normally current market selling price..

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ESTIMATION OF SALES AND PRODUCTION

Details can be furnished separately for each product Product A Yr 1 1 Installed capacity (qty.per annum) 2 No of working days 3 No of units 4 Estimated Production per day (Qty) 5 Estimated annual production (Qty 6 Estimated output as % of plant capacity (Qty 7 Sale ( after adjusting stocks) (Qty 8 Value of sale (in RS.) Product B Yr2 Yr3 Yr1 Yr2 Yr3

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COST OF PRODUCTION

SL.No

Material cost
Description Qty For process 1 X Y Z Contingency For process 2 X Y Z Contingency 7/7/2011
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Quantity required at various production levels(% of Installed Capacity) Rate 100% 75% 50% Remarks

LABOUR COST
SL.No Description No For process 1 Skilled Unskilled Supervisory etc Contingency For process 2 Unskilled Supervisory etc
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Quantity required at various production levels(% of Installed Capacity) Rate 100% 75% 50% Remarks

Unskilled Contingency

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UTILITIES
SL.No Description Quantity required at various production levels(% of Installed Capacity) Qty For process 1 Power Water Fuel etc Contingency For process 2 Power Water Fuel etc
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Rate

100% 75%

50%

Remarks

Contingency

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Factory Overhead
SL.No Description Quantity required at various production levels(% of Installed Capacity) Qty For process 1 Repairs & Maint. Rent Insurance etc. Contingency For process 2 Repairs & Maint. Rent Insurance etc. Contingency
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Rate

100 %

75% 50% Remarks

WORKING CAPITAL REQUIREMENTS



This includes: -all the three inventory components. sundry debtors -operating expenses -sources of working capital finance Bank finance is generally limited by the formula= Current assets as laid down by Tandon Committees MINUS Non bank current liabilities Margin requirements are: Raw materials 10-25% Work in Progress 20-40% Finished goods 30-50% Debtors 30-50%

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PROJECT FINANCE RISKS

In the financial world risk can be defined as any eveent or possibility of an event which can impair the corporate earnings or cas flow over short/Medium / long term horizon  In other woerds the potential for future returns to var from the expected return is risk.  If returns can be generated under all circumstances there would be no risk and the risk management would be irrelevant.  All organizations deal with risk but the magnitude and the nature of risk vary fro organization to organization.


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SOURCES OF RISK
PROCES

TECHNOLO GY

MARKET SHARE

SOURCES OF RISK

COMPETITI ON

PRODUCTIV ITY

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SOURCES, MAESURES AND PERSPECTIVE IF RISK

    

PROJECT SPECIFIC RISK-lower cash flows / earnings due to resulting from estimation error or project specific factors COMPETITIVEV RISK- unanticipated competitors action INDUSTRY SPECIFIC RISK- unexpected technological developments, regulatory changes MARKET RISK- unanticipated changes in macro economic factors, interest rate and inflation. INTERNATIONAL RISK- exchange rate risk and political risk

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MEASURES OF RISK
Standard deviation  Coefficient of variation  Semi variance


Properties of Risk:
Stand alone risk: This is the risk of a project whe it is viewed in isolation  Firm risk- called as corporate risk  Systematic risk- this represent the risk of a project from the point of view of a diversified investor. It is also called as market risk.

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RISK CLASSIFICATION
MANAGERIAL PERSPECTIVE RISKS NEED TO BE AVOIDED RISKS THAT SHOULD BE TRANSFERRED RIKS TO BE ACTIVELY MANAGED FUNCTIONAL PERSPECTIVE CREDIT/ COUNTER PARTY RISK MARKET RISK

OPERATIONAL RISK

OTHER RISKS
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SIMULATION ANALYSIS


   

Sensitivity analysis indicates the criterion of merit (NPV, IRR or any other) to variations in basic factors and provides information of the following type: If the quantity produced falls by 1% the NPV falls by 6% provided other things being equal. Though such information is useful it would not be adequate for decision making. The decision maker wpuld loke to know such consequences. This information can be generated by simulation.

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STEPS INVOLVED IN SIMULATION ANALYSIS

1.

2. 3. 4. 5. 6.

MODEL THE PROJECT- It shows how NPV varies with reference to changes in the project parameters and exogenous variables. Specify the values of the parameters and the probability distribution of the exogenous variables. Select a value at random from the probability distribution of the exogenous variables. Determine the NPV corresponding to randomly generated values of exogenous variables and pre-specified parameter values. Repeat steps 3 and 4 a number of times to get large number of simulated NPV Plot the frequency distribution of the NPV
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MANAGING RISK


1. 2. 3. 4. 5. 6. 7. 8. 9.

Risk mitigation or reduction strategies have cost associated with them and whether hey are profitable depends on a given circumstances. Fixed and variable costs. Pricing strategy. Sequential investment. Improving information. Financial leverage reducing the proportion of fixed operating costs and reducing dependence on debt lowers risk Insurance. Long ter arrangements with suppliers, employees,, lenders and customers. Strategic alliance. 7/7/2011 80 Derivatives.

PROJECT SELECTION UNDER RISK>




1.

2. 3.

Once information about expected return ( measured in terms of NPV or IRR or some other criterion of merit) and variability of return ( measured in terms of Standard deviation or range or other risk index) has been generated , the next question is should the project be accepted or rejected? There are several ways of incorporating risk in the decision process:Judgmental evaluation- once the managers assess the return and risk characteristics , the decision will have tube in consultation with all concerned groups like capital budgeting group, executive committee , Board of Directors. Pay back period requirement Risk adjusted discount rate method.
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OWNERSHIP STRUCTURES
Tax Benefits vs. Low-cost Financing  A primary decision that should be made early in the project design process is whether the project will be structured to take advantage of Accelerated Depreciation, or to take advantage of tax-exempt financing and/or other possible benefits of a public or nonprofit structure. Projects that such advantage realize substantial economic benefits, but also see substantial increases in ownership complexity. The difficulty of finding investor(s) with sufficient and appropriate tax appetite, and designing an ownership structure that is legal and not overly complex should be carefully considered.


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Existing Corporate Structure  The existing corporate structure of the primary group developing the project should be taken into consideration. It may be that no new corporate/business structure needs to be developed to create a project that takes advantage of low-cost financing or tax incentives. Community projects are complex regardless of their ownership structure, and avoiding creation of a new legal entity would reduce complexity in one area, lowering costs and risks.


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Complexity and Project Coordination

A substantial barrier to community development is the high transaction cost relative to the total project costthe cost of feasibility studies, permitting, project financing and interconnection negotiations, power purchase agreements and construction management.  Ownership and financing structures have varying levels of complexity, and with increased complexity comes increased risk and cost. Complexity will cost either time or money, and usually both  Risk has the same effects, and its allocation among the project coordinator, final equity owner(s), and financing sources is a key issue for successful project capitalization. Various plans may need more outside expertise than others, which is a cost to be considered in budgeting and planning. An estimate of the cost of legal, financial, and management expenses which will increase with complexityshould be carefully considered when choosing an ownership structure and financial plan.
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Structure of a PPP project A typical structure of a PPP project is based on a so-called 'Design Build Finance Maintain' ('DBFM') contract between a government entity and a project company. The contract will contain the obligations of the project entity, such as financing, building, delivering, operating and/or maintaining specific public infrastructure. The government is contracted to pay a pre-agreed, long term, index linked availability payment to the project company. The project company enters into contracts with companies or consortia which assume the before mentioned obligations of the project company 'back-to-back'. In this way the risks of the project company resulting from its obligations (including construction and maintenance risk) will be mitigated to a large extent.
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In general, the parties with whom the back-to-back contracts are made, will also be a shareholder of the project entity in order to ensure that the interests of the parties involved are aligned. This structure ensures that the risks that remain within the project entity are limited and that the main part of the risks will be transferred to the parties that have proven to be successful in controlling these risks. The project entity as being the contract party of the contracting authority, will integrate the different sub-projects and will take care of the financing of the project. Typically, the shareholders of the project entity are the construction and maintenance companies and financial parties, like DIF PPP.

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CAPITAL STRUCTURE
  
1. 2.

3. 4. 5. 6.

Equity Debt Key factors in deciding equity-debt ratio: Cost Nature of assets tangible and liquid assets (debt financing) and intangible assets 9 brand. Technical know how debt financing is used less. Business risk- demand variability; price variability; variability of input prices; proportion of fixed operating costs Norms of lenders Control considerations Market conditions
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SOURCES OF FINANCE

SOURCES OF FINANCE

INTERNAL ACCRUALS

SECURITIES EQUITY PREFERNCE BONDS

TERM LOANS

WORKING CAPITAL ADVANCE

OTHER SOURCES

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OTHER SOURCES
       

Deferred Credit Leasing & Hire Unsecured loans adnd Deposits Special schemes of Institutions Subsidies Commercial paper Fcatoring Securitization- packaging a designed pool of assets, mortgage loans, consumer loans, hire purchase receivable sand securities which are collateralized by the underlying assets

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STEPS IN SECURITISATION
Seasoning- The originator identifies the assets to be securitized  Credit enhancement- the originator or some other agency may enhance the credit quality of the underlying assets.  Transfer to a special purpose vehicle usually organized as a trust for valuable consideration. Once the transfer is completed the assets are taken off the Balance Sheet of the originator.  Issue of Securities: The SPV issues securities backed by the pool of assets held by it. These securities is called Pass Through Certificates ( PTC) because the cash flows received from the pool of assets are transmitted 9passed) to the holders of these securities on a pro-rata basis after deduction of service fee.

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RAISING VENTURE CAPITAL


1. 2. 3. 4. 5.

Preparing a Business Plan: Use simple and clear language. Avoid bombastic presentation and technical language. Focus on four basic elements: of people, product, market and competition. Give projection for about 2 to 5 yaerswithe mphasis on cash flows. Identify risks and develop strtegy to cope with the same. Convince them that the management is talented, experience, committed and etermined.

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RAISING CAPITAL IN INTERNATIONAL MARKETS.

 

    

EIUORO MARKETS: Euro-currency- ECBs for import of plant and Machinery. The common commercial borrowing is through Euro Currency Loans. Euro currency is simply a deposit of currency in a bank outside the country. Euro-dollar is dollar deposit in a bank outside US Euro currency loan is often a syndicated loan. Interest rate is related to LIBOR and the interest period may be 3,5,9 or 12 months. Repayments are in bullet payments or in installments. Euro-currency bonds- issued outside the country in whose currency the loan is denominated
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It is managed by a syndicate of investment banks and offered to investors in many countries It is a a bearer bond it is unregulated and payable to a person who carries it.. Interest is usually paid annually of half yearly. Global depository receipts (GDRs)- Since 1990s Indian companies issued GDRs which represent indirect investment in the Euromarkets. In a depository receipts scheme, the shares issued by a firm is held by a depository, usually a large International Bank who receives dividend , reports etc and issues claims called GDRs- with each receipt being a claim on a specified number of shares. The underlying shares are called as Depository Shares.
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Foreign domestic markets- selling securities in the domestic capital markets of other countries. US Capital market Export Credit schemes Buyers credit-credit is directly provided to Indian buyer for import of capital goods Suppliers credit- to overseas exporters

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VENTURE CAPITAL & PRIVATE EQUITY

Financing a risky project with promising returns is known as venture capital financing.  Generally VC is understood as investment for technology centric projects.  But a better understanding is all projects Reliance retail, software, a novel telecommunication switch development hand tool development for operational effectiveness to compete in international market, exports of processed horticultural / or marine products, advertising agency specializing cost effective outdoor formats also comes under VC


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VC Investment is different because1. High uncertainty levels dueto: Technology risk  Product market risk  Management risk  Liquidity risk 2. Information disclosure


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1. 2. 3. 4. 5. 6.

VC Investment Appraisal Assessment of business and Management Valuation of VC investment Stages of VC Investment Seed money stage- to prove the concept Start-up- for marketing & product development First round financing- sales and manufacturing Second round financing- working capital for normal sales Third round financing- expansion after broken even Fourth round financing.- to go public (Bridge financing)

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Private equity fund is a pooled investment vehicle used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions). At inception institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund.  A private equity fund is raised and managed by investment professionals of a specific private equity fim (the general partner and investment advisor). Typically, a single private equity firm will manage a series of distinct private equity funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully invested. 7/7/2011 99


Legal Structure and Terms  Diagram of the structure of a generic private equity fund  As discussed, most private equity funds are structured as limited partnerships and are governed by the terms set forth in the limited partnership agreement or LPA. Such funds have a general partner (GP), which raises capital from cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments and high net worth individuals, which invest as limited partners (LPs) in the fund. Among the terms set forth in the limited partnership agreement are the following:


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Term of the partnership the partnership is usually a fixedlife investment vehicle that is typically 10 years plus some number of extensions  Management fees an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations (typically 1 to 2% of the committed capital of the fund[1]  Carried interest- a share of the profits of the fund's investments (typically up to 20%), paid to the private equity funds management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors[1]


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Hurdle rate or preferred return a minimum rate of return (e.g. 8 - 12%) which must be achieved before the fund manager can receive any carried interest payments  Transfer of an interest in the fund private equity funds are not intended to be transferred or traded, however they can be transferred to another investor. Typically, such a transfer must receive the consent of and is at the discretion of the fund's manager  Restrictions on the General Partner - the fund's manager has significant discretion to make investments and control the affairs of the fund. However, the LPA does have certain restrictions and controls and is often limited in the type, size or geographic focus of investments permitted and how long the manager is permitted to make new investments

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Private Equity Investments and Financing  A private equity fund typically makes investments in companies (known as portfolio companies). These portfolio company investments are funded with the capital raised from LPs, and may be partially or substantially financed by debt. Some private equity investment transactions can be highly leveraged with debt financing hence the acronym LBO for leveraged buy-out. The cash flow from the portfolio company usually provides the source for the repayment of such debt.


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PROJECT FINANCIAL STRUCTURES


1.

2.

3. 4.

Full Resource Structure: If it is anew company implementing a project the proposed borrowings fo the company is fully secured by mortgaging of existing and future asset and or by hypothecation current assets. If it is for expansion or diversification by an existiong company who has already have asset mortgaged the lender will have total ( existing mortgaged assets and assets of new project) a pari passu charge on the entire stock of assets. While variability is assed on a stand alone basis total cash flows are considered to judge debt servicing as a whole. Project promoters also provide personal guarantee
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LIMITED RECOURSE STRUCTURE



 

 

The project is set up as separate company called SPV which will not handle any other business activity without the consent of th lenders. The promoter will have to take substantial stake in the project. And enjoys overall responsibility of the project. The sponsor provide stand by support for cost overruns provided the quantum of such support is crystallized prior to financial closure ( ( all the requirement of funds for the Project is tied-up) Security includes of registered mortgage / hypothecation of all assets. Cash flow of SPV is handled by independent agency acting on behalf of the security agency.
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Such LBO Financing most often comes from commercial banks, although other financial institutions, such as hedge funds and mezzanine funds, may also provide financing. Since mid-2007 debt financing has become much more difficult to obtain for private equity funds than in previous years.  LBO funds commonly acquire most of the equity interests or assets of the portfolio company through a newly-created special purpose acquisition subsidiary controlled by the fund, and sometimes as a consortium of several like-minded funds.  Private Equity Multiples and Prices  The acquisition price of a portfolio company is usually based on a multiple of the companys historical income, most often based on the measure of earnings before interest taxes depreciation and amortization (EBITDA). Private equity multiples are highly dependent on the portfolio company's industry, the size of the company and the availability of LBO financing.

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Portfolio Company Sales (or "Exits")  A private equity fund's ultimate goal is to sell or exit its investments in portfolio companies for a return (known as internal rate of return or "IRR") in excess of the price paid. These exit scenarios historically have been an IPO of the portfolio company or a sale of the company to a strategic acquirer through a merger or acquisition (M&A), also known as a trade sale. Increasingly more common has been a sale of the portfolio company to another private equity firm, also known as a secondary sale. In prior years, another exit strategy has been a preferred dividend by the portfolio company to the private equity fund to repay the capital investment, sometimes financed with additional debt (though this is currently difficult to obtain).  Private equity funds and private equity firms: an illustration  The following is an illustration of the difference between a private e

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PROJECT APPRAISAL


 

Market Appraisal-reasonableness of demand, price,, adequacy of marketing infrastructure judge the knowledge, experience and competence of marketing p personnel. Technical Appraisal product line/ capacity/ process/ engineering know-how/ raw materials and consumables/ location/ building/ plant & equipment/ manpower/ breakeven point. Financial Appraisal- reasonableness of estimate of capital cost/working results/; adequacy of rate of returnIRR,ROI,Debt service coverage ratio, debt-equity ratio, Economic Appraisal Managerial Appraisal
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CREDIT RISK RATING



   

Credit risk rating is a rank assigned by the Bank to its borrowers based on his ability and willingness to rep[ay the debt with interest. RBI guidelines require banks to have a comprehensive risk rating system Also any lending decision of the banks in lending should keep the at the minimum of risk. The banks can use the ranking for credit decision. The rating models differ from banks to banks. For example large banks incorporates factors like probabilty of default to comply with its requirements of the latest Basel accord.
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SALIENT FEATURES OF CREDIT RATING SYSTEM




1. 2. 3. 4. 5.

For large loans companies need to submit in a set of forms CMA Format- a detailed actual and projected operating and financial data. A detailed analysis of the data along with all other needed information and documents. To qualify for rating the company has to come clean onThe conduct of the account should be satisfactory No willful default. No issues relating to corporate governance. Ro environmental The company should have required commitment and competence. There should be no audit remarks.
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1. 2. 3. 4.

5.

The rating is usually done across the following dimensions: Financial risk Business and industry risk. Management risk A minimum of 50% score is set for the hurdle rate for sanction of new credit facilities or for confirmation of existing ones. Credit rating is an ongoing process. RBI wants the bank to carryout such ratings once in six months.

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KEY FINANCIAL RATIOS

For working capital loans Current ratio (TOL/TNW)- Total outside liabilities/ Tangible net worth PAT/Sales For term loans Project Debt-equity ratio (TOL/TNW) Gross average debt service ratio of Project and all loans separately Term of payments in years ROCE Fixed asset coverage ratio
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ROCE PBDIT/Interest Current assets turnover 7/7/2011

PROJECT CONTROL AND MONITORING


1. 2. 3.

  

Reasons for ineffective control: Characteristics of the project-multi-organisations and multi discipline projects Peoples problems Poor control and information systems Delay in reporting performance Inappropriate level of detail. Unreliable information

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Variance analysis approach  Performance analysis 1. Through review committees 2. Standards and targets 3. External review by experts/ consultants Effective follow-up and mid course correction using: 1. PERT 2. CPM 3. GNATT Chart

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