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Project Finance Modelling
A- Introduction to project finance
B- Design Principles and Best Practice
C-Time Management
D- Building the Model
E- Financial statements analysis and valuation for project finance
F- Cash Flow Cascade and Reserves
G- Project Ratios
H- Model Flexibility - Scenario Management
I- Project finance sources of funds
J- Project finance risks and mitigates
Project Finance Modelling Objective.
• Overall objective is to teach more complex project finance theory and concepts
through modelling.
• Don’t use really big template models. Instead work from blank sheet and
understand sophisticated issues.
• Understanding the modelling concepts is much more important than typing
formulas in excel.
What is the Project Finance?
Project Finance is typically defined as limited or non-recourse Financing of a new project through separate incorporation of vehicle or Project Company.
It involves non-recourse Financing of the development and construction of a particular project.
The lender looks at project revenues generated for the repayment of its loan, and project assets as collateral for its loan rather than to the general credit of the project sponsor.
Understanding the rationale for project Financing, how to prepare the Financial plan, assess the project risks, design the Financing mix, and raise the funds.
Understand the cogent (intellectual, powerful) analysis of why some project Financing plans have succeeded while others have failed.
Involves the creation of a legally independent project company financed
with:
• Non or limited recourse debt
• Equity provided by one or more sponsors
• Providers of the funds look primarily to the cash flow from the project as the source of funds to pay back the
loans (interest & principal) and to provide the return on the equity invested in the project
• Project finance is the analysis of the complete life-cycle of a project.
• Typically, a cost-benefit analysis is used to determine if the economic benefits of a project are larger than the economic costs.
Involves the creation of a legally independent project company financed
with:
• The analysis is particularly important for long-term projects of Growth CAPEX.
• The first step of the analysis is to determine the financial structure, a mixture of debt and equity, that will be used to finance the project.
• Then identifying and valuing the economic benefits of the project will produce and determine if the benefits outweigh the costs.
Principle Features of Project Finance
• Separate Legal Entity
• Equity Sponsorship
• Contractual Arrangements
• Debt Financing
• Non or Limited Recourse
Characteristics of Project Financing.
•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.
The Important Characteristics Of Project Financing.
1. Non-Recourse
The typical project Financing involves a loan to enable the sponsor to construct a project where the
loan is completely “nonrecourse” to the sponsor.
i.e., the sponsor has no obligation to make payments on the project loan if project revenues are insufficient to cover the principal and interest payments on the loan.
In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project.
The Important Characteristics Of Project Financing.
2-Off-Balance-Sheet Treatment
Depending upon the structure of a project financing, the project sponsor may not be required to
report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor.
Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.
The Important Characteristics Of Project Financing.
3. Maximize Leverage
In a project financing, the sponsor typically seeks to finance the costs of development and construction
of the project on a highly leveraged basis.
Frequently, such costs are financed using 80 to 100 percent debt.
High leverage in a non-recourse project financing permits a sponsor to put less in
funds at risk,
permits a sponsor to finance the project without diluting its equity investment in the
project and, in certain circumstances.
Also may permit reductions in the cost of capital by substituting lower-cost, taxdeductible interest for higher-cost, taxable returns on equity.
The Important Characteristics Of Project Financing.
4. Maximize Tax Benefits
Project financing should be structured to maximize tax benefits and to assure that all available tax
benefits are used by the sponsor or transferred, to the extent permissible, to another party through
a partnership, lease or other vehicle.
Who Are The Sponsors of Project Finance?
By participating in a project finance venture, each project sponsor pursues a clear objective, which
differs depending on the type of sponsor.
1. Industrial sponsors – They see the initiative as upstream and downstream integrated or in some way as linked to the core business
2. Public sponsors – Central or local government, municipalities and municipalized companies whose aims center on social welfare
3. Contractor/sponsors – Who develop, build, or run plants and are interested in participating in the initiative by providing equity and or subordinated debt
4. Financial sponsors/investors – Plays part of a project finance initiative with a motive to invest capital in high profit deals. They have high propensity of risk and seek substantial return on investments
Five Basic Steps to Finance Your Project
• Identify the Project
• Determine the Feasibility of the Project
• Identify Sources of Technology
• Identify Sources of Project Finance
• Mitigate the Project Risk
What is Project Sequencing?
Project sequencing refers to the category in the evaluation and selection of capital projects wherein
the finance manager decides whether or not to invest in a future project based on the outcome of one or more current projects
Importance of Project Evaluation and Sequencing
• The connection between different projects makes the analysis of the cash flow to make capital decisions
challenging.
• It is up to the finance manager to look at various issues when evaluating and selecting projects.
• While all capital projects are analyzed thoroughly, different categories can affect the evaluation and selection of capital projects.
• One of the categories is project sequencing. In some cases, projects can only be implemented in a sequence.
• Once the first project is executed and is found to be profitable, that then creates the option to execute the second project.
• So, the first one should be profitable before moving on to the next project.
• Project sequencing plays an important role in the entire capital budgeting process, as a single project can easily make a huge impact on other projects.
• That is why it is essential for finance managers to gain a thorough understanding of all the principles, categories, and steps involved in the process.
Why Choose Project Finance?
Project finance is invariably more expensive than raising corporate funding.
It takes considerably more time to organize and involves a considerable dedication of management time and expertise
in implementing, monitoring and administering the loan during the life of the project.
So there are a compelling reasons for sponsors to choose this route for financing a particular project.
• Insulate themselves from both the project debt and the risk of any failure of the project
• Share some of the risk in a large project with others. (some smaller companies balance sheets not strong enough to raise a project finance )
• Constrains ability to borrow (financial covenants or restrictions )
• Avoid consolidation of the project’s debt on to their own balance sheets. (depend on the particular accounting and/or legal requirements applicable to each sponsor, Reporting the Substance of Transactions” (FRS 5) is an example of this trend)
• Avoid disagree of risk-sharing with basis other joint ventures.
• Investing through a special purpose vehicle on a limited recourse basis can have significant attractions
Why Choose Project Finance?
Government sponsors attractions for Project finance:
• Attraction of foreign investment
• Acquisition of foreign skills and know-how
• Reduction of public sector borrowing requirement by relying on foreign or private funding of projects
• Possibility of developing what might otherwise be non-priority projects
• Education and training for local workforce
Problems with Public Finance Approach
• Constrained public expenditures
• Budget deficits in host country
• Draws from other social services
• Large financing needs for critical infrastructure and development projects
• Reduced aid flows to developing countries
• Private sector not engaged effectively
• Perpetuates existing shortfalls
• Government not always well suited to deal with all project risks
Why Do Sponsors Use Project Finance?
A sponsor (the entity requiring finance to fund projects) can choose to finance a new project using
two alternatives:
1. The new initiative is financed on the balance sheet (corporate financing)
2. The new project is incorporated into a newly created economic entity, the SPV, and financed off balance sheet (project financing)
#1 Corporate Finance
Alternative 1 means that the sponsors use all the assets and cash flows from the existing firm to guarantee additional credit provided by lenders.
If the project is not successful, all the remaining assets and cash flows can serve as a source of repayment for all the creditors (old and new) of the combined entity (existing firm plus new project).
#2 Project Finance
Alternative 2 means instead that the new project and the existing firm live two separate lives.
If the project is not successful, project creditors have no (or very limited) claim on the sponsoring firm’s assets and cash flows.
The existing shareholders then benefit from the separate incorporation of the new project into an SPV.
Global Accounting Standards
U.S. Accounting Standards
1- Relevance: Information provided must be of value to decision makers and have predictive value, confirmatory value, or both.
2- Materiality: Information presented must be material, or must have a significant impact on the financial position of the entity being reported.
3- Faithful Representation: To the extent possible, it should be complete, neutral and free from error.
4- Comparability: Information must be presented in a form that allows it to be compared with prior periods and with other companies in a similar business.
5- Verifiability: Information presented must be neutral and unbiased and unbiased, and must fairly represent the business transactions being reported.
6- Understandability: as understandable as possible for non-accountants with a reasonable knowledge of business.
7- Completeness: Within the limits of reasonable cost, information must be complete enough to make it usable and reliable.
The FASB developed a conceptual framework for financial accounting and reporting which forms a series of Statements of Financial Accounting Concepts (SFACs), the four basic principles underlying GAAP are:
While there is substantial overlap between IFRS and GAAP, there are also some key differences. Key differences include:
Auditing and financial Statement Reliability
The purpose of conducting and audit is to produce an audit report in which an independent audit firm indicates the scope of the audit and renders an opinion regarding the relevance, completeness and accuracy of the income statement, statement of financial position, statement of cash flow, any other statements.
Right Strategy
Right Delivery
A- Standard Unqualified Opinion:
The auditor concludes that the financial statements fairly represent the business' activities and that the following conditions are met.
All required financial statements were provided.
GAAS were followed in conducting the audit.
The statements were presented in accordance with GAAP
B- Unqualified with Explanatory Paragraph or Modified Unqualified
Some information requires special emphasize.
There is a change in who performs the audit.
The auditor questions the business' ability to continue.
C. Qualified
If exceptions are material, yet do not overshadow the usefulness of the information, a qualified opinion is given. Exceptions are noted in the written opinion.
D. Adverse
An adverse opinion is required when exception are so material that the auditor determines the financial statements may be misleading.
E. Disclaimer
Auditor cannot render an opinion, if the auditor is not independent or if the audit scope is so limited that no basis for forming an opinion exists.
Example
Derivatives and Hedge Accounting
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