Project Finance

Working Capital finance or the Working Capital credit facilities that we have discussed are in the
nature of short-term financing. The money lent by the bank by way of WC credit facilities such as
Cash Credit, Overdraft, Bills Purchased/Discounted, etc. returns back to the bank at the end of each
operating cycle which may extend, typically, up to 3-4 months. In other words, the cash borrowed by
the company from the bank turns over 3-4 times in a year. In these cases, the repayment of the cash
to the bank account is from sale of the finished goods/realization of trade receivables. Because of
this, the WC credit facilities are sanctioned for a 1 year period, and continuation of the facilities is
subject to annual review & renewal. These characteristics of Working Capital finance make it shortterm financing. Because of this short-term nature, WC credit facilities are legally repayable on
demand in terms of the relative loan agreement with the bank.
On the other hand, corporates may require long-term finance. As we have already seen, a corporate
may need to invest substantially in fixed assets such as land, factory building, plant & machinery,
equipments, office building, etc. for its operations. These assets are not to be sold and realized for
cash in the normal course of business, i.e. they will not be turning over as it happens in the case of
inventory & receivables. They remain with the company for long periods, are subject to wear & tear
during the process of manufacturing or usage, and are disposed of (or replaced) only at the end of
their useful life. These assets are also called Capital Assets. Obviously, these kinds of assets cannot
be financed by short term funds and the company will need long term funds to acquire them. We have
seen that the long term sources of funds are capital and reserves & surplus, preference shares,
debentures, public deposits, Term Loan from banks, etc. While equity capital is returnable to the
shareholders on in the event of winding up of the company, the repayment of the other long term
financing arrangements (redeemable preference shares, debentures, public deposits & Term Loan
from banks) will be from the profits or earnings or more accurately, cash profits from the
manufacturing/business operations of the company over the useful life of these kinds of fixed assets.
Term Loans are, therefore, long term funds lent by banks to corporates for acquiring or renovating or
modernizing capital assets. The repayment period of Term Loans is usually 5-7 years. (However, the
repayment period may go up to longer periods in the case of housing loans, loans for infrastructure
projects, etc.). Repayment is to be made in monthly or quarterly installments. Repayment will be from
the cash profits earned by the company from its operations during the repayment period. As security
for Term Loans, banks will normally obtain charge over the fixed assets financed by the Term Loans
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by way of mortgage (if the assets are immovable) or hypothecation (if the assets are movable such as
equipment or machinery). As these loans are repayable not on demand, but after a specified period
or term, they are called Term Loans.
A banker will have to adopt a different approach to evaluating or apprising Term Loan requirements
of a borrower and in considering sanction of Term Loan facilities, because of the following reasons:

The purpose of a Term Loan is acquisition of capital assets.

A Term Loan can be repaid only over a lengthy period of 5-7 years. However, repayments

will have to be made in monthly or quarterly installments.

Repayments will have to come from future income or cash profits earned by the company
from its operations by using the capital assets acquired through the Term Loan. Whereas in
the case of Working Capital finance, the underlying assets financed (raw material) itself will
turn into cash for repayment to the bank within a short period of 3-4 months at the end of the

operating cycle.
The long repayment period will involve more risk for the bank; the prospect of the company
running profitably in changing market conditions & economic cycles over the entire

repayment period of 5-7 years will have to be verified & established by the banker.
The security for Term Loans will be in the form of capital assets, unlike in the case of
Working Capital credit facilities where the security will be in the form of readily saleable
goods and/or realizable receivables.

In view of the above, the bankers evaluation or appraisal of Term Loans will focus on future income
earning prospects of the company for entire duration of the repayment period of the Term Loan. The
Term Loan appraisal will involve the following methodical steps:

Examination of technical feasibility (of the projected operations using the capital assets

acquired through the Term Loan).

Examination of economic viability (of the operations using the capital assets acquired through

the Term Loan/the company as a whole).

Financial Appraisal: This will include examination of the present financial condition of the
company, verification of the cost of the project for acquiring the capital assets, means of
finance for meeting the cost of the project, assessment of the financial capability of the
company for repayment of the existing term liabilities & the proposed Term Loan with
interest through profitability projections and debt service coverage ratio, along with

Sensitivity Analysis, Break Even Point Analysis and Internal Rate of Return Analysis.
Examination of the company managements background and its competence to run the
operations of the company on profitable lines for the duration of the repayment period.

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It should be noted that the banker will also carry out the due diligence process which we have already
described, while considering Term Loans to corporates.
9.1 Technical Feasibility:
The study of technical feasibility will include the following:

Land & locational advantages: Aspects such as extent of land available for existing/
proposed/future operations; nearness or accessibility to sources of raw material, other inputs,

and markets for finished products, etc. are studied in detail.

Plant & Machinery: Aspects such as economic size & capacity; nature of technology and
manufacturing processes involved, technical tie-up if any required, etc. are studied in detail, if

necessary with the help of technical specialists.

Capacity of the plant & machinery to manufacture/produce the anticipated output in terms of

quantity and quality.

Availability of skilled labour/employees.
Availability of utilities such as power, water, fuel, etc.
Environmental impact: Study of environmental impact is becoming increasingly important.
The technical feasibility study will have to take into account the requirement of complying
with the applicable local pollution control regulations. Such compliance may need substantial

investment in technology, equipment & processes.

Statutory approvals required for the project.

9.2 Economic viability:

This is to examine whether the project can be expected to have adequate earning capacity necessary
for repayment of its debt. Since the earnings will depend on the volume of sales, it will be necessary
for the banker to estimate how much of the output of the new project, or the additional production of
the existing company if it is going in for expansion of its capacity, can be absorbed in the market at
given prices. The examination will, therefore, involve study of:

Demand-Supply scenario: Size of the exiting market, current & anticipated growth rates,
economic & other factors impacting the growth of the market, market shares of the current

players, existing and anticipated capacity build up in the industry, etc.

Export: Scope of export market and specific risks involved in exports.
Industry scenario: Cyclicality, Government regulations, etc.
Marketing arrangements.

The above examination will help the banker in verifying whether the projected levels of sales, in
terms of volume and value, in the coming years are reasonable with reference to scope in the market.
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A banker will often seek expert consultation for techno-economic evaluation of a project, particularly
if it involves large capital investment and/or new technology or a new product is involved. Such
consultation may be with the banks own Technical Consultancy Cells or suitable outside consultant.
In such cases, the banker will obtain detailed report on the technical feasibility and economic viability
from the consultant to help him in his appraisal.
9.3 Financial Appraisal:
Present financial condition of the company:
In the case of existing companies which may require Term Loan facility for capacity expansion,
modernization of plant & machinery, further investment in fixed assets, etc. the present financial
condition of the company is examined by analysis of the audited financial statements and other
financial & corporate data available in the companys Annual Reports at least for the past 3 years.
9.4 Cost of Project:
Correct estimation of the total cost of the project involving new capital investment is important since
it impacts the means of financing, profitability, loan repayment or the debt-servicing capacity. The
banker will examine cost estimates item by item, and see whether they have been estimated
realistically after considering possible cost-optimization measures. Where possible, the banker will
compare the cost estimates with costs of similar projects of other companies from the database
available within the bank or outsourced from other agencies. Usually, Cost of Project has the
following component items:

Land, including site development cost

Construction of buildings
Plant & Machinery
Equipment & Miscellaneous fixed assets
Technical, engineering & consultancy fees
Preliminary & pre-operative expenses, including interest during construction
Provision for contingencies
Margin for Working Capital

The items 1 to 4 above are usually referred to as capital costs or hard costs. In the case of imported
plant & machinery or equipments, the care is taken to see that their landed cost is taken into account
by including marine insurance, ocean freight, customs duty and inland freight charges.

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It may be noted that the actual cost under Item 6 will be capitalized, i.e. rather than debiting the
expense account and showing it as an item of revenue expenditure in the P&L account, the amount
will be shown as an item in the assets side of the Balance Sheet and amortized gradually over a period
of time by debit to the P&L Account.
Margin for Working Capital refers to the investment in Current Assets from long term sources of
funds, which the Working Capital lenders will expect to be financed by the company from long term
sources as margin or Net Working Capital (say, 25% of the projected Current Assets), when they
extend Working Capital finance. This is calculated by projecting the level of Current Assets and
Current Liabilities in the period after commencement of commercial production of the project.
9.5 Means of Financing or Financing Pattern:
Broadly, this comprises of Equity component and Debt component. The ratio between the two
components (which is known as the Project Debt/Equity Ratio) is extremely important, as it will
directly impact the debt or the loan repayment capacity and interest cost over the entire duration of the
Term Loan facility. The Equity component is the promoters contribution which is brought in by way
of capital by the promoters/shareholders. In existing profit-making companies, this may include the
gradual plough-back of cash profit during the project implementation/construction period, in addition
to new capital funds brought in by the promoters up-front. The Debt component will include Term
Loan facility from banks and other kind of long term debt arrangements. A higher level of Equity
component in relation to the Debt component will afford greater comfort to the lenders, including the
bank, because it implies that a higher level of the project risk is borne by the promoters/shareholders
as well as lower debt servicing/repayment requirement. This means that a lower Debt/Equity Ratio
will be more acceptable to the lenders/bankers than a higher Debt/Equity Ratio. Bankers generally
consider a Project Debt/Equity Ratio level of 2:1 as a benchmark. This means that bankers will
expect at least one-third of the cost of the project to be borne by the promoters, while they may
consider term loan facilities of up to two-third of the project cost. In other words, the promoters shall
have to meet 34% of the project cost from their own capital as margin, and may expect to raise loans
from banks and others up to 66% of the project cost. However, the banker evaluating the project will
study existing TOL/TNW ratio of the company, existing cash profit, projected cash generation after
the proposed capital investment, and other relevant factors before determining the acceptable
Debt/Equity Ratio or financing pattern for the project.
Usually, Means of Finance has the following component items:
Equity:

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Equity Share Capital

Convertible Preference Share Capital
Internal Cash Accruals
Others (e.g. Central/State Govt. Capital Subsidy)

Debt:

Debentures
Term Loans from banks
Deferred Payment Guarantees
Unsecured Loans/Deposits
Others (e.g. Central/State Govt. Sales Tax Loan, Development Loan, Soft Loan, etc.)

Anticipated internal cash accruals during the period of project implementation from the existing
operations of an existing company may be reckoned as one of the means of finance, provided the
company is earning adequate profits and has adequate liquidity in terms of comfortable levels of
NWC and Current Ratio.
Capital Subsidies, Sales Tax Loans, Development Loans and Soft Loans are equity or loans facilities
on liberal terms provided by the Central or State Governments under specific schemes for
encouragement of industries in priority areas such as processing of agricultural produce, Research &
Development of new products, etc. that deserve special encouragement.
Deferred Payment Guarantees (DPGs) are guarantees issued by banks in favour of suppliers of capital
assets, guaranteeing payment for the capital assets sold to the borrower company, in quarterly/halfyearly installments with interest over a period of 5 years or so. In such cases, the supplier sells the
assets on deferred terms, and the borrower company gets the assets on deferred credit terms on the
strength of the banks guarantee. (For its immediate needs, the supplier may get its bills discounted
by its bankers against the DPG.). The DPG is a substitute for a Term loan; the only difference is that
the borrower company & the bank need not make the actual payment at the time of delivery of the
assets acquired. It is a non-fund based credit facility extended by the bank and availed by the
borrower company, such that the payments under the DPG can be made in installments with interest
over a period of 5 years or so.
It should be noted that the payments under the DPG will have to be met out of the cash accruals
generated by the operations as in the case of Term Loans. Since, for the banks, the risks involved in
issuing a DPG are the same as the risks involved in granting a Term Loan, the evaluation/appraisal of
DPG facility is done in the same manner as in the case of Term Loan.

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Unsecured Loans/Deposits refer to long term finance that the company may be able to arrange on its
own for the project. For the banker to accept this arrangement, these loans/deposits will have to be
subordinated to the Term Loans of the banks for repayment of principal and interest. This means that
these loans/deposits will be either not repayable/withdrawable during the entire period of the Term
Loans or repayable/withdrawable only with prior permission of the lending banks during this period.
The payment of interest on such subordinated loans/deposits will also be subject to conditions such as
approval by the bank of the interest rate payable on such loans/deposits, payments of interest on such
loans/deposits only after payments of interest & installments to the bank have been made, etc.
9.6 Profitability Projections and DSCR calculation:
Appraising the profitability of future operations of a project is a critical step in evaluation. For this,
the projected levels of sales (by volume & value), cost of production, and net profit are prepared and
verified by a banker. The following is a sample statement of Profitability Projections (this sample
statement shows columns for projections for 3 years only; however, similar projections for the actual
appraisal exercise are prepared for all the years covering the entire period of the proposed Term Loan
facility):
S. No.
1
2
3
4
5
6
7
8
9
10
11
12
13
13
14
15
16
17
18
19
20
21
22
23

Particulars
Installed capacity (quantity per annum)
No. of working days for the year
No. of shifts per day
Capacity utilization (%)
Production per annum (in quantity)
Gross Sales
Less: Excise Duty
Net Sales
Raw Material, etc. consumed
Power, water & fuel
Wages & factory salaries
Factory overheads
Depreciation
Add: Opening stocks-in-process
Less: Closing stocks-in-process
Cost of Production
Add: Opening stock of Finished Goods
Less: Closing stock of Finished Goods
Cost of Goods Sold
Gross Profit
Selling, General & Administrative expenses
Operating Profit
Add: Other Income
Less: Other Expenses
Profit Before Tax
Provision for Tax
Net Profit

Year 1

Year 2

Year 3

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The banker will verify each of the above items of projection for its reasonableness. Where warranted
and possible, he will also carry out inter-firm comparison of the key parameters, as well as industry
average comparison.
9.7 Debt Service Coverage Ratio (DSCR):
Project appraisal aims to ascertain the viability of a project, which to a banker, ultimately means
capacity of the operations to generate adequate cash profits to service the interest and repayment
installments every year for the duration of the Term Loan extended for the project. The quantum of
the Term Loan facility, the quantum of each installment and the entire repayment schedule will have
to be fixed in such a manner that the projected cash profits for each year should be able to cover the
loan servicing obligations.
The following is a sample format for calculation of DSCR:
S. No.
1
2
3
4
5
6
7
8
9

Particulars

Year 1

Year 2

Year 3

Net Profit
Add: Interest on Term Debt (existing & proposed)
Add: Depreciation
Add: Amortization, non-cash expenses
Cash Profit available for debt service
Interest on existing Term Debt
Interest on proposed Term Loan
Installments on Term Debt (existing Term Debt and
proposed Term loan)
Total Debt Obligations
Debt Service Coverage Ratio for the year
(DSCR = Item 3 / Item 7)
Average DSCR for the entire duration of the loan period

A banker will normally expect the projected DSCR to be at a minimum of 1.5:1 for all the years, and
the average DSCR to be above 2:1. If the DSCR is below 1:1 during the initial one or two years when
the operations of the new project may not have stabilized, it may indicate the need to provide an initial
moratorium period or holiday period for commencement of the repayment instalments.
9.8 Sensitivity Analysis:
The profitability projections are based on single value analysis, i.e. a single value is assumed for each
parameter such as selling price, volume of sales, cost of raw material, cost of power, etc. The single
value that is reckoned is the most likely value. However, in real-life situations, these assumed values
may be subject to change. In sensitivity analysis, the banker tests the viability of the project by recalculating the Cash Profit and the DSCR coverage under different circumstances such as when the
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selling price is reduced say, by 5%; or sales volume is reduced by 5%; or cost of power increases by
5%; or cost of raw material goes up by 10%; or a combination of one or more parameters.
To carry out the sensitivity analysis meaningfully, the banker will identify the most critical or
sensitive factors which are likely to impact the operations & cash profits, and estimate how much
these sensitive factors may vary during the loan repayment period (say, by 5%, 10%, etc). A typical
sensitivity analysis is prepared and studied in the following manner:
Scenario

A
B
C
D
E
F

Cash Profit
(Highest, Average
& Lowest during
Year 1 to Year 7)

DSCR
(Highest, Average &
Lowest during Year
1 to Year 7)

Average
DSCR

Base Case
Downside case if the Selling Price
is reduced by 5%
Downside case if the Sale Volume
is reduced by 5%
Downside case if the Raw
Material cost increases by 10%
Downside case if the Cost of
Power goes up by 5%
Downside case if the Cost of
Power goes up by 5% and the
Raw Material cost increases by
10%
Worst scenario case Cost of Power
goes up by 5%, Raw Material cost
increases by 10% & Selling Price
is reduced by 5%

If, from the above analysis, it is found that the viability of the project could be seriously affected by
any substantial increase in the cost of raw material, the banker may insist on the company entering
into long term contract for purchase of raw material and make this a condition for sanction of the
Term Loan facility.
9.9 Break Even Analysis:
In a manufacturing unit, if at a particular level of production, the total manufacturing cost equals the
sales revenue, this point of no loss/no profit is known as the Break Even Point. Break Even Point is
expressed as a percentage of full capacity. A good project will have reasonably low Break Even Point,
which would not be difficult to be reached even after providing for the uncertainties that may be
encountered in achieving the projected level of operations & profitably of the unit. The starting point
for the Break Even Analysis is the classification of expenses into Fixed Expenses (including semifixed expenses) and Variable Expenses. Fixed expenses are those expenses which must be incurred
irrespective of the level of production, and changes only when the scale of operations crosses that
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level, e.g. factory overheads, salaries, interest on Term Loans, Administrative expenses, etc. For this
reason, Fixed Expenses are also called Stepped Costs. On the other hand, Variable Expenses are those
expenses which vary directly in proportion to production, e.g. raw material/stores/spares consumed,
Power, water & fuel, interest on Working Capital finance, etc. If we deduct the Variable Expenses
from the Sales (i.e. Sales Variable Expenses), the result will be Contribution. Profit will be
Contribution less Fixed Expenses (Contribution Fixed Expenses).
The Break Even Point is arrived at by the following formula:
Break Even Point (BEP) = (Fixed Costs per unit / Sale Price per unit) Variable Costs per unit, This
will be the BEP in terms of number of units.
The sales turnover at BEP or Break Even Sales = Fixed Costs x Sales / Contribution.
The Break Even at installed capacity or Break Even Capacity = Fixed Costs x Capacity Utilization %
x 100% / Contribution.
In the context of project appraisal, the Break Even Point is expressed as percentage of full capacity. A
good project should have BEP of not higher than, say 50%.
9.10 Internal Rate of Return (IRR):
Internal Rate of Return (IRR) is a measure of the rate of return that the funds invested in the project
are expected to earn over the economically productive life of the project. It will enable investors in
the project, including lenders, to compare the rate of return that the funds invested in the project
would earn with the rates of return that other opportunities of investment may provide. In general,
investment in the project would be worthwhile if the IRR is higher than the current cost of capital and
debt funds.
IRR is calculated by arriving at the rate at which the discounted value of the cash flows of the project
(i.e. the present value of the future cash income from the project over its entire life) is equal to
discounted value of the investment outlay in the project (i.e. the present value of investments in the
project over its entire life). IRR represents the discounting rate at which the Net Present Value of the
cash inflows and the cash outflows of the project will be zero.
To calculate the IRR, the cash flows representing all the expenditure in the project (initial project
expenditure, yearly capital expenditure for normal maintenance & yearly increase in inventory &
receivables) for the estimated economically productive life time of the project (say, for 10 years) are
set out as Cash Outflows. Similarly, the Cash Inflows representing Cash Profits for these years are
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also set out. The Discounting Rate at which the Net Present Value of these two cash flows will
become zero is calculated by using an interpolation formula. All spreadsheet software packages, such
as Excel, have the function to calculate the IRR by this method, if the two steams of cash flows
(inflows and outflows) are input in the system.
To sum up, the Financial Appraisal of a project will include examination of the present financial
condition of the company, verification of the Cost of Project, Means of Finance, assessment of the
financial capability for repayment of the existing term liabilities & the proposed Term Loan with
interest through Profitability Projections and Debt Service Coverage Ratio, along with Sensitivity
Analysis, BEP Analysis and IRR Analysis.
9.11 Company Managements background and competence:
The study of managerial competence assumes importance in the context of Term Loan appraisal, since
the bank undertakes greater risk in the case of Term Loans. We have already seen that these risks
arise from the long-term nature of the exposure, reliance upon future earnings of the company for
repayments (i.e. repayments are not through short-term turnover of working assets as in the case of
working capital finance), changing market conditions & economic cycles, nature of security available
in the case of Term Loans, etc. Keeping this in mind, a credit analyst will evaluate the managerial
competence usually under four heads in the flowing manner:

Management Character: Whether the promoters are well-established members of society

whose integrity is not questioned and who are respected by peers; whether there is any
possibility of diversion of funds to other group companies; whether the promoters are fully
committed to this project, have experience in this line of activity, and whether this project will

contribute significantly to the overall business of the group.

Managements Capacity: Whether the promoters/group are financially strong with high net
worth; whether the quality of key management persons involved in the day-to-day operations
is good; whether they have adequate experience in this line of activity; whether the industrial

relations are satisfactory.

Managerial Succession: Whether there is well-defined succession plan in place; whether the
success of the project is dependent on one person; and whether the possible successors have

sufficient skills, experience and knowledge.

Management Reputation: Whether the track record of the company/promoters/group reveals
that they have been meeting obligations towards creditors/lenders as per agreed terms;
whether their credit track record with bankers is satisfactory; whether the company/group has
been

in

existence

for

sufficiently

long

time

in

the

market,

whether

the

promoters/company/group have adequate capability to raise capital in the market from public
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or private sources at competitive rates; and whether their reputation with their customers and
suppliers is good.
9.12 Post-sanction follow up
For Term Loans, this will include loan documentation, creation of security, registration of security,
disbursement of the Term Loan facility, verification of end-use of funds lent by the bank and
monitoring of the project implementation till its completion. Usually, the bank will disburse the Term
Loan facility in phases in line with an agreed project implementation schedule, after verifying whether
the capital funds/margin required to be brought in by the companies have actually been brought in.
Wherever possible, payment to suppliers will be directly made by the bank from disbursements in the
Term loan facility. In respect of large and complex projects, the bank may engage the services of
outside consultants for monitoring the project implementation.
As already discussed, Term Loans for large projects, particularly where the total quantum of Term
Loan component exceeds Rs.100 crores, may involve joint lending arrangements such as consortium
or multiple banking arrangements. Tie-up of such high-value Term Loan requirements may also be
arranged by a single banker or merchant banker under an arrangement called syndicated loan
arrangement. Under the syndicated loan arrangement, several banks are invited to participate in the
lending on common terms & conditions and each bank takes up a suitable share of the overall Term
Loan requirement of the project.

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