Project Finance – A Primer
It is the funding of projects related to infrastructure and industrial sectors.
What is project finance?
Project finance is funding projects related to infrastructure and industrial sectors based on the project's projected cash flows rather than the sponsor's financial statements.
This helps sponsor new investments by organizing the funding around the project's cash flow from operations and assets without further guarantees from external parties.
Thus it can ease investment risk and increase finance at a relatively low cost, to the benefit of sponsors and investors alike.
Typically, a special purpose entity (SPE), called a special purpose vehicle(SPV), is made for each project invested in; this mitigates the risks of project failure by guarding the other assets of the project sponsor.
This finance more or less holds a greater degree of complexity than other finance methods. It is used in mining, industry, infrastructure, telecommunications, and entertainment.
understanding project finance
Long-term financing of infrastructure, industrial, telecommunications, mining, and public services projects using a financial structure that limits recourse.
The capital used to fund the project is expected to be repaid using the cash flow generated from the project.
This financial structure is most appropriate for the mining, electricity, and infrastructure sectors.
The low risk of technological obsolescence, ease of predicting the market, and the chance of selling to a few large buyers make these sectors ideal for this non-recourse financial structure.
This type of financial structure is non-recourse. In non-recourse financing, the lender of a loan can only receive repayment from the profits generated by the project. This helps protect the personal assets of the sponsor.
As a result, the maximum penalty the debtor can have is the seizure of the assets by the lenders.
The money made by the Special Purpose Entity must be enough to finance operating expenses and repay lenders' debt. After these costs are met, the remaining profit is divided among the sponsors.
Why is Project Finance used?
The benefits of following this structure are that it lowers the financial risk to all parties involved in the project, such as investors, sponsors, lenders, etc., making investing safer.
Imagine a project sponsor named ABC limited. This company plans to enter a project to build highways in country XYZ. A compelling argument for the company to use this finance is that the project's risks will remain separate from its current business operations.
If the project were to fail, this would not put the current business of the sponsor at risk. On the contrary, in most cases, it will safeguard the sponsor's capital and debt capacity and allow the project to be financed with more money than if a corporate finance structure was implemented.
Additionally, it also increases the availability of capital for the project. For example, if company ABC were to build an underground tunnel from New York to London, it would simply be too expensive for one company.
A project finance structure ensures that more capital is available for the project because money can be pulled in from many participants and all parties feel less at risk.
Why is technical feasibility important in project management?
When various parties come together to draft a project plan, the project must essentially be technologically feasible. Therefore, various factors must be considered, including infrastructural needs, bureaucratic needs, technical methods used, and availability of machinery and resources.
An advanced infrastructure level includes transportation, the availability, and cost of labor, access to water and power, etc. Without easy access to resources needed to work on the project, the project would be too difficult to finance.
Bureaucratic requirements must also be met. A high amount of paperwork and bureaucratic restrictions on a project will make completing the project's deadlines difficult.
Licensing requirements can discourage a project. For example, if several parties come together to start a gold mining project in country A, but country A imposes high restrictions and stringent registration requirements for gold mining, this project would be risky.
The technical process is essential, and the projects selected must either be available or within reach of the parties involved. Furthermore, technological processes must be feasible regarding cost and money.
There must also be an availability of the resources needed. These resources might include raw materials, electricity, fuel, machinery, etc. Supplies would be procured either indigenously or from an external party to ensure that the project runs smoothly.
What parties are involved in financing a project?
This finance is a complicated concept and is often more complex than other financing methods. Numerous parties are involved in a project, and each has an important role in helping construct and maintain the project.
It is of paramount importance to consider the project corporation itself. This company will develop, manage, and maintain the project. These kinds of corporations generally exist as SPEs (Special Purpose Entity). They are seen as legal entities within the laws of the nation/nations where the project is being developed.
The sponsors are the investors and owners of the project who have given up their capital, hoping for a return on their capital from the project. The sponsors can either be an individual, a company, or a variety of sponsors.
There can be various sponsors, such as industrial sponsors, public sponsors, contractors, or financial investors.
The lenders of the project play an important role as well. Individuals, companies, financial institutions, banks, or even governments may offer loans to the project company in exchange for interest on the principal amount.
The suppliers provide raw materials, machinery, water, food for labor, or any other essential resource required for the project in return for payment, which is recorded as an expense on the project company’s income statement.
Finally, there is the host government. This is the government of the country in which the project is taking place. Some projects might have multiple host governments. An example is the English Channel tunnel.
Theoretically, the host government dictates registration and licensing requirements but, in reality, is pressured by powerful foreign companies to bend to their will.
The host government might try to aid the project, offer tax subsidies, low bureaucratic requirements, etc., and might even be involved as a supplier.
Sometimes host governments might be hostile to foreign entities financing the project, impose high taxes and bureaucratic shackles, and even try to nationalize the project.
corporate finance Vs. project finance
Corporate finance is an area of finance that deals with how corporations finance their operational needs to maximize income and minimize costs. Corporate finance covers both the short-term and long-term financial needs of the firm.
The overall financial health, balance sheet, and income statements are used to evaluate financial performance in corporate finance. In addition, project feasibility analysis, project asset value, and forecasted cash flow are used in this finance.
Corporate finance also holds more risk, as a bad venture might put the company's assets at risk of being seized. In project finance, only the cash flows and assets of the project are used as collateral.
In corporate finance, the returns would be moderate as the risk is generally lower, and in contrast, the risk in project finance is high, which could typically mean higher returns.
The purpose of the corporate finance model is to ensure that available resources are being used to their optimal capabilities so that shareholders gain satisfactory returns. Therefore, it is beneficial when the company has various investments with a similar risk profile.
The success or failure of these ventures would show in the company's balance sheet directly. The company's assets are seen as collateral and can be seized by lenders in the event of a debt default.
In project finance, the project risks and rewards are shared by many entities, and they do not spill over to other entities except for the degree of participation in the project.
In contrast to corporate finance, project finance has little or no impact on the sponsor corporation's balance sheet because lenders' right to claim the assets in the event of debt default is restricted to cash flow generated from the project. The lender can claim assets if those are insufficient to repay the loans.
What are the steps to finance a project?
Not all projects are the same; some might have a huge budget and rigorous maintenance and tracking requirements. Establishing a budget and calculating project costs are both parts of project financial planning.
The goals and objectives for your project will build on the initial purposes outlined in the business plan. At this step, you will give finer detail to the initial broad ideas and set them in a project charter as reference points for your project as it proceeds.
Within your team, everyone should know what their role is and who is responsible for different elements of the project. Assigning tasks should remove any uncertainty about roles and responsibilities on your team.
Among the many advantages of financial planning are the ability to estimate profits, lower financial risk, and prepare for unforeseen costs.
Planning begins with estimating the project's cost using either top-down or bottom-up methods.
The first and most essential step would be to estimate the project's costs. This may sound simple at first but can get very complicated, especially regarding large projects.
Several things must be forecasted, such as the total number of employees, machinery, raw materials, and other resources needed to complete the work. All these expenses must be recorded along with additional costs, such as licensing, transportation, etc.
A budget helps establish financial stability. By tracking expenses and following a plan, a budget makes it easier to manage the project's finances.
A budget needs to be created when costs have been estimated. The budget outlines how the funds are distributed following the financial policies of your SPV.
The SPV or SPE is an affiliate of a parent company that purchases assets from its balance sheet.
By luring independent equity investors to aid in the purchase of debt obligations, the SPV gives the original parties access to more capital.
The budget displays the expenses, the allocation of capital and funds, etc. Ultimately the project costs have to be covered within the budget.
Project estimates are seldom entirely accurate. Costs might exceed the original budget, and a contingency budget should be made in such cases.
The amount set aside for contingency and the specifics of what it is meant to cover may be described in documents or left to the project manager's decision.
When contingency is not explicitly stated but is nonetheless ensured through methods like increasing the number of days given for a project's component, this practice is frequently referred to as padding.
A contingency budget must be calculated after estimating the uncertainty. For example, if you counted your project to be $10,000 with 90% confidence, you could also ask for a $1000 contingency budget to represent the uncertainty.
The $1000 can be accessed if the original budget was underestimated or if some circumstance compels you to seek more funds. Unfortunately, not all companies allow contingency budgets, and this has to be decided upon by the involved parties.
The next phase is tracking the costs of the project. Every expense must be counted, starting from the fuel used for transportation to the electricity used by laborers. Important expenditures must be approved so the project can be within budget.
Cash flow management is crucial in project finance. First, ensure your sponsors have approved the work ahead of time, and that sufficient resources are available for the project. Then track the spending periodically.
The actual status of both expenses and forecasted expenses should be reported. If the project exceeds the budget, it is essential to manage your expectations.
Cash Flow management in a project can be complex but is one of the most important components in ensuring the project company does well and completes tasks within the given deadlines.
Conclusion
Project finance is a means of financing projects that are generally too costly of a risk for one corporation to take alone. Therefore, these initiatives are handled as separate entities from their parents throughout their lifespan.
For the parent, a project finance venture is entirely an off-balance sheet entity. As a result, all finance obtained by this entity must be paid back only from cash flow and from its assets.
Even if the venture is unfruitful, the parent's assets cannot be seized to cover the project's debts.
It is frequently used in the real estate, mining, telecommunication, and power industries, to mention a few.
There are two main types of project finance jobs; the first is lending.
The projects can be funded by loans from banks or other lenders, public debt, or equity invested by the original parties involved.
Regarding it as a career, there are two main types of jobs. Lending jobs and advisory jobs. Lending jobs deal with providing finances for the project, whereas advisory jobs offer advice on the project.
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