Project Finance

PROJECT FINANCE
Mukesh Ahuja
MBA III
Apeejay Institute of Management
Jalandhar
INTRODUCTION
O With a view to harnessing advancements in

S&T to economic development, GoI laid
emphasis on industrialisation through
successive Five Year Plans.
O Rapid industrial development needed massive
investment.
O Prior to independence, there were no
institutional arrangements for term finance.
INTRODUCTION
O GoI, therefore, established the following

financial institutions:
O Indl. Finance Corporation of India (1948)
O Indl. Credit & Inv. Corpn. of India (1955)
O Indl. Development Bank of India (1964) &
O Indl. Reconstruction Bank of India (1971)
O Similarly, State Governments also established

SFCs in their respective states.
INTRODUCTION
O For long, commercial banks confined their

lendings to meet WC requirements only and
they did not play any active role in extending
term finance.
O However, with increasing proportion of Term
Deposits in their deposit portfolio and the
paucity of resources in the country, it was felt
that banks could enter the field of term
finance, in a role complementary to that of
Term Lending Institutions.
PROJECT BACKGROUND
O The purpose of term assistance is to meet a

part of the capital expenditure of a project.
O A project can be defined as ¶A scheme of
things to be done during a specified period in
future for deriving expected benefits under
certain assumed conditions·.
O A project may be in the nature of setting up a
new industrial unit, modernisation, expansion,
diversification and promotion of R&D.
PROJECT BACKGROUND
O To set up a project, certain capital
expenditure needs to be incurred in acquiring
assets such as L&B, P&M and other
infrastructural facilities like roads, water
supply, railway sidings, etc., in addition to the
Preliminary / Pre-Operative Expenses and
margin on WC Limits.
O Where promoters of a project are unable to
meet the entire capital expenditure out of
their own resources, Term Loans are
sanctioned to supplement the promoters·
contribution.
PROJECT BACKGROUND
O Promoters of an industrial project can

constitute themselves into any of the
following forms of business organisations to
implement the project : Sole Proprietorship,
JHF, Partnership, Co-operative Society & Joint
Stock Company.
O Our discussion of the subject would revolve
around Joint Stock Company as promoter.
PROJECT BACKGROUND
O The Promotion Stage is a crucial stage in the

entire life cycle of a project. Promotion in
relation to a project will comprise broadly the
following functions:
O I] Identification of a project
O II] Feasibility investigation
O III] Assembling the proposition

O IV] Financing the proposition
I] Identification of a Project
O The first step in the project promotion is the

identification of a project. An industrial
project originates as an idea in a promoter
when he observes the existence of a potential
market for a certain product.
O The promoter, on the basis of his experience,
background and ability, then considers the
feasibility of manufacturing and marketing the
product at a remunerative price.
O There should be an unsatisfied demand.
II] Feasibility Investigation
O A detailed feasibility study is a costly exercise.
It is, therefore, desirable that, before it is
undertaken, marketability of the product to
be manufactured is firmly established.
O There are agencies, specialising in market
research, which conduct such market studies.
Promoters may take advantage of their
services.
OA market study aims at assessing the
aggregate demand for a product.
O The promoter will now undertake the detailed

feasibility investigation proper, comprising
two feasibility studies:
O i) The Technical Feasibility Study
O ii) The Economic Feasibility Study

- Technical Feasibility
O Technical Feasibility Study covers the
following aspects:
O Location of the project
O Lay-out of the Plant
O Size of the Plant
O Factory construction
O Manufacturing process / Technology
O Process Design
O Product Design
O Scale of Operation
O Infrastructural facilities
- Economic Feasibility
O The prime objective of setting up a project is
to derive a fair return on the investment.
O Economic Feasibility Study, therefore,
concerns itself with matching of economic
resources with the physical requirements of a
project and determining the viability of
investment therein.
III] Assembling the Proposition
- CoP & MoF
O When a promoter is satisfied about the
technical feasibility and economic viability of
a project, the next task is to work out the
Cost of the Project and the Means of financing
it.
O The Cost of the Project would broadly include:
(a) L&B (b) P&M (c) Misc. Fixed Assets (d)
Technical Know-how, Engg. & Consultancy
fees (e) Preliminary and Pre-operative
expenses (f) Provision for contingencies (g)
Margin on WC Limits
IV] Financing the Proposition
O Setting up of a project involves acquisition of

Fixed Assets which facilitate the process of
production. Fixed Assets have a relatively
longer life and are generally not meant for
resale. They are required to be retained over
a period of time to exploit their productive
potential.
O C/A go through the operating cycle of RM, WIP
and FG, which when sold bring in cash. This
cycle is generally completed in a short period
of less than one year.
O Thus, investment in C/A is realised over a

short term, while investment in Fixed Assets is
long term in nature.
O It is realised through surplus generated in the
form of Net Profits, Depreciation and other
non-cash write-offs.
O As it takes a long time for the Fixed Assets to
pay for themselves, the promoter should raise
suitable long term funds to finance a project.
O Keeping the foregoing in view, the promoter

will explore the financial feasibility of the
project by examining
O a) The possible long term sources of finance
O b) The feasible financial leverage
O c) The expected return on the investment


M M
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hare apita etaine arnings eentres er oans Ps P ic eposits
it Preerence
- Long Term Sources
O The aggregate amount of finance raised for
financing a project is referred to as Capital,
comprising two components ² (a) Owned
Capital and (b) Borrowed Capital.
O The other sources of long term funds are:
(a) Capital Subsidy applicable to projects
coming up in certain notified backward areas,
and (b) Interest free sales tax loans offered by
State Governments.
- Financial Leverage
O After considering availability of long terms
sources of finance, the promoter will decide
about a suitable financial structure for the
Company.
O It will depend upon the financial leverage
envisaged in the combination of sources of
finance under the two categories, viz., Owned
Capital and Borrowed Capital.
O Few projects can be financed entirely by
equity or debt.
- Financial Leverage
O The divergent interests of debt and equity are
brought into alignment by the concept of Debt
/ Equity gearing which determines the level of
debt that can be supported by a given
quantum of equity.
O For this purpose, Debt means Funded Debt
including all term liabilities and equity will
include Share Capital and retained earnings, if
available.
O No standard D/E Ratio can be prescribed.
- Return on Investment
O The amount invested in a project can be

recouped through annual cash flows, over a
period of time.
O In arriving at a financial plan for the project, a
promoter will examine the attractiveness of
the project, alternative sources of
investment.
O The process which assists the management in
such a task is collectively known as ¶Capital
Investment Evaluation·.
O The most important and widely used Capital
Investment Evaluation techniques are:
O Pay-back Method
O Net Terminal Surplus Method
O Excess Present Value Method
O Internal Rate of Return Method

O The object of Pay-back Method is to find out
the period of time required for recovering the
entire amount of investment made in a
project.
O The cash flows (Net Profit + Depreciation +
Other non-cash write-offs) are compared with
the outlay on the project to determine the
pay-back period. Years to pay back would be:
Total Investment
Cash Flow per annum
O Net Terminal Surplus Method employs the
concept of compounding which involves
re-investing the simple interest earned each
year along with the principal so that the
principal grows each year by the amount of
interest earned during the previous year and
interest being calculated on the increased
principal also grows.
O Future Value = Principal x (1+i)±
O Excess Present Value Method is based on the
discounted cash flow technique and uses the
concept of discounting which is just the
opposite of compounding.
O In discounting, we arrive at the Present value
of a future sum to which the original amount
(which we want to find out), invested at a
particular compound rate of interest has
grown.
O PV = Future sum
(1+i)±
O Internal Rate of Return Method ² It is that rate
at which the sum of the discounted cash flows
is equal to the investment outlay. In other
words, IRR is the rate which makes the
Present Value (PV) of benefits equal to the
Present Value of costs or reduces the Net
Present Value (NPV) to zero. The object of
this method is to find the rate of return which
a project is likely to earn over its useful life.
O IRR = Lower Discount Rate + Diff. Between the two discount rates x NPV at lower discount rate
Abs. diff. between the two NPVs.
Types of Term Assistance
O The types of term assistance extended by the

Bank can be broadly classified into:
O I] Term Loans (Incl. Forex Loans)
O II] Deferred Payment Guarantees
O III] Bill Discounting Facilities
O IV] Underwriting of Shares / Debentures

-Term Loan
O A Term Loan is a loan granted for a fixed term
of not less than one year, intended normally
for financing fixed assets acquired / to be
acquired, carrying interest at a specified rate,
and scheduled for repayment in instalments.
O Depending on the term for which the said
terms loans are granted, they could be
classified into (a) Short Term Loans (b)
Medium Term Loans and (c) Long Term Loans.
-DPG
O Deferred Payment Guarantee (DPG) is a
contract to pay to the supplier the price of
machinery, supplied by him on deferred
terms, in agreed instalments with stipulated
interest on the respective due dates in case of
default in payment thereof by the buyer.
O A DPG is, in many respects, a substitute for a
Term Loan and, as far as the buyer of P&M is
concerned, it serves the same purposes as a
Term Loan.
O Standards of appraisal are the same as TL.
- Bills Discounting
O Under a contract for sale of machinery on
deferred payment basis, the balance
remaining to be paid after the initial down ²
payment represents the deferred receivables
of the seller.
O Thus, the funds of the seller get blocked for
unduly long periods and the seller requires
finance against such deferred receivables to
replenish his Working Capital.
- Bills Discounting
O To facilitate availment of finance against the
deferred receivables, the seller usually draws
a series of usance bills with graded maturities
to coincide with the due dates of payment of
the relative instalments (including applicable
interest).
O The usance bills drawn by the seller will be
accepted by the buyer before they are
discounted by the seller·s banker.
- Underwriting of Shares
O The necessity for underwriting arrangement
arises only in the case of a Public Limited
Company resorting to raise through the capital
issue market, a part of the Share Capital for
part-financing a project.
O Underwriting is a contract whereby a person
agrees, in consideration, to take up a
specified number of shares or debentures or
amount of debenture stock to be offered to
the public, in the event of the public not
subscribing for them.
- Underwriting of Shares
O Underwriting as a business will come under the scope
of ¶Investment Banking· as distinct from ¶Commercial
Banking·.
O In view of this, therefore, a high degree of selectivity
should continue to be exercised in undertaking
underwriting business.
O However, the business stemmed not so much from
the point of view of earnings on the investment as
from the consideration that no viable project
enjoying national priority should suffer for want of
underwriting support.
Project Appraisal
O The purpose of Project Appraisal is to

ascertain whether the project will be sound ²
technically, economically, financially and
managerially ² and ultimately viable as a
commercial proposition.
O The appraisal of a project will involve the
examination of:
O a) Technical Feasibility : To determine the
suitability of the technology selected and the
adequacy of the technical investigation, and
design.
Project Appraisal
O b) Economic Feasibility : To determine the

conduciveness of economic parameters to setting up
the project and their impact on the scale of
operations.
O c) Financial Feasibility : To determine the accuracy
of cost estimates, suitability of the envisaged pattern
of financing and general soundness of the capital
structure.
O d) Commercial Viability : To ascertain the extent of
profitability of the project and its sufficiency in
relation to the repayment obligations pertaining to
term finance.
Project Appraisal
O e) Managerial Competency : To ascertain that

competent men are behind the project to
ensure its successful implementation and
efficient management after commencement of
commercial production.
O A project should also be examined, wherever
appropriate, from the point of view of its
value to the national economy in terms of
socio-economic benefits like generation of
employment opportunities, forex earnings, the
quantum of import substitution, etc.
Project Appraisal
O The first step in Project Appraisal is to find out

whether the project is a acceptable by
examining salient features such as:
O The background and experience of the applicants,
particularly in the proposed line of activity
O The potential demand for the product
O The availability of the required inputs, utilities and
other infrastructural facilities
O Whether the project is in keeping with the priorities,
if any, laid down by the Government.
Project Appraisal
O The original application may not contain all

the basic data / information. In such cases, it
may be necessary to interview the applicants
and elicit all the necessary data / information
with a view to forming an overall idea about
the general feasibility of the project.
O After satisfying itself about the a
acceptability of the project, the Branch should
call for from the promoters, an ¶Application·,
containing the following essential data /
information, such as:
Project Appraisal
O a) Particulars of the project along with a copy

of the Project Report furnishing details of the
technology, manufacturing process,
availability of construction / production
facilities, etc.
O b) Estimates of cost of the project detailing
the itemised assets acquired / to be acquired,
inclusive of Preliminary / Pre-operative
Expenses and WC margin requirements.
Project Appraisal
O c) Details of the proposed means of financing

indicating the extent of promoters· contribution, the
quantum of Share Capital to be raised by public
issue, the composition of the borrowed capital
portion with particulars of Term Loans, DPGs, Foreign
Currency Loans, etc.
O d) WC requirements at the peak level (i.e., when the
level of Gross Current Assets is at the peak) during
the first year of operations after the commencement
of commercial production and the banking
arrangements to be made for financing the WC
requirements.
Project Appraisal
O e) Project Implementation Schedule.

O f) Organisational set up along with a list of
Board of Directors and indicating the
qualifications, experience and competence of
(i) The key personnel to be in charge of
implementation of the project during the
construction period and (ii) The executives to
be in charge of the functional areas of
purchase, production, marketing and finance
after commencement of commercial
production.
Project Appraisal
O g) Demand projection based on the overall

market prospects together with a copy of the
market survey report.
O h) Estimates of sales, CoP and profitability.
O i) Projected P&L Account and B/S for the

operating years during the currency of the
Bank·s term assistance.
O j) Proposed amortisation schedule, i.e.,
repayment programme.
Project Appraisal
O k) Projected Funds Flow Statement covering

both the construction period and the
subsequent operating years during the
currency of the Term Loan.
O l) Details of the nature and value of the
securities offered.
O m) Consents from the Government / other
authorities and any other relevant
information.
Project Appraisal
O In respect of existing concerns, in addition to

this information, particulars regarding the
history of the concern, its past performance,
present financial position, etc., should also be
called for.
O The ¶Application· completed in all respects
and duly signed by the authorised signatories
of the Company will form the basis for the
detailed appraisal of the project.
Project Appraisal
O An inspection of the project site (or factory in

the case of existing units) is a must.
O Each project has to be examined in proper
perspective having due regard to its nature,
size and scope.
O Although the basic techniques employed for
appraising the viability of various projects are
more or less the same, there could be no
standard or uniform approach for appraising
all projects.
Project Appraisal
O The ultimate objective of the appraisal

exercise is to ascertain the viability of a
project with a view to ensuring the repayment
of the borrower·s obligations under the Bank·s
term assistance.
O Therefore, it is not so much the quantum of
the proposed term assistance as the prospects
of its repayment that should weigh with the
Branch while appraising a project.
Project Appraisal
O In project appraisal, nothing should be

assumed or taken for granted.
O All the data / information should be checked
and, wherever possible, counter-checked
through inter-firm and inter-industry
comparisons.
O It should be borne in mind that ´Healthy
scepticism is a cardinal virtue in project
appraisal.µ
Project Appraisal Memorandum
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Project Finance

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PROJECT FINANCE

O With a view to harnessing advancements in

O GoI, therefore, established the following

O Indl. Reconstruction Bank of India (1971)

O Similarly, State Governments also established

O For long, commercial banks confined their

O The purpose of term assistance is to meet a

O Promoters of an industrial project can

O The Promotion Stage is a crucial stage in the

O III] Assembling the proposition

O The first step in the project promotion is the

O The promoter will now undertake the detailed

O ii) The Economic Feasibility Study

O Setting up of a project involves acquisition of

O Thus, investment in C/A is realised over a

O Keeping the foregoing in view, the promoter

O b) The feasible financial leverage

O c) The expected return on the investment

hare apita etaine arnings eentres er oans Ps P ic eposits

O The amount invested in a project can be

O Internal Rate of Return Method

O The types of term assistance extended by the

O IV] Underwriting of Shares / Debentures

O The purpose of Project Appraisal is to

O b) Economic Feasibility : To determine the

O e) Managerial Competency : To ascertain that

O The first step in Project Appraisal is to find out

O The original application may not contain all

O a) Particulars of the project along with a copy

O c) Details of the proposed means of financing

O e) Project Implementation Schedule.

O g) Demand projection based on the overall

O i) Projected P&L Account and B/S for the

O k) Projected Funds Flow Statement covering

O In respect of existing concerns, in addition to

O An inspection of the project site (or factory in

O The ultimate objective of the appraisal

O In project appraisal, nothing should be

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