Project Financing and Raw Materials

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Questions and Answers

What is contingent claims analysis used for?

To renegotiate contracts

To reallocate risks

To assess overall project flexibility

To value options for project managers to manage risks (correct)

Contracting risk refers to the risk of bilateral departures from contract terms.

False

What can happen if a supplier has agreed to a price ceiling on materials, but the market price has risen substantially above the ceiling?

The supplier has an incentive to take actions that would weaken the impact of the price ceiling, such as substituting lower quality materials or delayed deliveries.

When the price of oil rose, interest rates would be higher, but then Pemex would be better able to afford the higher rates; when the price of oil fell, interest rates would be lower, which would help to keep the _______________________ positive.

net cash flow to equity Signup and view all the answers

Match the following risks with their descriptions:

Contracting risk = Risk of one party departing from contract terms Risk of switching product lines = Risk of losing sales to larger firms Signup and view all the answers

What is an advantage of contract flexibility?

It allows firms to switch product lines or production techniques Signup and view all the answers

Incentive alignment is achieved when both parties have an equal share of risks and benefits.

False Signup and view all the answers

What can happen if a firm is unable to expand capacity when sales are growing rapidly?

Failure to expand could mean the loss of sales to larger firms. Signup and view all the answers

What is the main purpose of forward and futures contracts for companies like gold or platinum producers?

To lock in a price today for delivery at some time in the future Signup and view all the answers

Long-term contracts are not important for new mining companies because they can easily obtain financing and invest in physical capital.

False Signup and view all the answers

What is the key to a stable environment in managing risks?

Managing risks in such a way that the parties to a contract have incentives to abide by the terms of a contract and to avoid actions that would undermine it. Signup and view all the answers

The aim of risk reallocation is not just to reduce risk to one party by shifting it to others, but rather to aim for an _______________________ perspective.

efficiency Signup and view all the answers

What is an attribute of contract efficiency?

Degree of risk aversion Signup and view all the answers

Contracts with purchasers, suppliers, and workers cannot be used to share risk efficiently.

False Signup and view all the answers

Match the following terms with their definitions:

Risk Reallocation = The process of redesigning or reorganizing a project to efficiently share risk among parties. Incentive Alignment = The process of creating incentives for parties to abide by the terms of a contract. Signup and view all the answers

Why do companies seek to secure long-term contracts?

To arrange their financing, invest in the necessary physical capital, hire workers, and begin operations in a stable environment. Signup and view all the answers

What is the primary benefit of a supply or pay contract to the project's sponsors?

All of the above Signup and view all the answers

A supply or pay contract is a zero-sum contract where one stakeholder has to lose for the other to gain.

False Signup and view all the answers

What is the purpose of indexing the supply price in a long-term contract to reflect changes in the general price level or linking it to the price of a close substitute?

To ensure that the project owners and suppliers are protected from price fluctuations and have a stable income stream. Signup and view all the answers

Long-term contracts with suppliers can be beneficial to both the project's ______________ and the suppliers of the raw materials.

owners Signup and view all the answers

What is the benefit of a supply or pay contract to the supplier?

Securing a stable income stream Signup and view all the answers

In some instances, it may be beneficial to the project's owners to pay a premium to secure a long-term supply-or-pay contract with its raw material suppliers.

True Signup and view all the answers

Match the following terms with their corresponding descriptions:

Term 1: Contract Flexibility = Description 2 Term 2: Risk Allocation = Description 1 Term 3: Incentive Alignment = Description 3 Signup and view all the answers

What is the benefit of a supply or pay contract to the project owners in terms of cash flow?

A lower variability over time in their cash flows. Signup and view all the answers

What is the focus of the basic methodology of applied welfare economics?

Economic efficiency Signup and view all the answers

The methodology in this book measures the net economic benefit of the project by adding the total resource costs to the total benefits of the output.

False Signup and view all the answers

What is the purpose of stakeholder analysis?

To break down the overall benefits and costs of a project into component pieces, delineating the benefits and costs of particular institutions or groups. Signup and view all the answers

In an undistorted market, the costs and benefits of non-tradable goods and services in a project are estimated using the three postulates.

economic Signup and view all the answers

What is included in the definition of distortions in the context of this book?

All of the above Signup and view all the answers

The aim of risk reallocation is to reduce risk to one party by shifting it to others.

False Signup and view all the answers

Match the following concepts with their descriptions:

Economic efficiency = Measures the net economic benefit of a project Stakeholder analysis = Breaks down the benefits and costs of a project into component pieces Distortions = Include taxes, subsidies, trade taxes, licenses, and quotas Signup and view all the answers

What is the benefit of stakeholder analysis in an economic appraisal of a project?

It helps identify and measure the distributive effects of a project, providing information on the benefits and costs of particular institutions or groups. Signup and view all the answers

What determines the price of a non-tradable good or service?

Interaction between local consumers and local suppliers Signup and view all the answers

In a non-distorted market, the demand price of an item is always equal to its supply price.

False Signup and view all the answers

What does the demand curve of a good show in an undistorted market?

The maximum price that consumers are willing to pay for successive units of the good. Signup and view all the answers

A difference may exist between financial and economic prices even in the absence of _____________.

distortions Signup and view all the answers

Match the following concepts with their descriptions:

Economic Cost = The cost of an input used by a project Economic Benefit = The benefit of an output produced by a project Signup and view all the answers

What is the purpose of analyzing the market for a good or service before evaluating the impact of a project on that market?

To show how the three postulates can be used to estimate economic costs and benefits Signup and view all the answers

Long-term contracts are not important for new mining companies because they can easily obtain financing and invest in physical capital.

False Signup and view all the answers

In a supply or pay contract, the supplier benefits from a _______________________ perspective.

stable Signup and view all the answers

What is represented by the area OPmaxCQm in Figure 7.1(a)?

Total Economic Benefit Signup and view all the answers

The demand curve in Figure 7.1(c) represents the willingness of suppliers to supply a product at a given price.

False Signup and view all the answers

What is the purpose of combining the demand and supply curves in Figure 7.1(c)?

To determine the net gain or loss in the industry by adding up the economic costs and benefits Signup and view all the answers

The net economic benefit in Figure 7.1(c) is given by the triangle _______________________.

EPmaxC Signup and view all the answers

Match the following concepts with their definitions:

Economic Cost = The cost of producing a product Economic Benefit = The benefit of consuming a product Net Economic Benefit = The difference between the economic benefit and cost Signup and view all the answers

In Figure 7.1(c), the supply curve represents the quantity of the product that suppliers are willing to supply at a given price.

True Signup and view all the answers

The area OECQm in Figure 7.1(b) represents the _______________________.

Total Economic Cost Signup and view all the answers

What is the purpose of Figure 7.1(c)?

To determine the net economic benefit of the industry Signup and view all the answers

What is the primary purpose of Column (9) in the table?

To calculate the income and wealth taxes paid by households Signup and view all the answers

The GDP of 1985 is 127,598 millions of Rands.

True Signup and view all the answers

What is the main difference between Column (1) and Column (12)?

Column (1) represents the total GDP, while Column (12) represents the total capital stock net of those of general government services Signup and view all the answers

The cost of newly stimulated domestic savings is expressed in _______________________ prices.

current Signup and view all the answers

Match the following columns with their descriptions:

(2) = Column obtained from the sum of wages and salaries paid by corporations and 35% of net operating surplus generated by unincorporated businesses (5) = Resource Rents (9) = Income and wealth taxes paid by households Signup and view all the answers

What is the purpose of analyzing the market for a good or service before evaluating the impact of a project on that market?

To determine the net economic benefit of the project Signup and view all the answers

The net economic benefit is always positive.

False Signup and view all the answers

The aim of risk reallocation is to aim for an _______________________ perspective.

optimal Signup and view all the answers

What is the benefit of a supply or pay contract to the project owners in terms of cash flow?

The project owners can secure a stable cash flow stream over the long term Signup and view all the answers

Match the following concepts with their descriptions:

Stakeholder analysis = Analysis of the impact of a project on different stakeholders Applied welfare economics = Measures the net economic benefit of a project by adding the total resource costs to the total benefits of the output Signup and view all the answers

What is the total Labor Income in 1985?

69,115 Signup and view all the answers

The GDP in 1986 was higher than in 1985.

True Signup and view all the answers

What is the percentage rate of return in 1987?

24.13% Signup and view all the answers

The GVA in Agriculture in 1990 was _______________.

12,488 Signup and view all the answers

Match the following years with their corresponding GDP values:

1988 = 209,613 1992 = 372,227 1995 = 548,100 Signup and view all the answers

What is the total Taxes on Products in 1995?

32,768 Signup and view all the answers

The Real Return to Capital in 1999 was higher than in 1998.

True Signup and view all the answers

The Value Added Tax in 2000 was _______________.

3,886 Signup and view all the answers

What is the percentage rate of return in 2003?

124.07% Signup and view all the answers

What is the total Resource Rents in 2004?

23,377 Signup and view all the answers

What does the national income consist of?

Sum of interest, rent, and profit Signup and view all the answers

Land improvement values are considered as reproducible capital.

False Signup and view all the answers

What should be excluded from the capital base to calculate its rate of return?

Land, government capital, and income from public sector productive entities Signup and view all the answers

The value added due to the time value of the owners and their family members should be separated from the _______________________ in non-corporate enterprises.

gross return to capital Signup and view all the answers

Why do we want to exclude government capital from the capital base?

Because it is not private sector capital Signup and view all the answers

The rate of return on capital is calculated based on the real earnings of reproducible public-sector capital.

False Signup and view all the answers

The capital base used to calculate the rate of return should exclude the portion that we estimate as accruing to _______________________.

land Signup and view all the answers

Study Notes

Project Financing and Raw Materials

Lenders often require project sponsors to have firm contracts with suppliers of main raw materials to secure financing.
These contracts provide an incentive to suppliers to adhere to delivery schedules and can be beneficial to both parties.

Supply or Pay Contracts

A supply or pay contract commits a creditworthy supplier to deliver raw materials or pay the project if they cannot deliver.
The contract can specify how the supplier can recoup payments if they are made.
These contracts can be beneficial to both project owners and suppliers, providing a stable income stream and reducing cash flow variability.

Long-term Contracts

Long-term contracts with suppliers can be beneficial to project owners and suppliers, as they can provide a stable income stream and reduce cash flow variability.
Contracts can be indexed to reflect changes in the general price level or linked to the price of a close substitute.

Risk Management

Companies may pay a premium to secure a long-term supply-or-pay contract with suppliers to manage risks.
Forward and futures contracts can be used to hedge risks, but their duration is usually short and they can be costly.

Risk Reallocation

The aim of risk reallocation is to redesign or reorganize a project to reallocate risk efficiently, not just to shift risk to others.
Contracts can be used to share risk efficiently, taking into account the degree of risk aversion of parties involved.
Contingent claims analysis can be used to value options available to manage risks.

Contracting Risk

Contracting risk refers to potential unilateral departures from contract terms by one party, jeopardizing the other party's position.
One-sided contracts or changing circumstances can cause one party to take actions that undermine the contract.
For example, a supplier may take actions to weaken the impact of a price ceiling if market prices rise substantially above the ceiling.

Non-Tradable Goods and Services

A non-tradable is a good or service where there is no incentive for domestic suppliers to export or for consumers to import.
The price of a non-tradable is determined by the demand of local consumers interacting with the supply response of local suppliers.

Market Analysis

To understand the impact of a project's demand for an input or output, we start by analyzing the market for that input or output.
The analysis begins with an existing market for a good or service in the absence of a new project.

Analyzing Economic Costs and Benefits

The demand curve for a good in an undistorted market shows the maximum price that consumers are willing to pay for successive units of the good.
Figure 7.1(a) presents the demand curve for a good, with the total economic benefit represented by the area OPmaxCQm.
The total economic cost is represented by the area OECQm in Figure 7.1(b).
The net economic benefit is given by the triangle EPmaxC in Figure 7.1(c).

Methodology of Applied Welfare Economics

The methodology focuses on economic efficiency by subtracting total resource costs from total benefits.
It measures the net economic benefit of a project by adding up the dollar values of the net economic benefits regardless of who are the beneficiaries.

Stakeholder Analysis

Stakeholder analysis breaks down the overall benefits and costs of a project into component pieces, delineating the benefits and costs of particular institutions or groups.
It helps deal with distributive effects and offers suggestions on how to include this information in the economic appraisal of a project.

Applying the Postulates

The three postulates are used to estimate economic costs and benefits of non-tradable goods and services in an undistorted market.
Distortions include taxes, subsidies, trade taxes, licenses, and quotas, and monopoly markups.

Calculating the Cost of Newly Stimulated Domestic Savings

The cost of newly stimulated domestic savings is calculated by subtracting the sum of wages and salaries paid by corporations, 35% of net operating surplus generated by unincorporated businesses, and other factors from the total GDP.

Components of GDP

Column (1) represents GDP in current prices.
Column (2) represents labor income, which includes wages and salaries paid by corporations.
Column (3) represents taxes on products, which includes VAT and excise duties.
Column (4) represents the resource rent, which is the income earned from the exploitation of natural resources.
Column (5) represents depreciation, which is the decrease in the value of assets over time.
Column (6) represents income and wealth taxes paid by households.
Column (7) represents income and wealth taxes paid by corporations.
Column (8) represents property income received by households.
Column (9) represents the value added in the financial sector.
Column (10) represents the return to domestic savings.
Column (11) represents the real return to domestic savings.
Column (12) represents the capital stock net of those of general government services.
Column (13) represents the rate of return to domestic savings.
Column (14) represents the rate of return to domestic savings in percentage terms.

Trends in the Data

The data shows a general trend of increasing GDP, labor income, and return to domestic savings over the period from 1985 to 2004.
The resource rent and depreciation also show an increasing trend, while the income and wealth taxes paid by households and corporations show a decreasing trend.
The property income received by households and the value added in the financial sector show a mixed trend.
The rate of return to domestic savings shows a general trend of increasing, with some fluctuations over the period.

Calculating the Return to Domestic Investment

The return to domestic investment is calculated by subtracting the sum of wages and salaries paid by corporations, taxes on products, and other factors from the total GDP.
The data shows a general trend of increasing return to domestic investment over the period from 1985 to 2004.
The rate of return to domestic investment also shows a general trend of increasing, with some fluctuations over the period.

Sources of Data

The data for the period from 1985 to 2000 is sourced from the South African Reserve Bank, South Africa's National Income Accounts 1946-2004, (June 2005).

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Description

Learn about the importance of contracts with raw material suppliers in project financing, including supply or pay contracts and their benefits.