Financing Business

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  FINANCING BUSINESS   FINANCE 1.   INTRODUCTION Project Finance is the long term financing of infrastructure and industrial projects based upon the projected cash flow of the project rather than the balance sheets of the project sponsors. It is the financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks that provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project assets and paid entirely from cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modelling. The financing is typically secured by all of the project assets, including the revenue producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms. Assets that have been financed on a project basis include pipelines, refineries, electric generating facilities, hydroelectric projects, dock facilities, mines, toll roads, and mineral processing facilities. It is the method of financing very large capital intensive project, with long term gestation period, where the lenders rely on the assets created for the project as security and the cash flow generated by the project as source of funds for repaying their dues. Project financing discipline includes understanding the rationale for the project financing, how to prepare the financial plan, assess the risks, design the financing mix, and raise the funds. In addition, one must understand the cogent analyses of why some project financing plans have succeeded while others have failed. A knowledge base is required regarding the design of contractual arrangements to support project financing; issue for the host government legislative provisions, public/private infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the projects borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the project’s feasibility.  The following are the characteristics of the project financing:     A separate project entry is created that receives loan from lenders and equity from sponsors.    The component of debt is very high in project financing. Thus project financing is a highly leveraged financing.    The project financing and all its other cash flows are separated from the parent company’s balance sheet.    Debt services and repayments entirely depend on the project’s cash flows. Project assets are used as collateral for loan repayments.    Project financier’s risks are not entirely   covered by the sponsor’s guarantee.    Third parties like suppliers, customers, government and sponsors commit to share the risk of the project. Project financing is most appropriate for those projects which requires large amount of capital expenditure and involve high risk. It is used by companies to reduce their own risk by allocating the risk to a number of parties. It allows sponsors to:    Finance large projects than the company’s credit and financial capabilities would permit.      Insulate the company’s bala nce sheet from the impact of the project.    Use high degree of leverage to benefit the equity owners. Project financing is not a means of raising funds to finance a project that is so weak economically that it may not be able to service its debt or provide an acceptable rate of return to equity investors. In other words, it is not a means of financing a project that cannot be financed on a conventional basis. 2.   WHY PROJECT FINANCING    Favourable tax treatment: - project financing is often driven by tax efficient consideration. Tax allowances and tax breaks for capital investment etc. can stimulate the adoption of project finance. Projects that contract to provide a service to state equity cab use these tax breaks to inflate the profitability of such ventures.      Favourable financing term:- project financing structure can enhance the credit risk profile and therefore obtain more favourable pricing than that obtained purely from the project sponsor’s credit risk profile.      Political risk diversification: - establishing SPV’s (special purpose vehicles) for project in specific countries quarantines the project risk and shields the sponsor from adverse developments.      Risk sharing:- allocating risk in a project financing structure enables the sponsor to spread risk over all the project participants, including the lender. The diffusion of risk can improve the possibility of project success since each project participants accepts certain risks; however the multiplicity of participating entities can result in increased cost which mush be  borne by the sponsor and passed on to the end consumer-often consumers that would be better served by public services.      Collateral limited to project assets:- non recourse project finance loans are based on the premise that collateral comes only from the project assets. While this is generally the case, limited recourse to the assets of the project sponsor is sometimes required as a way of incentivizing the sponsor.      Lenders are more likely to participate in a workout than foreclose:  - the non-course or limited recourse nature of project financing means that collateral has limited valuein liquidation scenario. Therefore, if the project is experiencing difficulties the best chance of success lies in finding a workout solution rather than foreclosing. Lenders will therefore more likely to cooperate in a workout scenario to minimize losses.      Expansion of the sponsor’s debt capacity: - financing on a project basis can expand the debt capacity of the project sponsors. First, it is often possible to structure a project so that the project debt is not a direct obligation of the sponsors and does not appear on the face of the sponsors’ balance sheets. In addition, the sponsors’ contractual obligation with respect to the project may not come within the definition of indebtedness for the purpose of debt limitation contained in the sponsors’ bond agreement or note agreements. Second, because of the contractual arrangements that provide credit support for project borrowings, the project company can usually achieve significantly higher financial leverage that the sponsors would feel comfortable with if it financed the project entirely on its own balance sheet. The initial leverage ratio is substantially greater that the typical corporate leverage ratio. The amount of l everage a project can achieve depends on the project’s profitability, the nature and magnitude of project risks, the strength of the project’s security arrangements, and the creditworthiness of the parties committed under those security arrangements.   Therefore we understand  project financing as an activity that involves raising funds on a limited-recourse or nonrecourse basis to finance an economically separable capital investment project by issuing securities (or incurring bank borrowings) that are designed to be serviced and redeemed exclusively out of project cash flow. The terms of the debt and equity securities are tailored to the characteristics of the project. For their security, the project debt securities depend mainly on the profitability of the p roject and on collateral value of the project’s assets. Depending on the project’s profitability and on the proportion or debt financing desired, additional sources of credit support may be required. A project financing required careful financial engineering to achieve a mutually acceptable allocation of the risk and rewards among the various parties involved in a project.    3.   IMPORTANCE OF PROJECT FINANCING PROJECT FINANCE  is worthy of study because of the size and complexity of the projects that can be financed using this technique. Project financing typically accounts for between 10% and 15% of total capital investment in new projects worldwide and for more than half the capital investment in very large projects all over the world. It has proven to be a very useful financing technique throughout the world and across a broad range of industry sectors. It is likely to be increasingly important in the years ahead as emerging economies increasingly rely on it to exploit their resource deposits and develop their infrastructure. Studying project finance is interesting because it requires the application of all the tools in the corporate finance tool kit. It will also help improve the understanding of how firms choose their capital structures, how contracts affect managerial decision making and firm behaviour, and how organizational choice can affect firm value. As project financing typically involves very high leverage, 70% or more debt initially on average, it is a potentially fruitful area for investigating the financial consequences of high leverage. 3.1   ANALYZING VIABILITIES To arrange financing for a stand-alone project, prospective lenders (and prospective outside equity investors, if any) must be convinced that the project is technically feasible and economically viable and that the project will be sufficiently creditworthy if financed on the basis the project sponsors propose. Establishing technical feasibility requires demonst rating, to lender’s satisfaction, that construction can be completed on schedule and within budget and that the project will be able to operate at its design capacity following completion. Establishing economic viability requires demonstrating that the project will be able to generate sufficient cash flow so as to cover its overall cost of capital. Establishing creditworthiness requires demonstrating that even under reasonably pessimistic circumstances; the project will be able to generate sufficient revenue both to cover all operating costs and to service project debt in a timely manner. The loan terms-in particular the debt amortization schedule lenders require  – will have a significant impact on how much debt the project can incur and still remain creditworthy. We understand these concepts in detail as follows .   3.2 TECHNICAL FEASIBILITY  Prior to the start of construction, the project sponsor(s) must undertake extensive engineering work to verify the technological processes and design of the proposed facility. If the project requires new or unproven technology, test facilities or a pilot plant will normally have to be constructed to test the feasibility of the processes involved and to optimize the design of the full scale facilities. Even if the technology is proven, the scale envisioned for the project may be significantly larger than existing facilities that utilize the same technology. A well executed design will accommodate future expansion of the project; often, expansion beyond the initial operating capacity is planned at the outset. The related capital cost and the impact of project expansion on operating efficiency are then reflected in the srcinal design specifications and the financial projections.
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