Literature Review
For the financing of international business ventures and high-risk large-scale projects, project finance (PF) has gained considerable favor over the last three decades. Defined as non-recourse or limited financing, project financing is done through a vehicle company. The funding that is obtained is strictly used only for the project without any involvement of the government or the corporate world. PF sees creditors and ventures sharing the same project risk. In project finance the cash flow is transparent. The world economy is growing at a very fast pace and it is this factor that has made project finance emerge over corporate finance. It is predicted to become a very outstanding name in the emerging markets and become popular for the world’s infrastructure needs.
Vishwanath (2007) believes that Project finance generates funds that are easily converted into hard currencies and so it is ideal for the capital-intensive infrastructure. However, it is equally not good for high-risk projects where there is uncertainty of the returns. The choice for project finance over corporate is especially taken in the following instances.
Ownership structure
Цhen the liability of parents to projects is limited, project risk exposure to the creditors is limited. This affects the project-specific debt allocation and joint venture availability.
Agency Effects
This includes improved incentives of Information production, restriction of free cash flow of the project, increase in outside observation of the project, wherein management is decentralized and is specialized as well.
Other Effects
Sponsors become half-suppliers which increases sponsors’ ranking, avoidance of double taxation, where allocation of services is not just limited to the sponsors alone.
When Project Finance is not a good choice
The idea of using project finance is dropped in cases that involve higher costs of the projects, lower leverage of the project, and when complexities exist between the project and the firm.
Risks in the Project Finance
Sometimes the firms are heavily burdened by the risks of the project and cannot bear with it by themselves. Hence, for this reason, the PF enables the sharing of the risk amongst the participants of the project who know how to handle it. The risks of the project could either be financial or operational. The operational risks are the completion risks, operational risks, and performance risks. The financial risks are the currency risks and the interest rate risks.
There is also another risk which is the liability risk which is associated with death or injury. Vashwanath (2007) claims that performance risk is when the sponsor cannot meet up the deadlines and fails to provide the standard of work required. Another term is used which is called the “off-take risk”. This is the risk when a given project fails to meet the market price. There is also a risk associated with the size of the project. The identification of risks is very essential as this allows the risks to be evaluated and be covered. A sponsor equity subscription is one method by which technology risk is covered. The major risk of a project is the completion risk. This is when the actual costs of the project are more than the estimated costs, the quality could not be met with, the quantity falls short and the completion date of the project is extended. All in all the risks vary from project to project.
Table1: Risk sharing amongst project participants (Vishwanath, 2007).
Merna and Nijiru (2002) point out that project finance involves two major things which are as follows:
Types of Contracts used in Project Finance
- Throughput agreement
- Payor put contracts
- Take or pay contracts
- Take it offered a contract
- Hell or high water contract
Throughput agreement: In this type of contract, the oil companies play a major role. In the case where other companies fail in the usage of the pipeline, the owner is liable to provide oil so that the company gets enough cash for the loan.
Put or pay contracts: This takes place when the suppliers fail to give inputs, to cover the excess costs to the company and also when the third party is not available for the recovery of the revenue loss.
Take or pay contract: In this type of contract, the purchaser is liable to pay for the output whether delivery is taken or not. If the project delivery fails, then the purchaser is not bound to pay. The contract covers all the fixed costs or the project’s capacity to some extent.
Take it offered contract: This is very much like the take or pay contract. The only difference is that the purchaser must take the delivery.
Hell or high water contract: In this type of contract the purchaser has to pay even if the output is not delivered. This contract favors the lenders as they are more protected by this option.
Financial Aspects
Even though project finance is non-recourse, this is far from the actual reality. Lenders always need guarantees and need assurance. In such instances, the sponsor provides guarantees in the form of a Capital Subscription agreement, Clawback agreement, and cash deficiency agreement.
Capital subscription agreement: In case the project company is falling short on the cash, companies that are creditable buy securities for cash.
Clawback agreement: In case the project is falling short on cash, then the sponsors have to return the benefits of cash. This amount is equivalent to the benefits and dividends received. Such agreements are also named a cash trap as the lenders are assured of prompt payments.
Cash deficiency agreement: According to this agreement, the owners of the project guarantee funds to the operating company for the maintenance of the working capital.
Vishwanath (2007) argues that according to the concession agreements, the SPV can recover operation and maintenance costs, and also the project costs in 30 years through fee concessions.
References
Merna, T. & Njiru. C. (2002) Financing infrastructure projects. London, Thomas Telford.
Vishwanath, S. R. (2007) Corporate Finance: Theory and Practice. India, SAGE.