PROJECT FINANCE

History of Project Finance

Project financing is not a new financing technique. Venture by venture financing of finite-
life projects has a long history; it was, in fact the rule in commerce until the 17th century. For
example in 1299 the English Crown negotiated a loan from the Frescobaldi (a lending Italian
merchant bank of that period) to develop the Devon silver mine. The loan contract provided
that the lender would be entitled to control the operation of the mines for one year. The lender
could take as much refined ore as it could extract during that year, but it had to pay all cost of
operating the mines. There was no provision for interest. The English Crown did not provide
any guarantees ( nor did any one else) concerning the quantity or quality of silver that could
be extracted during that period. Such a loan arrangement was a forebear of what is knows
today as the production payment loan.

CONCEPT OF PROJECT FINANCING

Project financing refers to the means of finance employed for meeting the cost of the project.
The means of finance refers to the long term sources of finance use for meeting the cost of
the project.

Sources of Finance

 Equity capital and preference capital

 Convertible and non- convertible debentures
 Rupee term loans
 Deferred credit
 Sales tax deferment and exemption
 Unsecured loans and deposits etc.

WHAT IS PROJECT FINANCE?

Project finance (unique approach to “off balance sheet , non – resource” financing)

Project financing is an innovative and timely financing technique that has been used on many
high profile corporate projects, including Euro Disneyland and the Euro tunnel. Employing a
carefully engineered financing mix, It has long been used to fund large scale natural
resources projects, from pipelines and refineries to electric generating facilities and hydro
electric projects. Increasingly, project financing is emerging as the preferred alternative to
conventional method of financing infrastructure and other large scale projects worldwide.

Project financing discipline includes understanding the rationale for project financing, how to
prepare the financial plan, asses the risk , 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 to support project financing issues for the host government legislative provisions,
public/private infrastructure partnerships, public/private financing structure; credit
requirements of lenders, and how to determine the projects borrowings 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 projects feasibility.

CHARACTERSTICS OF PROJECT FINANCIG

 A separate project entity is created that receives loans from lenders and equity from
sponsors.
 Component of debt is very high in project financing.
 Debt services and repayments entirely depend on the projects cash flows.
 Project assets used as collateral for loan repayments.
 Project financing most appropriate for projects involving large amount of capital
expenditure and involving high risk.

Financial assistance is granted to the project based on the total project cost. A project in a
small scale sector would be financed by banks and / or state financial corporations and state
Industrial Development Corporation. The project could be financed any one of the
institutions or in consortium with each others. This is determined by total requirement of loan
funds for the project.
FEASIBILTY STUDIES

To implement any project, the entrepreneur needs to carry out different types of feasibility
studies. This feasibility study evaluates all the risks and returns and tries to balance them and
help the entrepreneur to finalise his plans. It enables the company to anticipate problems that
are likely to be encountered in the execution of the project and places it in better position to
respond to all the queries that may be raised by financial institutions and others concerned
with the project.

Different feasibility studies include:

MANAGERIAL FEASIBILITY

Every business has different requirements from the management. Businesses, which are
complex, require significant experiences on part of top management to run it. Management
expertise is not only technical know – how but also in understanding market dynamics,
ability to distribute product effectively, manage manpower and environment.

In cases, where MNC, which has a long track record and significant experience, is
implementing a project, it would be an added comfort about management feasibility. In
businesses, which are technologically driven based on intellectual capital, technocrats would
be preferred.

The ultimate success of even a very well conceives project lies upon how competently it is
managed. Besides project implementation, other important function required to be controlled
can be broadly classified.

ECONOMIC FEASIBILITY

The project has to generate an acceptable rate of return, which adequately covers your cost of
capital. The expected rate of return depends on the risk profile of the project. In a rational
economic world, nobody implements a project to make losses. In other words net present
value has to be positive if you discount the cash flow by the desired rate of return.

COMMERCIAL FEASIBLITY (AVAILABILITY OF KEY FACTORS)

We would like to distinguish between commercial feasibility and economic feasibility.

Commercial feasibility refers to availability of raw material, skilled labour, infrastructure and
other factors of production. A number of projects have run into rough weather due to poor
commercial viability. One of the classic examples of this is a cycle factory which was set up
in Baroda, Gujrat. The management was good, market survey showed existence of a good
market and the government was giving fiscal incentives. What was overlooked was
availability of skilled labour. Bicycle assembly is a hard work and labour in Gujrat is used to
process industries. Therefore project failed. The centre of the bicycle industry is Ludhiana
where native are sturdy people and used to hard work and have requisite skills in assembly of
bicycles.
FINANCIAL FEASIBILITY

The ability to raise money to implement the project is of paramount importance. The
promoter should be capable of raising funds either from his own sources or from banks and
institutions. One area that often gets overlooked is contingency planning. In most cases, the
first generation entrepreneur has problems in raising funds to implement his project, and even
if he does so, he lacks staying power and is not able to withstand unforseen problems like
delays and overruns.

TECHNICAL FEASIBILITY

An entrepreneur should have the requisite number of technically capable people as well as
technology required to set up and run the plant. The technology should be such that is could
adapt to local conditions. Technology transfer from overseas often fails in this regard. The
conditions in US are quite different from India. Most parts of India are hot and dusty.
Sophisticated process controls have known to fail. Therefore, knowledge and suitability to
local conditions is very important.

SOCIAL FEASIBILITY

Many a time plants may be viable economically and financially but would be socially
undesirable. An example would be dye units, which have mushroomed around Ahmedabad.
These are polluting and generate effluents not acceptable to the society and environment. In
last 5 years, India is slowly becoming environment conscious and friendly. So using
hazardous chemicals or polluting industries may not get the necessary clearance. For
instance, the state government has ordered closure of all dyes units in Gujrat unless suitable
effluent treatment is implemented.

MARKET FEASIBILTY

This is a critical analysis because the output of any factory has to sell in the market place for
the promoter to earn revenues. Very often demand analysis and projections are optimistic
leading to problems in the future. Another observation has been that products that sell abroad
many not have a market in India. India in general is a cost conscious market and the promoter
has to keep this in the back of his mind.
ENVIORNMENTAL ASPECTS:

The project should be sensitive to the demand of the environment. Environmental concerns
are highly significant today.

Key questions raised in the ecological analysis:

 What is likely damage caused to the environment?

 What is the cost of the restoration measures?

Environmental planning evaluates the likely impact of a project on the environment and
suggests remedial action to minimize damage.

MANAGEMENT BY SOUND PROMOTERS

The promoters form the backbone of every project. While a bad promoter can make a mess of
a good project, a good promoter can make a success of a weak project.

Following are the qualities of sound promoters:

 Willingness to make sacrifices

 Leadership skills
 Decisiveness
 Confidence in the project
 Marketing orientation
 Strong ego.

While new promoters and technocrats are being encouraged, care is taken to ensure that all
the aspects of managing an industrial enterprise have been carefully considered. The
promoters are appraised by the institutions to ensure that they have the requisite
resourcefulness, undertaking, commitment and ability to manage the unit.

The resourcefulness of the promoters is gauged from their business experience, organization
of offices, know-how, approvals and sanctions required for the project and the ability to
organize and present the project to the institution with the understanding and credibility.

The understanding of the promoters is gauged by the details submitted to the institutions and
the manner in which the additional information sought by the institution is furnished.

The commitment of the promoter is determined from the desire to plan the long term
objectives or be satisfied with short term gains. In addition to these provisions for recruitment
and training requisite personnel in the field of production, administration and management
are assessed. This is shown by he time schedule indicate for implementation of project and
package for the retention of the personnel.
Criteria for Promoters Appraisal:

A. Managerial attributes:
 Ability to plan
 Clarity of goals and objectives
 Ability to organize
 Ability to select right kind of people
 Ability to procure right kind of equipment and spares.
 Ability to direct
 Ability to control
 Knowledge of finance or technology.
 Production ability
 Marketing and sales ability
 Problem solving capability
 Readiness to delegate
 Communication skills
 Human relation skills
 Forecasting skills
 Leadership style
 Ability to co-ordinate
 Consistency
B. Entrepreneurial attributes
 Ability to take calculates risk.
 Commitment to project.
 Perception of market opportunity.
 Willingness to take new challenges.
 Readiness to co-operate.
 Positive self confidence
 Ability to create a following
 Creativity and innovation
 Initiative and drive
 Resourcefulness
 Achievement motivation
 Perseverance and persistence
 Quality consciousness.
 Inquisitiveness.
 Desire to change.
 Absence of dissatisfaction
 Independence in thinking
 Flexibility and adaptability
 Attitude to ambiguity
 Learning from failure
 Cohesiveness
C. Personal Attributes
 Appearance
 Level of education
 Business experience
 Experience relevant to project being financed.
 Technical capacity
 Maturity
 Ability to get along with others
 Financial support and stability
 Supportive family background
 Ability to get along with others
 Financial support and stability
 Supportive family background
 Ability to raise finance from outside resources.
 Social, economic and industrial awareness.
 Resourcefulness
 Intelligence
 Patience
 Honesty and noble mindness.
PROJECT RISK

Two main sources of risk:

 Business Risk
 Financial Risk

A project should ideally have the ability to raise further capital from any source it wishes to
tap to meet the future financing needs.

Sensitivity analysis is a popular method used for assessing risk. Risk analysis of a project is
one of the most complex areas in finance.
PROJECT APPRAISAL BY FI`S

A project report is essential before decision for setting up of any project is taken. We have
seen that an entrepreneur must study all the aspect of the project including the product to be
manufactured. An assessment of the total cost of the project and proposed means of financing
with emphasis on overall profitability of the project is necessary. Project report must
therefore include all these information and cover entire aspects of a project to stand scrutiny
by financial institutions who shall appraise the project from the following angles before
taking any decision to grant term loans. The feasibility of a project can be ascertained in
terms of technical factors, economic factors or both. A feasibility study is documented with a
report showing all the ramifications of the project. In project finance, the pre financing work
(sometimes referred to as due diligence) is to make sure there is no “dry rot” in the project
and to identify project risks ensuring they can be mitigated and managed in addition to
ascertaining “debt service” capability.

TECHNICAL FEASIBILITY

Technical feasibility refers to the ability of the process to take advantage of the current state
of the technology in pursuing further improvement. The technical capability of the personnel
as well as the capability of the available technology should be considered. Technology
transfer between geographical areas and culture needs to be analysed to understand
productivity loss due to differences (see cultural feasibility).

The

 Product mix
 Location
 Land and building
 Capacity
 Process of manufacture- technology employed
 Plant and equipments
 Collaboration
 Manpower requirements and break even point
 Power and water supply
 Effluent disposal
 Implementation schedule

MANAGERIAL FEASIBILITY

Managerial feasibility involves the capability of the infrastructure of a process to achieve and
sustain process improvement. Management support, employee involvement, and commitment
are key elements required to ascertain managerial feasibility.

 Focus on larger social point of view

 Methodology adopted is referred to as the social cost benefit analysis
 Assessing understanding of the promoters.
  Quality of the management
 Assessment of the entrepreneur, board of directors, chief Executive and departmental
heads.

ECONOMIC FEASIBILITY

This involves the feasibility of the proposed project to generate economic benefits. A benefit-
cost analysis and a break even analysis are important aspects of evaluating the economic
feasibility of new industrial projects. The tangible and intangible aspects of a project should
be translated into economic terms to facilities a consistent basis for evaluation.

FINANCIAL FEASIBILITY

Financial feasibility should be distinguished from economic feasibility. Financial feasibility

involves the capability of the project organization to raise the appropriate funds needed to
implement the proposed project. Project financing can be a major obstacle in large multi-
party projects because of the level of capital required. Loan availability, credit worthiness,
equity and loan schedule are important aspects of financial feasibility analysis.

 Assessing reasonableness of the estimate of capital cost.

 Assessing reasonableness of the estimate of working results
 Assessing adequacy of rate of return: (general norms :- IRR – 15%, ROI – 20-25%
after tax and DSCR – 1.5 to 2 )
 Assessing appropriateness of the financing pattern : (general debt – equity ration norm
of 1.5:1, promoter’s contribution – 12.5% to 22.5% of project cost etc.)

CULTURAL FEASIBILITY

Cultural feasibility deals with the compatibility of the proposed project with the cultural setup
of the project environment. In labour intensive projects, planned functions must be integrated
with the local cultural practices and beliefs. For example, religious beliefs may influence
what an individual is willing to do or not do.

SOCIAL FEASIBILITY

Social feasibility addressed the influences that a proposed project may have on the social
system in the project environment. The ambient social structure may be such that certain
categories of workers may be in short supply or non existent. The effect of the project on the
social status of the project participants must be assessed to ensure compatibility. It should be
recognized that workers in certain industries may have certain status symbols within the
society.

SAFETY FEASIBILTY

Safety feasibility is another important aspect that should be considered in project planning.
Safety feasibility refers to an analysis of whether the project is capable of being implemented
and operated safely with minimal adverse effects on the environment. Unfortunately ,
environmental impact assessment is often not adequately addressed in complex projects.

POLITICAL FEASIBILTY

A politically feasible project may be referred to as a “politically correct project”. Political

considerations often dictate directions for a proposed project. This is particularly true for
large projects with national visibility that may have significant government inputs and
political implications. For example, political necessity may be a source of support for a
project regardless of the projects merits. On the other hand, worthy projects may face
insurmountable opposition simply because of political factors. Political feasibility analysis
requires an evaluation of the compatibility of project goals with the prevailing goals of the
political system.

ENVIORNMENTAL FEASIBILITY

Often a killer of projects through long, drawn out approval processes and outright active
opposition by those claiming environmental concerns. This is an aspect worthy of real
attention in the very early stages of a project. Concern must be shown and action must be
taken to address any and all environmental concerns raised or anticipated. A perfect example
was the recent attempt by Disney to build theme park in Virgina. After a lot of funds and
efforts, Disney could not overcome the local opposition to the environment impact that the
Disney project would have on the historic Manassa battleground area.

MARKET FEASIBILITY

Another concern is market variability and impact on the project. This area should not be
confused with the Economic Feasibility. The market needs analysis to view the potential
impacts of market demand, competitive activities etc. and “divertible” market share available.
Price war activities by competitors, whether local, regional, national or international, must
also be analysed for early contingency funding and debt service negotiations during the start
up, ramp up and commercial start up phases of the project.

Any project can be commercially viable only if it is able to sell its production at a profit. For
this purpose it would be necessary to study demand and supply pattern of that particular
product to determine its marketability. Various methods such as regression method for
estimation of the demand are employed which is then to be matched with the available supply
of that particular product. The prospect of exporting that product may also be examined while
assessing the demand. If the selling of the product is already been tie up with the foreign
collaboration or some of the other users the fact needs to be highlighted. This factor shall
definitely have a positive influence on the commercial viability of the project. Necessary
factors that may influence the supply position such as licensing of new products, introduction
of the new products, changes in the import policy etc. shall be taken into cognizance while
estimating the market potential of any project. This exercise shall be conducted for
sufficiently longer period say 5 to 10 years to determine the continued demand for the
product during the currency of the loan granted by financial institutions. These factors are not
only important from the financial institutions point of view but also help the promoter to take
aright decision in selecting the size of the plant and determining the capacity utilization.

The financial institutions look into following considerations in considering the marketing
appraisal of the project;

 Product, scope of the market, competition.

 Special features, quality and price
 Examining reasonableness of demand projections (existing and future)
 Export facilities
 Assessing adequacy of marketing infrastructure and principal customers
 Judging competence of key marketing personnel
 Selling arrangements
 Trends in price.
SCOPE OF FEASIBILTY ANALYSIS

In general terms, the elements of a feasibility analysis for a project should cover the
following:

Need Analysis

This indicates recognition of a need for a project. The need may affect the organization itself,
another organization, the public or the government. A preliminary study is then conducted to
confirm and evaluate the need. A proposal of how the need may be satisfied is then made.
Pertinent questions that should be asked include:

 Is the need significant enough to justify the proposed project?

 Will the need still exist by the time the project is completed?
 What are the alternate means of satisfying the need?
 What are the economic, social, environmental and political impacts of the need?

Process Work

This is the preliminary analysis done to determine what will be required to satisfy the need.
The work may be performed by a consultant who is an expert in the project field. The
preliminary study often involves system models or prototypes. For technology oriented
projects, artists conception and scaled down models may be used for illustrating the general
characteristics of a process. A simulation of the proposed system can be carried out to predict
the outcome before the actual project starts.

Engineering & Design

This involves a detailed technical study of the proposed project. Written quotations are
obtained from suppliers and subcontractors as needed. Technology capabilities are evaluated
as needed. Product design, if needed, should be done at this time.

Cost Estimate

This involves estimating project cost to an acceptable level of accuracy. Levels of around
-5% to +15% are common at this level of project plan. Both the initial and operating costs are
included in the cost estimation. Estimates of capital investment and of recurring and
nonrecurring costs should also be contained in the cost estimate document.

Sensitivity Analysis

It can be carried out on the estimated cost values to see how sensitive the project plan is to
the estimated cost values.

Financial Analysis
This involves an analysis of the cash flow profile of the project. The analysis should consider
rates of return, inflation, sources of capital, payback periods, breakeven points, residual
values and sensitivity. This is critical analysis since it determines whether or not and when
funds will be available to the project. The project cash flow profile helps to support the
economic and financial feasibility of the project.

Project Impacts

This portion of the feasibility study provides an assessment of the impact of the proposed
project. Environmental, social , cultural , political and economic impacts may be some of the
factors that will determine how a project is perceived by the public. The value added potential
of the project should also be assessed. A value added tax may be assessed based on the price
of a product and the cost of the raw material used in making the product. The tax so collected
may be viewed as a contribution to government coffers.

Conclusions and Recommendations

The feasibility study should end with the overall outcome of the project analysis. This may
indicate an endorsement or disapproval of the project. Recommendations on what should be
done should be included in this section of feasibility report.
COST OF THE PROJECT

It is very important to estimate each constituent of the project cost with utmost care. As far as
possible, the estimate should be based on the supporting data. Care should be taken to ensure
sufficient cushion for the unforeseen factors as well as for the as well the inflationary trends.
The cost of the project is estimated after assessing the critical process parameters and the
suitability of the technology for manufacturing the proposed product under Indian Scenario.

CRTICAL FACTORS AFFECTING THE COST OF THE PROJECT:

PRODUCTION TECHNOLOGY

Suitability of the technology needs to be evaluated in terms of the soundness, raw material
capital investment involved, cost of production and absorption capacity of the promoters,
during the appraisal the institution may insist on visiting the site using same or similar
technology to evaluate its feasibility and longevity.

RAW MATERIAL AND INPUTS

Raw material used for manufacturing should be easily available preferably under OGL (Open
General License)

CAPITAL AND PRODUCT MIX

The capacity of the unit should be so planned that the cost of the production of the product is
optimal. The plant capacity should be so installed to ensure maximum profitability. The
installed capacity should also have the flexibility for the future expansion and diversification
at the minimal additional capital expenditure.

Broad Heads of the Cost of the Project:

 Land, location and site development

 Building and civil work
 Plant and machinery
 Technical know how and engineering fees/ royalty.
 Miscellaneous fixed assets
 Utilities
 Preliminary and pre- operative expenses
 Provision for contingencies
 Margin money for working capital
NORMS AND POLICIES OF FINANCIAL INSTITUTION

ELIGIBILITY

 Till recently, long term loans were provided to concern in certain industries only and
denied to concerns in industries placed on the negative list.
 Gradual shift in policy.
 Currently, inclination of FI’s to finance almost every kind of industry.

DEBT- EQUITY RATIO

One of the important factors which determine the components for the financing of a project is
the debt – equity ratio. These are certain guide lines prescribed by IDBI for debt equity ration
for different category of industries. They are;

 General debt – equity norm for medium and large scale proportion is 2:1
 General debt – equity norm for small scale projects is 3:1

However it has been learnt that financial institution these days require debt equity ration of
1.5:1 for medium to large scale industries.

PROMOTERS CONTRIBUTION

FI’s require promoters to contribute 25 to 30% of the project cost. This is lowered selectively
in certain cases like capital intensive projects, high priority projects etc.

The GOVT. of India has classified the location in three categories:

 ‘A’ category : No industry districts

 ‘B’ category: Where Industrial activities have already started.
 ‘C’ category: Where Industrial activity has gained sufficient ground.

The promoter’s contribution may reduce as we move from ‘C’ to ‘A’ in order to promote
industrial growth in backward areas. The promoters contribution is also reduce for the non
MRTP companies.

FOREIGN CURRENCY LOANS

In case of large projects involving heavy capital equipments, foreign currency loans are
emerging as an important source of project finance. The department of Economic Affairs
Govt. of India specifically permits borrowing in foreign currency loans in respect of specific
projects.

Apart from rupee term loans, FI’s also provide foreign currency loans. This assistance is now
provided only for the import of capital equipment.

There are two types of foreign currency borrowings:

 Fixed rate borrowing; funds that can be borrowed on fixed interest rates.
  Floating rate borrowings; funds that can be raised on floating rates of interest.

Fixed rate of borrowings insulate the borrower against the movements in the interest rates.
KEY FINANCIAL INDICATORS USED BY FI’S

INTERNAL RATE OF RETURN (IRR)

Internal rate of return is defined as the discount rate which equates the present value of the
investment in the project to the present value of the future returns over the life of the project.
This is an indicator of the earning capacity of the project and higher IRR indicates better
prospects for the project. The project investment in cash outflow which is assumed to be
negative cash flow and returns are assumed to be positive cash flow. The sum total of the
discounted cash flows shall be zero as above is the IRR.

 Cash outflows and cash inflows of the project taken into the consideration
 Ideally IRR should be 15% or more.

DEBT SERVICE COVERAGE RATIO (DSCR)

Debt service coverage ratio is calculated to find out the capacity of the project servicing its
debt i.e. in repayment of the term borrowing and interest. The Debt service coverage ratio is
worked out in the following manner.

DSCR= Net PAT + Depn. + Interest on Long term borrowing

(Repayment of term borrowing during the year + Interest on

Long term borrowing)

The higher DSCR would impart intrinsic strength to the project to repay its term borrowing
and interest as per the schedule even if some of the projections are not full realized. Normally
a min. DSCR of 2:1 is insisted upon by the term lending institution and repayment is fixed on
that basis.

BREAK EVEN POINT

Estimation of working results pre supposes a definite level of production and sales and all
calculations are based on that level. It may, however, not to possible to realise those level at
all times. The minimum level of production and sale at which the unit will run on ‘no profit
no loss’ is known as break – even point can be expressed in terms of volume of production or
as percentage of plant capacity utilisation.

The cost of production may be divided in two parts as under:

Fixed Costs: These costs are not related to the volume of production and remain constant
over a period of time. Examples of such costs include rent of building, depreciation, interest
on term loans etc, salaries of permanent employees etc.

Variable Costs: These costs have direct relationship with the column of production. The cost
will increase with any increase in the level of production. Examples of such costs include raw
material, fuel and power, wages, packaging etc.
SENSITIVITY ANALYSIS

It may also be sometimes necessary to carry out sensitivity analysis which helps in
identifying elements affecting the viability of project taking into account the different sets of
assumptions. While evaluating profitability projections, the sensitivity analysis may be
carried in relation to changes in the sale price and raw material costs, i.e. sale price may be
reduced by 5% to 10% and raw material costs may be increased by 5% yo 10% and the
impact of these changed on DSCR. If the new DSCR, so calculated after changes, still proves
that the project is viable, the financial institution may go ahead in funding the projects.

NET PRESENT VALUE

The Discounted Cash Flow (DCF) Technique which is more commonly known as Net
Present Value method (NPV) takes into account the time value of money for evaluating the
cost and benefits of a project. It recognises that streams of cash inflows at different points of
time differ in value. A sound comparison among such inflows and outflows can be made only
when they are expressed in terms of common denominator i.e. present values. For
determining present values, an appropriate rate of discount is selected and the cash flow
streams then are converted into present values with the help of rate of discount so selected. If
NPV is positive (i.e. difference between present values of inflows and outflows) the project is
taken to be viable and as such proceeded with otherwise not.

Other indicators ( Debt equity Ratio, Current ratio, Profit margin on sales, Return on owners
equity, ROI after taxes, ROI before taxes)

OTHER INDICATORS

 Profit margin on sales = Net profit after tax / sales

 Return on owners equity= Net profit after tax / promoters cont. + S / L
 Debt – equity ratio = Long term Debt / equity
 Current Ratio = Current assets / current liabilities
 ROI before taxes = PBT + Depn. + Interest / project cost
 ROI after taxes = PAT + Depn. + Interest / project cost