PROJECT FINANCE ANALYSIS AND CASESbyRAYMOND SCOTT MORGANBA University - PDF document

1 PROJECT FINANCE: ANALYSIS AND CASESbyRAY
PROJECT FINANCE: ANALYSIS AND CASESbyRAYMOND SCOTT MORGANB.A., University of California, Santa Barbara(1972)SUBMITTED IN PARTIAL FULFILLMENTOF THE REQUIREMENTS FOR THEDEGREE OF MASTER OFSCIENCEat theMASSACHUSETTS INSTITUTE OFTECHNOLOGYMay, 1976Signature of Author rc..v.m ..w...r......... ...fred P. Sloan School

2 of $hagement, May 7, 1976Certified by .
of $hagement, May 7, 1976Certified by .......,,..r.-.b...v.n .... ............Thesis SupervisorAccepted by ............Chairman, Departmental Committee on Graduate Students(JUN 11197618A~R1nnt PROJECT FINANCE: ANALYSIS AND CASESbyRaymond Scott MorganSubmitted to the Alfred P. Sloan Schoolof Mhnagement on May 7

3 , 1976,in partial fulfillment of the req
, 1976,in partial fulfillment of the requirementsfor the degree of Master of ScienceAbstractThis thesis was conceived of as a first attempt to relatethe growing new field of project finance to the formal models andanalysis of modern finance theory. Initially, a cursory descrip-tion of project finance as it is c

4 urrently seen by the major UnitedStates
urrently seen by the major UnitedStates financial intermediaries is developed and comments are madeon this exploration. Three cases of project finance and a flow-chart of project financing activities are provided to give thereader a working exposure to the field and to provide a basis forthe unfclding of some d

5 escriptive models. Finally, some tentati
escriptive models. Finally, some tentativesteps are made at explaining in formal terms what is really hap-pening in a project financing with an eye towards eliminating manyof the myths that currently surround this useful but poorly under-stood financing technique.Thesis Supervisor: Stewart C. MyersTitle: Associ

6 ate Professor of Finance2 thesis advisor
ate Professor of Finance2 thesis advisor, thesis reader, associated with ... ................ ... Life Insurance ........................on Foxhead III WAI Project Finance Flow ....85 Other Printed Other Resources............................................ ... .. a particulara poorly in the a "popular" t

7 hat the were a why project done and migh
hat the were a why project done and might make 12Two CaveatsThis thesis has been written very much from a theoreticalstandpoint, and, as such, there is considerable variance with respectto what the real world perceives as project finance. The most im-portant variance has to do with the value of the project, wh

8 ich isassumed in this work to be determi
ich isassumed in this work to be determined by the adjusted present valuemethod2 : the value of the project is the present value of thefuture cash flows discounted by a rate that depends only on syste-ratic risk of the project and adjusted by the present value of thetax shield. Bankers and others tend to accept

9 discounting eitherby a weighted average
discounting eitherby a weighted average cost of capital or by a weighted average ad-justed by "feel" for all risk. Since these rates tend to be muchlower than APV rates, the result is a quite high present value. Thisdifference of viewpoint is not well accepted by many individualsin the real world and has led a

10 t times to a very negative reactionto ce
t times to a very negative reactionto certain of the ideas.The second caveat is simply a reminder to the reader thatthis paper is neither a survey of current project finance practicenor an introduction to the field. In the intention of developinga theoretical understanding of project finance, much descriptivema

11 terial has been left out. There are many
terial has been left out. There are many complex business issues2 Myers (24) 13not covered by finance theory that are quite important in projectfinance, and it would be most unwise to believe that this somewhatsimplistic paper is a complete introduction to project financeactivity.Nevertheless, this thesis will

12 hopefully provide a well-prepared indivi
hopefully provide a well-prepared individual with some insight into project finance. Thisis hardly the last word in the theory of either project lending orfinancial intermediation, yet at the same timer it is to be hopedthat some small insight can be gained by looking at the area in thelight of modern theory. I

13 f nothing else, this thesis hopes to dem
f nothing else, this thesis hopes to demy-thologize the field of project finance and to begin to subject thisfield to a more rigorous analysis than has heretofore been the case. and insurancefinance." These sector lenders finance through rather than from project financing of theparents ,s provide adequate fund

14 ing very large project finance been much
ing very large project finance been much and direct here will foreign questions. project financing although anything financing will can be financed and production "carve-outs" very explicitly a zero-content a direct 17important issue when a parent cannot give direct credit backing to aproject due to limits im

15 posed by other debt covenants or related
posed by other debt covenants or related con-straints.HistoryProject finance is nothing very new. Most bank loans aremade on the basis of an adequate cash-flow in a company that has noexternal credit backing. Most construction financing, for example,can be considered as a form of project financing. What is uniq

16 ueabout project finance and why it has c
ueabout project finance and why it has come into the public' view re-cently has been its use by major corporations to finance massiveforeign investments. Non-recourse financing of some sort has.beenused by major U.S. corporations since at least the end of World WarII, and there are some marginal cases throughou

17 t the history of bank-ing. The first eve
t the history of bank-ing. The first event that is well recognized as a "modern" projectfinancing was the British Petroleum Development funding for the FortiesField of the North Sea Oil find, initiated in 1971. By 1973, ProjectFinance was a recognized issue in commercial banking, and a few ofthe largest and mos

18 t sophisticated banks were beginning to
t sophisticated banks were beginning to develop was done. viable possibilities financing. Unspoken, part of the in-These basic strong credit are grossly ,ty�ar7to,rytrtait VBt.,aest,j7t1AjtL,eetPntttttDP"tire"sttn�tsZEt..tenrtr.tt1FtNclPa2eigstt.ti.ensts.Gtis7kstitIst1JtsaJtrg­eJ5st.sJte

19 tvst oJ5tiwko�smiRrmaؐ
tvst oJ5tiwko�smiRrma��tR�t.7tib"ete1tDglt"t�t"et'bbti'deS. ift"ntnirJ9t,.2tV"trht.AtF krLt�steAstss,hnntWFWF,rZhent,s,acA.,.ltns1Ltohltdiirtensos-cctt-t1idjoCtt but better of the at theare many 22character of the borrower.Once a d

20 ecision has been made to take the busine
ecision has been made to take the business, the almostuniversal next step is to determine exactly what are the potentialrisks, the significant risk variables, and to run a cash-flow sensi-tivity analysis on the projects. The risk analysis is usually brokendown into marketing risks, principally price and quantit

21 y; input risks,including reserve risks i
y; input risks,including reserve risks in a natural resources project, raw material,labor, and material; and operating risks, including costs and "willit work" questions. Other major risks commonly looked at include taxa-tion, government regulation or expropriation, and completion. Finan-cial risks, especially

22 the consequences of increases in interes
the consequences of increases in interest ratesand the inability to raise further capital at times of need are oftenalso explored, although usually separately from the "real" analysis.Many decisions are made at this preliminary level, including a generalfeeling for what are acceptable risks, and tentative plans

23 for amelio-rating unacceptable risks.Ca
for amelio-rating unacceptable risks.Cash flow analysis can run from very simple straight linesingle value pro forma worksheets to complex dynamic simulationswith up to fifty variables.6 The most common approach is to generate6 The major New York City bank that has this computer system is not toohappy with it.

24 After putting a project through the mac
After putting a project through the machine analysis, theyusually end up putting a bright young MBA to work with an adding machineand slide-rule (they claim not to trust electronic calculators!) to grindout a very simple paper and pencil alternative analysis with 10 to 20"likely cases." .ys.itltF"ms"siFs

25 2006E;i7sgo�s,ds8�
2006E;i7sgo�s,ds8�gnsauSpnsrsrsunLF8tssF�kes,.kSt"�snRsnarcs,g,eyrarsrA,7aeauacys,hAee�arisf2lt�ngs"aeBsAsIFs.hahs1 hrunGB2s,slA1Bns,i2slBi1aesn�rcs,i,e r�rsInses,sJCvstbfrstTEstls.srnf."ss tuts-. .inite­s. captive client a

26 re indistinguishable few very great deal
re indistinguishable few very great deal 25rate will have to be set to allow for this. The second element ofpricing a loan is the cost, expressed as a percentage of the face valueof the loan, of generating the loan and servicing it. A third cost,related to the second, can be seen as a sort of insurance premium

27 against the expected costs of default in
against the expected costs of default in terms of additional servicingcosts.7There is little systematic evidence on the cost of projectfinance, and none on the breakdown of charges on the above morphology.By 1974, however, there was evidence of about a 3 per cent to a 4per cent spread above prime on domestic do

28 llar financings.6 It hasbeen estimated b
llar financings.6 It hasbeen estimated by individuals at Chemical Bank that 1 per cent to 2per cent was explained by risk factors and that most of the remaining2 per cent could be explained as the costs of organizing the financing.Since the average life of the financings studied here was about fiveyears, these

29 figures are not inconsistent with 6 per
figures are not inconsistent with 6 per cent to 8 per centestimates received from Morgan Stanley and Citibank for "consulting andorganization" costs.7 The costs of Loregone interest and capital in the case of defaultis covered by the difference between the expected rate and the statedrate.a Castle (15) includin

30 g risk project financings have divergenc
g risk project financings have divergence between best interest an indi-a syndicate of the more important the lead become dependent most frequent the loan. annual inter-bonus. In project financing plus 4% loan, the on the and up smaller participants, that the a syndicate specific activities.have done project

31 financing havelike leases, constraints a
financing havelike leases, constraints against format may Commercial banks provide both they are a competitive Almost every has had some project financing, per cent of the lead banker. of theMerchant Banking on the must be banks have a project financing Investment BankersInvestment bankers and they some role

32 crucially important and can private plac
crucially important and can private placement funding. They their own banking have 11 commercial bank it is becoming clear own analysis bankers will a position of re-investment banker's defensive attitude very unofficial a specific 32spoken to. Except in very extraordinary situations which may requirethe expert

33 ise of the investment banker in public i
ise of the investment banker in public issues or creatingnew forms of financial securities, it is not clear that investmentbankers have much of a future in project finance.Life Insurance CompaniesLegally, life insurance companies cannot invest more than avery small fraction of their assets overseas, and as a re

34 sult havemore or less been totally exclu
sult havemore or less been totally excluded from international project finance.On the domestic scene, however, there are no real constraints thatwould prevent the insurance companies from taking an important rolein project financing. One of the most commonly recognized problemsin project finance is the lack of

35 a good source of long-term funds,and the
a good source of long-term funds,and the insurance companies are well positioned to provide the answerto this gap. Unfortunately, the lending authorities in the insurancecompanies seem to suffer from a lack of vision as regards project fin-ance. No need is seen for a marketing function in any of their lending,a

36 nd as far as project financing goes, the
nd as far as project financing goes, they are willing to consideronly a "golden few" laid at their feet by bankers and investment passive providers little interest time and talent insurance companies of the project financing companies seem of exports. Almost every developed nation good deal It is project.' The

37 tion and a very important they are a na
tion and a very important they are a nation's it is be of a financing project finance successful experience provide enough he trips cases are Flow Chart." lue of be seen such. In absolute "must follow" a common 37the Holt Machine Tool Company the problems that they were havingfinding adequate high-bay, high-

38 bearing strength floor warehousespace. A
bearing strength floor warehousespace. After further discussion "ith other area executives, he dis-covered that there was in fact a serious shortage of these facilitiesin the Toledo area, and that several companies were having to shipgoods to Detroit for storage. From his knowledge of heavy con-struction he est

39 imated that an adequate structure could
imated that an adequate structure could be builtfor about $350,000, including iterest, plus the cost of land, andthat banks would commonly lend about 85 per cent of the costs ofconstruction. With leased industrial land at a rate of $64,000 ayear, the going rate for this type of warehouse space in Toledo($9.25 p

40 er square foot per year) yielded a cash
er square foot per year) yielded a cash breakeven utiliza-tion rate of less than 40 per cent. A brief discussion with hisboss convinced Mr. Richards that this was a viable investment op-portunity, and he arranged for meetings with a number of Toledobankers..William S. Reed was a senior lending officer with Ohio

41 Westshore National Bank, specializing in
Westshore National Bank, specializing in industrial constructionloans. He met with Mr. Richards on the afternoon of February 4,1974, to discuss the loan for the warehouse. While it became readilyapparent that the bank would not be especially interested in fundingthe project, Mr. Reed did suggest that Mr. Richar

42 ds should talk to five years), and that
ds should talk to five years), and that report from at the at its on time and at of the a floating-rate on the per cent Interest rates a significant of the deal, as represent Mid-cash and but he per cent of the adamant, however, he had and call that he against future Cash Flow Income Analysis: Land Lease and

43 Income Land LeaseInterest on Cash Surpl
Income Land LeaseInterest on Cash Surplus Land Lease Rental Income fits that 47Case IIPfeiffer Coal MineNew West Coal Mines was a moderately successful Chicago-basedholding company that was put together in the early 1950's to produceand market steam coal in the Midwest. Net worth was about $46 millionwith no

44 debt outstanding in the early 1960's, wi
debt outstanding in the early 1960's, with profit and sales of$1.6 million and $86 million, respectively. In 1964, New West begana wide ranging diversification program into chemicals, food-processing,defense-related electronics, and motels, financing a great deal ofthe expansion via public offerings of conventi

45 onal and convertibledebt. While profits
onal and convertibledebt. While profits were acceptable in the late sixties, there wasnot sufficient management skill to operate the diverse interests ofthe firm, and 1970 and 1971 were unmitigated disasters. Frank Thomsonbecame Chairman of the Board in February of 1972, and quickly becameconvinced that a turn

46 around of the company required the dives
around of the company required the divestitureof several subsidiaries. By April of 1973, the motel, electronics,and food processing groups had been sold off but at a substantial write-down of net worth. While there was no problem in covering the debtservice with the income from coal and chemicals, there was onl

47 y $17million in book equity covering $96
y $17million in book equity covering $96 million in book debt. were several of the somewhat unusual had a financial plan West's investment not feel that any of a project unfamiliar with West Finance from New The most a detailed sensitivity rates, and syndicate various of the required a of the least $45.00 New

48 West's had found a twelve-year he could
West's had found a twelve-year he could a financeablehad shopped West brought proposal with of the numbers were almost immediate somewhat over-extended, hostile public were quitecomfortable with On an finance situation, indeed be interested West's guarantee itself should New West follow through a threat an o

49 il-drilling a contract funds for e. &#
il-drilling a contract funds for e. �Pl"sne1ns..ei4t"smPeFs.Pts in no bank wishesto form, Upon completion, make quarterly 56addition, one half of the net "excess" cash flow will also be used toretire the principle of the bank loan at an accelerated rate. No ac-celeration of the long-term loan will

50 be permitted.Financial Constraints on P
be permitted.Financial Constraints on PfeifferWorking capital must remain above $5 million. No dividendsmay be paid while the bank debt is outstanding. Pfeiffer Coal Mines,Inc., is prohibited from engaging in any business other than the oper-ation of the mine and appropriate related activities. No assets ofthe

51 corporation may be transferred without
corporation may be transferred without the consent of the Trustee,except mined coal at the stipulated contract price or at the fair mar-ket value of that coal. All assets must be properly maintained or re-placed at need, all taxes must be paid, and all reasonable and properinsurance for this type of operation

52 must be maintained in force.Guarantees M
must be maintained in force.Guarantees Made by New WestNew West guarantees that it will maintain working capital of$5 million in Pfeiffer. It further guarantees that it will completethe project in the face of any cost overruns, time delays, or other If the pleted because per cent After Tax $45.00 per 61Proje

53 ct: Pfeiffer MineIncome:Fixed CostIntere
ct: Pfeiffer MineIncome:Fixed CostInterestDepreciationNet Contri-butionGross LossAfter TaxBreakeven (YearBreakeven (YearDepreciat ion =Interest = 0$2,000,0002,500,0004,000, 000$8,500,0006,384,000$2,116,000($1,058,000)1) = 235,000 tons= 80%13) = 120,000 tons= 37.5%2, 000,000These figures do not allow for depleti

54 on at 10% of gross income orany cost dep
on at 10% of gross income orany cost depletion method. face of "weak" balance sheet. The a guarantee differing upinions project can a rather little formality of an in 1974, investment banker today. Two that they of the a complex of the of an a relatively new technology significant additonal costs and it is Ne

55 t of had been and the of the spectacular
t of had been and the of the spectacularly profitable position. Since in theof the 66financing for the project. The ownership structure, owners, and theirproportional contribution was to be taken as given, and each was to beassumed to be competent to arrange its own financing. Manhattan Trustwas instructed to

56 assist the development of funding for th
assist the development of funding for the host govern-ment, and to maximize the financing available to the project itself soas to minimize both financing costs and the required contributon of theventure partners. As a general measure, they would be interested in$250 million in term bank loans and $200 nillion i

57 n subsidized exportfinancing for equipme
n subsidized exportfinancing for equipment, and as a guess they proposed that the hostgovernment should be able to get about $175 million in World Bank andother very low cost funds.A cash-flow analysis was run and the bank quickly came to theconclusion that such a financing was close to impossible, except witha

58 n iron-clad take-or-pay contract. To the
n iron-clad take-or-pay contract. To the surprise of the bankers, theMcKenzie representatives were not at all perturbed by this, and in factsuggested that if it would make matters easire they were sure the theV nture group would be willing to write take-or-pay for future deliverycontracts for up to 9 million to

59 ns a year at the greater of $21 a tonor
ns a year at the greater of $21 a tonor cash costs plus $10. On the basis of these arrangements, ManhattanT ust was more than willing to give their assurances of the availabilityof financing if the low-cost funds for the government were arranged.Negotiations with the World Bank and other sources of concession-a

60 ry loans were initiated, and it became r
ry loans were initiated, and it became readily apparent that there commercial members Their West Dollars, Jointof the until only in the a reasonable difficulty holding was held out the financing, and was signed agreement was 68various parties to arrange for the commitment of other financingsover the next two w

61 eeks, while the legal representatives pr
eeks, while the legal representatives preparedthe formal documents. There was substantial eleventh hour negotiationabot some nuances of the contract, but there were no important dif-ferences of opinion on the basics. The individual elements of theoverall agreement were signed between May 20 and May 29, 1974, an

62 dthe general accord wrapping all element
dthe general accord wrapping all elements of the financing togetherwas signed May 30, 1974, to go into effect June 1 of that same year.The economic viability of the project is not strictly recog-nized by the contracts and legal specification. The return to thefirms involved is in fact quite high, but for a subs

63 tantial portionof the life of this proje
tantial portionof the life of this project they will not be recognized at the pel-letizing plant. At an estimated basing price of $11.00 the bbl. forcrude, McKenzie engineers expected in January, 1974, that the costof Australian 64% pellets in June of 1977 would be about $36.00 theton against the West African p

64 roject cost of $21.00 the ton.The host g
roject cost of $21.00 the ton.The host government was willing to accept the relatively lowcash returns that they would receive from the project in its earlyyears because they will be receiving, essentially free, a massiveinfrastructure while providing substantial improvements in the oppor-tunities for its labor

65 force and a very healthy net flow of fo
force and a very healthy net flow of foreignexchange. 69Basic Elements of the WAI Ltd. FinancingThe CorporationWAI Ltd. shall be the owner and operator of the mine and facili-ties in question. It will be a limited liability association under thelaws of the host country and with all the rights and privileges of

66 adomestic corporation. The ownership in
adomestic corporation. The ownership in private hands shall be 20 percent held by McKenzie West Africa Ltd., a Bahaman association; Red SunSteel, a Japanese corporation, 30 per cent; and EuroFeric AG, a Swisscorporation, 50 per cent. In lieu of taxes, the government of the hostcountry shall have a 50 per cent

67 interest in the corporation.The sole pur
interest in the corporation.The sole purpose of the corporation is to develop and exploitthe ore body specified in the technical addenda to the agreement, andthe corporation shall engage in no activity not directly associatedwith this purpose except as needful to the over-all success of theproject.The Host Gove

68 rnmentThe host government, in exchange f
rnmentThe host government, in exchange for a 50 per cent interest 70in the project and $0.10 (U.S.) per ton in land-use fees shall provideto the corporaton access to the specified ore body, sites for the develop-ment of hydroelectric power and dams, port facilities, and plants, andthose rights-of-way for roads,

69 railroads, and power cables most proper
railroads, and power cables most properfor the completion of the project. For this consideration, it shallalso guarantee and accept loans from the World Bank and other suchagencies and deliver the proceeds whole and intact to the corporation.The host government and all succeeding governments shall passno law i

70 mperiling the rights of the private inve
mperiling the rights of the private investors in this projector the free transfer of the outputs into foreign hands. In the lightof the consideration in ownership and fees, the host government shalllevy no taxes on the income, property, or values of the corporation, andshall set no wages or wage tax so as to re

71 nder the corporation disad-vanataged wit
nder the corporation disad-vanataged with respect to any other domestic corporation. All importsby the corporation not for resale shall be without duty, and all exportsof iron pellets shall be without duty, quota, or other restrictions.No restrictions on the transfer of monies for the repaymentof debts shall be

72 imposed, and foreign private investors
imposed, and foreign private investors shall be al-lowed to freely repatriate profits up to 20 per cent of their investedcapital per year. Foreign investors are guaranteed the right to keepincome in the corporation in the form of its receipt, and further areguaranteed the right to buy local currency for the pu

73 rchase of locallabor, supplies, and equi
rchase of locallabor, supplies, and equipment at a rate that reflects the world price 71of that currency. The unit of accounting for this project shall bethe United States Dollar.FacilitiesThe corporation shall build and develop an iron-ore mine ormines of the open pit type to supply the needs of a pelletizing

74 plantof ten million tons output capacity
plantof ten million tons output capacity, a pelletizing plant of no lessthan ten million tons output capacity, harbor and dock facilities tohandle ten million tons of iron pellets per annum plus ancillary cargosboth inbound and outbound, dams and hydroelectric plants to produce130 per cent of the peak energy re

75 quirements of the project, an elec-trifi
quirements of the project, an elec-trified railway running from the mine-site or sites to the processingplant and thence to the port facilities capable of carrying the appro-priate loads, and all appropriate roads and power transmission facilitiesas specified in the technical addenda. All transportation and pow

76 erfacilities shall be open to the use of
erfacilities shall be open to the use of the residents of the area tothe extent that this does not interfere with the safe and normal oper-ation of the project. of the of the for the 74The final contract commits the commercial partners to give"first preference" to WAI Ltd. in their purchases of iron pellets a

77 ndcommits WAI Ltd. to give them "first p
ndcommits WAI Ltd. to give them "first preference" in selling all non-contracted output. These transactions are to take place at "the goingfair commercial rate." All other sales are to be to the "best avail-able buyer" at the "best business price."FinancingThere are four "layers" fo financing involved in this p

78 roject.The first is a simple equity cont
roject.The first is a simple equity contribution by the various participants.The second layer is funds provided by the the World Bank and other con-cessionatory sources for twenty years at an average rate of three percent. The third source of funds is concessionatory agreements associatedwith the foreign purcha

79 se of U.S., French, Japanese, Dutch, and
se of U.S., French, Japanese, Dutch, and otherequipment; ten-year terms were standardized for all agreements, and theaverage rate was 7 per cent. The remainder of the required funds wasprovided by a consortium of banks at a rate equivalent to the primeplus 2 per cent.The bank debt is "superior" to the World Ban

80 k loan and any newdebt taken on. The rat
k loan and any newdebt taken on. The rate on the debt is specificly set as the weighted the currency 14 of the for the involved. TheseLtd. up of $245be rolled loan until drawn down before pellets, WAI use of more capital subordinated 16an ordinary mercial borrower the government export finance in fact wild div

81 ersity these funds equipment itself from
ersity these funds equipment itself from the of the from presenting agencies, therein fact been assumed payment on potential government that the shall apply any disputes arising Gross CashGross Profit@ 3% 79WAI, Ltd.Cash Flow (First Year) (continued)9MM tonsProfitReturn on SalesReturn on Investment ($750)Retu

82 rn on Equity$6,400,0003.4%0.8%1.6%10MM t
rn on Equity$6,400,0003.4%0.8%1.6%10MM tons$16,400,0007.8%2.1%4.2% ReU Sun 81ManhattanBankConsortium $245(18 Banks)Los Angelisn itorjk7Bks $27)BostonTrustGulfSuli her(3036cenzietealInc .McKenzieWest AfricaLtd.10%Europea?4 BaRank ( kConsortiumBanqe dule Seine($65) (40%)NormanidySteelNethSteelEuro Feric25%Variou

83 s For-eign Trade$185 Banks(8 nations)Oea
s For-eign Trade$185 Banks(8 nations)OeakaBankRed SunTrading Co.All NipponLand BankRed Sun HSteel Go15%World Bank,Etc.)Bt)vernment50%DebtWAI Ltd.Equity $21/ton or the reader, ment, the put the have a from taking of "adequate ore body much competing a "ready this sort Project Finance sacred about going about

84 project financing more common Alternate
project financing more common AlternateProcurementContact Relevant Sources (world-Government / wide)ElementsDefine Project InitiateConceive ofProjeact FinancingProjectActivityDevelop VenturePartnersDevelop CapitalCost Estimates Analyze Strategies,Select BestDevelop Detailed--DefineAlternaPlans Based ontive Fin

85 ancing Financing SourcesStrategiesDeterm
ancing Financing SourcesStrategiesDetermine Objec-tive Function for CapComputer Modeling ExpPrepare CashFlow EstimatesDevelop ComputerFinancial Modelital Cost,enditure UpdatePrepare SensitivityAnalysisUpdate ProcurementSources2 Select OptimalFinancing q Prepare Prelimi-Strategy nary ProposalsArrange Meetingswit

86 h Financial In-stitutions andGovernment
h Financial In-stitutions andGovernment ExportCredit AgenciesUpdate Computert"Model; Data.-Rerun./% Select lead Barto Form FinancConsortium------Revise Prospectusnking Negotiate SharesLead Bank CntNegotiate Pricefdr Commercial (interest rate)Loan ConsortiumNegotiate TermsNegotiate Prelim-inary Commitmentsfrom G

87 overnmentExport CreditAgencies Obtain Pr
overnmentExport CreditAgencies Obtain PreliminaryCommitment from -ConsortiumModify Financial Determine Sensi-Model .tivity of Specific.od.lProject FinancialStructure toChanges in ProjectVariableselect Optimum UNFinancing PlanRenegotiate BankTerms unacceptableto Project Viability'a0 Prepare Finalfinancing Pro- -

88 -'spectusObtain FinalCommitment fromGove
-'spectusObtain FinalCommitment fromGovernment Export--OCredit AgenciesDistribute Pro-- Begin Finalspectus to Negotiations onFinancing Institu- All Loan Commit-tions mentsObtain FinalCommitment fromBanking Consortium Government Export ignBorr owe r(s) s'igCredit Agencies V Loan AgreementsPrepare LoanAgreementCo

89 mmitment FeesBeginBanking Consortium Bor
mmitment FeesBeginBanking Consortium Borrower(s) Si gn -Prepare Loan -- Loan Agreements 4)AgreementsCommitment FeesBeginDraw Down ApprovalReceivedDraw Down ApprovalReceived ----'CBorrower(s) Begin Borrower(s) Completeto Prepare "Condi- and Submit "Condi-tions Precedent" tions Precedent"data for FinancingInstitu

90 tions EquipmentShippedCash PaymentsMadeM
tions EquipmentShippedCash PaymentsMadeMonitor Draw-DownProcedures. Cer-tification: Ad-minister LoanProject Completion Monitor RepaymentTrof LoanRenegotiation onBasis of ChangedCircumstancesModify ContractsARenegotiation onBasis of ChangedCircumstancesM IfModify Contracts Input to Refinanc-ing of Project, if ..

91 Project Paid Outany ,c.stEt ( .,, -,.. 0
Project Paid Outany ,c.stEt ( .,, -,.. 0 v­sgrn �sge " tuki. t ahroAm w �yN a.r2rBS ESvSlsSirc 2 s.t2y"tS a project much difference were structured noted before in fact While a In fact, clear. Yes, this paper. which guarantees be indifferent between "pure" project was costless there are

92 unique circumstances, make extraordinary
unique circumstances, make extraordinary itself valuable. perfect markets securities, then set up The cost foregone casheconomic standpoint, in the 98C pE(x)Fig. 1 Pure project financeCoverage of debtprovided byopportunityequitycashequity I----a -afE(x)Fig. 2 One formfinanceof "impure" projectP(x)P(x)$nmemq 99

93 if the probability that X P is small, it
if the probability that X P is small, it would not be unreasonableto expect that little difficulty would be found in arranging this kind ofa project financing. In the rather confused world of the 1970's, thereseems to be very few projects that are so robust as to have appropriatelysmall probabilities that their

94 value will be less than the required pa
value will be less than the required pay-out. Of the few that have been financed this way, it is apparent thatthere was a serious misjudgment in quite a few cases; almost every pureproject financing has had problems in the recent recession.By itself, this model of a "pure" project financing does notexplain why

95 this format would be used rather than t
this format would be used rather than taking the project aspart of the ordinary investment portfolio of the firm. What is criticalin this model is that it explains what is going on when people talk ofsky-high debt/equity ratios in some project financings. While it istrue that the book value debt/equity ratio i

96 s quite high, the market valueratios wil
s quite high, the market valueratios will be in line with other equally risky projects. Hopefully, thisburies the myth of the 100 per cent debt-financed project.Impure Project FinanceThe construction of opportunity equity provides a useful insightinto the general structuring of a project financing. As previousl

97 y noted,a "pure" project financing could
y noted,a "pure" project financing could occur if and only if the value of the financings could One way, of add cash equity "protecting" this effect. the project. of this of "impure" project 101'Variance ReductionTruncation/'Natural ProjectFig.3 Other types of "impure" project finance$120EWE .....$150.... -m m

98 AP(x)$1O O...6..a b cFig. 4 State depend
AP(x)$1O O...6..a b cFig. 4 State dependent outcomes$180 a firm the firm no real both a and an a project financing project depends is lost, an opportunity, become possible the total well reduce a feeling financing arrangement persons actively the field. a project a company off athat the integral part more will

99 -19an integral very hard hazard problems
-19an integral very hard hazard problems 20 which will firm invests on the project will cost $84.00, financing, however, in T2c, present value make any 106Making a Growth Opportunity "Bankable"It has been shown elsewhere23 that embodied value in a firm(real assets plus commitments) is worth far more as a ba

100 sis for debtcapacity than the present va
sis for debtcapacity than the present value of growth opportunities. The reason forthis is that the value of an option depends significantly upon the amountborrowed against its future value. Consider, to begin with, the simplecase of a firm with no assets except one investment opportunity. Thisopportunity has a

101 fixed cost of exercise and outcomes tha
fixed cost of exercise and outcomes that vary with re-spect to the states of nature at the time of exercise. It is logicalthat at Tl when the option of exercising happens, the management of thisfirm will observe which state obtains and make the investment only if thevalue of the project is greater than the req

102 uired cash expence. If weallow for compl
uired cash expence. If weallow for complete financial markets, the value of the firm isV = f q(s)x(s) [V(s)- lds0where q(s) is the value of a dollar delivered in Tl if state s occurs23 Myers (30) 107and x(s) is the decision variable where X(s) = 0 if v(s) Iand X(s) = 1 else. Since x(s) = 1 only for s &#x 000; s

103 a then thevalue of the firm can be rewri
a then thevalue of the firm can be rewrittenV = f q(s) W(s)-I]dsa(see Figure 5).Consider what happens when the one opportunity firm borrows inTO, exercising its investment option in T1 (see Figure 6). It borrowspart of the cost of the investment in TO, promising to repay P whenthe value of the project is realiz

104 ed. When Ti arrives, the firm willmake t
ed. When Ti arrives, the firm willmake the investment I, combine it with the borrowing, and exerciseits option only if V(s) &#x 000; I + P. Unless V(s) I the investment wouldlead to an'increase in societal wealth and the debt holders would getpart of their money back, but the equity holders will not exercise th

105 eoption, because they see no gain from f
eoption, because they see no gain from ft. The value of the firm2" is24 Note that these arguments apply to the value of the firm with manygrowth opportunities also. The more debt outstanding, the fewer statesin which it is-worth while exercising any growth option, and the lowerthe value of the firm. �

106 ;kestRcnn a company a specific firm borr
;kestRcnn a company a specific firm borrows investment required S 0 110V(s)Pc StatesFig. 7 Value of debt for project with nooptionality 111and why various bookvalue ratios (a measure of real assets in place)are used as primary criteria by banks and related institutions. Analternative terminology for real asset

107 in this context is committedinvestment,
in this context is committedinvestment, or a project whose completion in T2 is not dependent upona decision made by surveying the states in T1.Consider again Figure 6. If the firm went to the market toborrow funds for the project in question, promising to pay P whenthe value of the project is realized and prom

108 ising that the projectwould be completed
ising that the projectwould be completed independently of what state obtains at Tl, then ifthe market has faith in the firn's promises, it would be indifferent be-tween this security and one on a real asset.2 The value of the debtis once againsV= c q(s)V(s) ds + fo q(s)P dsa 0 cWhile the value of the equity isV

109 E = 0 q(s) V(s I-P] dsa 02s Note that it
E = 0 q(s) V(s I-P] dsa 02s Note that it is not rational for the firm to really act this way.If, in fact, any state less than a obtains, the firm will lose lessif it pays off the creditors directfy than if it makes the investment. o.7FsRi."S.PSAS..PS",CeC, S".. a1"Ba�gS sa7k.b"G.beAEi,eb"sb..e.S"cbd

110 6.J.b.ef.�­5bkJ,o1fb.,k2Rmti
6.J.b.ef.�­5bkJ,o1fb.,k2Rmtibd71 ibB.Rt..Ca.""ab"p1t�s�7gbs uk-rb yields a substantially the ore limited market a large producer can extract contracts withlarge segments of the significant with market, thenentry will prices, and ownership, then function itself be possible this

111 value. of its a guarantee of this proj
value. of its a guarantee of this project financing a definite of price. 116other sources of developmental funding. By forcing as many possibleactors to bear the costs of their detrimental actions, there can bea substantial improvement in the funds available for investment in aproject.Risk ReductionIt is obvi

112 ous that the specification of limits upo
ous that the specification of limits upon the valuesof the independent variables in a function reduces the "risk" associatedwith that function, at least so far as risk is measured by the varia-bility of the value of the function. It should also be obvious fromobservation that there are a large number of financi

113 al institutions,such as banks and insura
al institutions,such as banks and insurance companies, which have a tendency to beextremely risk-adverse. In fact, in the United States and most otherdeveloped nations, there exists a very large pool of funds which areheld by these institutions which are legally restricted in the kindand degree of risk they may

114 take. In many cases, project financecan
take. In many cases, project financecan be seen as a way to structure a security in such a way as to makeit conform to the policy and legal restricitons of the institutions.It is not clear that the restrictions placed upon comierciallending are economically or financially rational in many situations,but to the

115 degree the constraints are binding, the
degree the constraints are binding, they impose a cost on a substantial of time such a they can of (his) that they and the examiners." Other persons have a project's rather telling project financing we can't otherwise unavailable Capital Asset 118a reduction in non-systematic risks, yet it is known that banks

116 infact do charge for non-systematic ris
infact do charge for non-systematic risk. 27 It is not unreasonablethen that a firm wishing to finance a project might in fact arrangeto have someone other than a bank absorb some of the non-systematicrisks. Consider a product X whose market price, Px, is a randomfunction with a normal distribution, mean Px, a

117 nd a variance. Thereis a project which w
nd a variance. Thereis a project which will produce X at a cost Cwhich will be financedpartially by bank debt, and produce output Q. To the extent thatProbability [(Q x (Ps-C)) Cash flow to service debt] &#x 000; 0the banks will charge a risk premium. To an X trading company, however,the value of the expected l

118 oss due to PxPx is exactly offset bythe
oss due to PxPx is exactly offset bythe expected extra profit due to Px &#x 000;Px. For a guaranteed price Px,the trading company would be indifferent about buying the output of theproject; so at a price Px-g, where g is quite small, the tradingcompany would be willing to buy the output of the project. If Q x g

119 is less than the premium charged by the
is less than the premium charged by the bank, then the owners of the27 See Chapter 5, Debt Capacity of a Project, and Chapter 2, with re-spect to pricing. trading company 28There have been of the item in fully explored, ward diversification company shareholders not all that un- classic limited a parent (low cre

120 dit a "reasonable"current debt holders
dit a "reasonable"current debt holders may very a substantial next issueover and risk. In many instances an investment opportunity when have access have a tendency be ratio has any balance sheet"other ratios, financing will so asof the "project financing," it is potential borrower not quite ordinary bank the

121 firm it is to "get of the 124a financi
firm it is to "get of the 124a financing, and no one really demands that the loan be able to pay outunder all circumstances; who will be around to collect after Armageddon?On the other hand, it is not unreasonable to set out a large number ofpossible conditions that the bank sees some reasonable possibility o

122 fhappening, and to lend no more than the
fhappening, and to lend no more than the value of the firm given the"worst case." Likely problems might include price declines, technologi-cal problems with the plant or the product, labor problems or managerialincompetence. In banking, this lasc issue is usually considered to bethe crux of the problem, and res

123 idual values are defined around this iss
idual values are defined around this issue.One residual value that banks look at is the value of the borrowerat the point of technical default on the loan covenants. These covenantsrepresent the intervention point where a bank or other institution canbegin to take an active part in the running of the firm if th

124 e value ofthe firm starts to fall. They
e value ofthe firm starts to fall. They can almost always be seen as presentingconditions under which there is still a comfortable margin for turningthings around. While the negotiation of loan convenants is a very impor-tant element in project finance, in almost no case is much weight placedon them in defining

125 how much can be borrowed.The "fundament
how much can be borrowed.The "fundamental" residual value of a project is the scrapor open market value of the assets. The liquidation value of a projectis again very seldom at issue in what is commonly known as project real debt a strong credit mustthat goes into value of a natural obvious from something mor

126 e purely riskless 30 additional moneycle
e purely riskless 30 additional moneyclear what some sort finance theorist, less than however, are the bank; more serious issue than default simply make a required for the 128in essence to the theorist's definition.Measuring the cost of default to a lending institution isa very complex task which has to date

127 not been well addressed. 32The component
not been well addressed. 32The components of the cost of default are relatively obvious. Thefirst element that comes to mind of course is the loss of incomeand capital associated with the default. Secondly, there is thecosts in terms of management time and talent that is absorbed bya default. These represent th

128 e basic economic costs of default.Additi
e basic economic costs of default.Additionally, there are a number of not well defined but very realcosts associated with making a mistake in the banking environment.Bank examiners tend to dislike anything that looks like a default,and can be downright uncivilized if they find a problem associatedwith a non-ord

129 inary loan, such as a project finance. S
inary loan, such as a project finance. Secondly,project financings are large, rather public transactions, and as aresult, banks tend to find that their reputation to some degree"rides" with the project. A default impinges upon the reputation32 The American Bankers' Association has an on-going study that hopesto

130 define the explict costs of a default o
define the explict costs of a default on a commercial loan and togenerate some range of values to use as criteria. The individual con-tacted there requested that his name not be cited, but a twenty-minutephone conversation yielded the following closing remark: "We can giveyou a number, but it is pure --------.

131 We have too many people who willtell us
We have too many people who willtell us exactly what the cost is but none who can produce a justifica-tion that could hold up in an Introduction to Finance course. If Icould find another job, I'd declare the whole project hopeless and goon to something else." worth something their repu-Conversations with offic

132 ers suggests considered when much can le
ers suggests considered when much can lend them?"33 have been Consider a additional outsideof the outside owners side owners, As the 131outside debt holders. Agency cost arguments also would tend to ex-plain why independent and extraordinary projects are financed thisway as opposed to projects that will be an

133 integrated part of anexisting line of b
integrated part of anexisting line of business. that the of the left unchanged. Additivity Theorum finance, and somefact that up" part of its in the of the been valued under source had in the one could the case,one small be some of money, some element decrease confidence very clearly context of perfect market

134 it isvery much of the a separate of th
it isvery much of the a separate of the the debt. 136tentative ideas on the debt capacity of a project were brought forward,and the possible impacts of using project finance on the value of thefirm were briefly explored.The Future of Project FinanceThis thesis has established that there is some validity toth

135 e distinction between project finance an
e distinction between project finance and other forms of lending,and as such, it is a useful addition to the repertoire of the fin-ancial institutions. In the minds of some managers, project financehas taken on an almost mystical air as the "solution" to financinghuge projects in a world of growing economic com

136 plexity and in-creasingly scarce capital
plexity and in-creasingly scarce capital. To the extent that it represents a wayof increasing the flexibility of financing economically viable oppor-tunities, this is true; but there is no magic in the concept. Tobe viable, a project financing must have at its base a project thatis extraordinarily valuable and

137 is associated either with limited riskso
is associated either with limited risksor risks that can be readily transferred to others. Far from everyworthwhile investment opportunity can meet these requirements.It is likely that there will be more use of project financein the future. There are some very real advantages in certain cir-cumstances to split-

138 off financing, and as time passes, it is
off financing, and as time passes, it is to be 138Arising from the paper itself, the entire problem of risk-shifting represents an interesting problem in capital market theory:If a firm's equity owners are diversified and thus indifferent tonon-systematic risk, could the firm costlessly assume risk fromanother

139 actor which is for some reason risk-aver
actor which is for some reason risk-averse? The effectsof a change in riskiness of the firm itself as it changes assetscould also be explored, along with the problem of wealth transfersbetween debt and equity holders. Last, but far from least, a usefulmodel of the debt capacity of a firm or project that fully m

140 atchesmodern capital market theory could
atchesmodern capital market theory could be developed, possibly as an ex-tension of the models developed in this thesis. c.ekn.aatrBoPPknri­oaa,.ArBaaeeer1.,t(.mog"r�GcA ­A"rCsldJk r "� Operatisnal Castle, Grsver April, 1975.FkA.�Pk.l Distr.ss." J"int V.ntur.s." IndkrePt Fkna

141 Ac. " Ballknger, f"rthc"ming. 141Bibliog
Ac. " Ballknger, f"rthc"ming. 141Bibliography_(continued)Periodicals (continued)27. Wilson, Robert. "Theory of Syndicates." Econometrica, January,1968.Manuscripts28. Jensen and Meckling. "Theory of the Firm: Managerial Behavior,Agency Costs, and Ownership Structure." 1975.29. Lessard, Donald R. "Evaluating Inte

142 rnational Projects--An EconomicPerspecti
rnational Projects--An EconomicPerspective." 1976.30. Myers, Stewart C. "A Note on the Determinates of Debt Capacity."1975.31. and Turnbull. "Capital Budgeting and the CapitalAsset Pricing Model: Good News and Bad News." 197".32. Sell, J.A. "Extra Active Project Financing in Less DevelopedCountries." 1973.33. W

143 arner, Sidon I.G. "Mixed International J
arner, Sidon I.G. "Mixed International Joint Ventures in theExploration, Development,-and Production of Petroleum." 1972.34. Warner, Jerold B. "Bankruptcy Costs, Absolute Priority, and thePricing of Risky Debt Claims." 1975. Merton, Robert of Boston; Trust Company.from over thirty project finance from these ver