Financial Aspects of Projects PDF

lOMoARcPSD|11547315 Financial aspects of projects Introduction to Project Finance and Legal Aspects of Projects (Technische Universiteit Delft) Scannen om te openen op Studeersnel...

lOMoARcPSD|11547315 Financial aspects of projects Introduction to Project Finance and Legal Aspects of Projects (Technische Universiteit Delft) Scannen om te openen op Studeersnel Studeersnel wordt niet gesponsord of ondersteund door een hogeschool of universiteit Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315 Introduction to project finance – CT3102-15 Lecture 1 We need to understand project finance: investors compare financial returns and risks of different project with financial analysis. They apply financial analysis to determine whether the project adds value and how much value it will bring them. Benefits of projects are important for project investors, but could also be enjoyed by the general public. Traditionally, governments funds projects with a general interest benefit. These project often have an imbalance between the part that is repaid economically and socially. This imbalance can be caused by (not) dealing with global warming for example. The rewards need to flow to the investors, otherwise they will not invest. These financial investors translate all effects into monetary terms. We must present what financial benefits they will earn with financial analysis. Three analysis:  Multi-criteria analysis (non-monetary externalities): analyses a problem, provides a relative ranking of alternatives, needs to specify relative weights.  Cost-Benefit analysis (monetary externalities): needs to translate al effects into monetary terms, provides an absolute ranking of alternatives.  Financial analysis (cash-flows only): private sector investors only look at the financial benefits earned by themselves, a good business plan is crucial. An investor wants to know about the project:  Its costs: for what and when – cash outflows  Its revenues: for what, when and for how long? – cash inflows  Its risks that the costs turn out to be more (or less)  Its risks that the revenues turn out to be less (or more)  A good business plan  Its financial projections  Different potential scenarios that could occur to see what happens to the investment returns Project finance (for example infrastructure) is characterized by:  Long construction and operating life  Lenders expect repayments  High debt to equity ratio  Project company physical assets worth less than debt  Company has limited life  No guarantees from investors in the project company for the project finance debt Governments partner up with the private sector more and more, for example with Public Private Partnerships (PPP), Private Finance Initiative (PFI) or Independent Power Producers (IPP). Reasons for governments to use project finance:  Budget: government budgets are under pressure  Complexity and cooperation: o PPP enables construction assets with no or a small upfront investment o Project finance can be very long term (25 years) o Projects are getting more complex: difficult for governments to build up and retain the necessary skills 1 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315  Private sector efficiency: o Private sector undertakes project more efficiently o Costs are lower if investments are undertaken through project finance o Project finance helps to spread the risks and thereby reduces the government’s risk Reasons for investors to use project finance:  High leverage  Unequal partnerships  Lower cost  Long term finance  Borrowing capacity  Enhanced credit  Risk limitation  Reduces need for outside investors  Risk spreading  Tax benefits  Developer leverage  Off-balance-sheet financing Reasons for third parties (off-taker / contracting authority to use project finance:  Lower product or service cost  Third party due diligence  Additional investment in public  Transparency infrastructure  Additional inward investment  Capital at risk  Financial-market development  Lower project cost  Technology transfer A special vehicle / entity is created for each project: a Special Purpose Company (SPV), because financing is based upon the projected cash flows of the project only (not the entire balance sheet of sponsors). Besides, lenders and investors only have recourse (means for repayment) to returns of the project itself. A SPV has no assets other than the project. A SPV shields others assets of a project sponsor from project failure. This construction makes project finance a complicated financing method. Financiers need to have deeper understanding of the project to assess the risks, requiring a closer cooperation with the project team. Due to this complexity a lot parties are involved in project finance:  SPV  Lenders  Active sponsors: construction  Financial advisors contractor, equipment supplier,  Technical advisors operator and maintenance contractor,  Legal advisors fuel supplier, off-taker  Debt financiers  Passive sponsors: investment funds,  Equity investors institutional investors, shareholders,  Regulatory agencies local partners  Multilateral agencies 2 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315 Difference lender and investor: a lender is entitled to the return of moneys lent to a project plus interest, but has no further interest in the outcome of the project. An investor takes stake in the project and enjoys a share of income. Project finance debt (lender) has first call on the projects net operating cash flow. Investors are thus more dependent on the project success: they are taking higher risk, so they expect higher return. Lenders on debt and investors on equity. Summary of lecture 1:  Time and money are scarce  Financial feasibility not the only factor to consider, but it is the key factor: even good ideas need money to be executed.  Investors evaluate a project by abstracting a project into a series of cash flows. Lecture 2 Financial analysis abstracts a project into a series of expected cash flows (how much and when do you have to invest & how much and when do you receive revenues?). These cash flows provide a uniform basis with which projects can be compared (Time Value of Money). This is called ‘Discounted C cash flow analysis’ (DCF). Future cash flows are ‘discounted’ back to a today value: DCF= n (1+i) Cn. The ‘Net Present Value’ (NPV) calculates the value of a series of cash flows: NPV =∑ n. n (1+i) The higher the NPV is, the better a project is able to finance itself.  If cash flows are later, they are worth less.  If a project is delayed, the value of it is reduced. The ‘Internal Rate of Return’ (IRR) measures financial return of an asset over its life. The IRR is the discount rate at which the NPV is zero. Finding the IRR is a iterative process.  If a project is delayed, the IRR of it is reduced. 3 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315 A contract authority has two important decisions to make:  The Investment Decision: o Investor’s capital costs money. o The project will add value if it earns a higher return than you need to pay on your own invested capital. This is called the ‘hurdle rate’. o If the IRR is higher than the investor’s cost of funds (the hurdle rate), the investment can be expected to add value for the investor. o The higher the project risk, the higher the expected return needs to be. o The needed margin needed between the hurdle rate and the IRR is determined by the ‘Capital Asset Pricing Model’ (CAPM).  The Financing Decision (after you have decided to invest): o The investor can choose to fund his investment with a mixture of debt and equity: the ‘capital structure’. The optimum capital structure is determined by the ‘Weighted Average Cost of Capital’ (WACC). o Generally speaking, funding with debt reduces the funding cost. This increases the NPV of a project for the investor, because the NPV is determined by discounting the project cash flows at the funding rate (= WACC + risk premium). o Why is debt cheaper than equity?  Lenders have a contractual right to repayment of their loans: lower risk and thus a lower expected return (5% against 10-20%).  The price you pay lenders (interest) is tax deductible from the borrowers taxable income and dividends paid to equity investors are not. After-tax cost of debt = interest cost * (1 - tax rate) o WACC = (after-tax cost of debt * debt ratio) + (cost of equity * equity ratio) o The WACC falls as the company finances investments with a higher proportion of debt. This is called leverage. Leveraging up:  The consequence of more debt increases the return for the equity providers. This is called leverage or gearing: the equity returns are boosted. However, this is only true if the project return is higher than the cost of borrowing!  When the project return falls below the borrowing rate, leverage works against the investor: the equity return plummets. The higher the debt, the harder the equity return falls. This is called the leverage effect and is caused by the fact that lenders want the same rate of return on their loans irrespective of the actual investment returns. Infrastructure investments often have low project returns, thus low funding costs are a necessity. Therefore, infrastructure projects tend to be highly leveraged. Project finance can afford high levels of debt because it reduces the risk of returns falling short. It achieves that by a substantial focus on project risks and management of these risks: that is the real value of project financing. Lecture 3 A risk is an uncertainty that can affect the prospects of achieving project goals. You cannot eliminate the uncertainty itself, but you can influence how uncertain events affect the project. This is called Risk Management:  Cause – circumstance that exists today that brings uncertainty (pollution in the underground)  Event – (pollution found: construction cannot begin)  Effect – results that impacts the project objectives (schedule is delayed) In project finance you look always to the financial objectives: you want to quantify what the effect of an event is on the expected cash flows. The project risks needs to be reduced, because: 4 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315  Investors want to be paid for taking risks: if a project is too risky, the investors require a return that the project cannot generate.  A project will function in a competitive market: project returns under pressure. Risk Assessment is important because highly leveraged SPVs have little ability to absorb risks. Risk minimization is key for project financing: project finance lenders are willing to bear only limited risks, because when a projects runs into trouble they have no upside and full downside. Investors have a financial upside in more risky projects, lenders do not. Financial impact of a risk = the probability of a risk occurring * the financial damage if it occurs Due diligence is the review and evaluation of project contracts and commercial, financial and political risks. The review does so by ensuring that all the necessary information is available. The basic principle of due diligence is: risks should be borne by the parties who are best able to control or manage them, e.g. the SPV allocates the construction risks to the construction contractor. The process includes 4 steps: 1. Risk identification: make a Work Breakdown Structure (WBS), with all the project activities listed. 2. Risk quantification: you then determine the variables (=events) in each activity and the drivers (=effects) that drive the cash flows in each variable: Quantify the effect of an event for your project cash flows by calculating the impact of each variable on the business case of each in the model (e.g. effect on NPV), e.g. rank them according to a scale of 5. 3. Risk Estimation: define the probability of reaching each of the defined values, e.g. rank them according to a scale of 5. 4. Risk ranking: rank each event in relative importance: impact * probablilty. A risk matrix table is the inventory list of identified risks for a party that negotiates a project financing transaction, by setting out:  What each risk is  Whether the risk is contracted over (if not, the SPV will wear the risk)  What risk mitigation there is  What the financial impact of the risk is A risk matrix table enables us as a negotiating partner:  To identify risk items that are most important to get right; spend most project management time on.  To identify the key areas where we need to be persistent in negotiations.  To identify items where we can be more lenient in negotiations.  To be prepared to anticipate to and address concerns from lenders and investors. 5 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315 The effect of a risk is determined by the sensitivity analysis. In this analysis one variable is changing at a time. However, risks do not occur one at a time. Often risks are correlated: they occur in combinations. They can be correlated to a larger or lesser extent. This is the largest disadvantage of this analysis. The Monte Carlo analysis does not have this disadvantage. This analysis is changing all variables together and looking at the overall cash flows and overall probability. Risks can occur in every phase of a project:  Project phases: o Planning o Designing o Engineering o Construction o Commissioning  Operational phases: o Input o Production o Output As the project progresses risks need to be re-evaluated. For example, once a project has been commissioned, all the preparatory risks fall away. This increases the value of the project. Investors capture benefits of this:  Risks fall away  Discount rate for cash flows reduces  NPV  Funder rate can be lower – refinance at a lower rate Lecture 4 Yescombe groups the risks in three different types: 1. Commercial or project risks 2. Macro-economic or financial risks 3. Regulatory and political risks Commercial risks  Revenue risks are the risks that revenues will not be sufficient to service operating costs and service debt. Mitigation for revenue risks: o Offtake agreement (take or pay) covering both volume and price o Availability-based project agreement (usage risk borne by the Contracting Authority: toll/fare/usage fee fixed o SPV has a long term credit risk on the off-taker / contracting authority. Sometimes the SPV can buy credit insurance  Commercial viability involves whether the project is commercially sound. The project contract needs to make long-term commercial sense for the contract parties. Mitigation for commercial viability: o Research market potential: is there already a market? / Analyse usage forecast for infrastructural project o Competitor analysis: how are they faring? What is their market position? o Proven technology? o Are structural changes envisioned for the market in which the project operates? o Is the party guaranteeing the income (e.g. the off-taker / contracting authority) credit worthy? o Experience of other projects? 6 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315  Construction risks are the risks inside the construction process that affects the project ability to be delivered on time and budget. For example: o Site acquisition: risk that during construction pieces of land have not been acquired in time for construction companies to have access to during construction. Mitigation: in PPP the contracting authority is often made responsible for this risk as they can acquire large areas of land for infrastructure development from multiple owners. o Site condition:  Different risks:  Geological structure could be a risk for foundations or piling costs  Previous use: clean-up costs for example  Latent defects: defects in existing assets on site  Pre-existing contamination  Discoveries at the site  Mitigation: inspection, condition precedent. Make this pre-condition before investing. o Permits o Construction contractor risks are risks that have to do with technical and financial capacity related to the construction parties that are involved. Mitigation:  Define a clear end product: minimum standards and specifications  Select only experienced contractors  Select only financially strong contractors  Principal guarantees from a third party (e.g. a bank guarantee)  Escalating financial penalties  Alignment of financial interests, e.g. equity participation requirement and lock up  Maintenance period commitment (maintenance bond) to ensure problems come up on your own watch  Use standard agreements  Use integrated agreements (only one party responsible for end result)  Construction and operations and maintenance integrated  Ongoing monitoring by experienced external party  Acceptance survey by experienced external party at commissioning  Fixed cost agreement  Tight cost control o Delay in project completion o Cost overruns  Operating risks: operation not at projected level. Operating problems can arise out of technological deficiencies of performance degradation (deteriorating service quality of an asset). Mitigation: o Preference for only proven technologies with existing references o Long term performance guarantee from EPC contractor or from the sponsor  Input supply risks o E.g. supply of raw materials cannot be guaranteed. The consequences of an interruption can be costly due to a lack of resources, which makes it unable to operate. This supply risk can be mitigated by concluding a long-term ‘input supply contract’. The supplier must have:  Proven experience  Proven credit standing (in case he becomes liable for damages)  Proven sources to the commodities to be supplied  Failure to complete connections o Price increases can affect the financial performance of the project. Sponsors want these price risks hedged. The SPV can mitigate these risks by: 7 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315  Concluding fixed price contracts with its suppliers  Passing on the price risk to the off-taker  Creditworthiness of supplier  Quantity and timing of supply  Quality of supply  Environmental risks (e.g. pollution risk or other effects on the surroundings). Most projects have an impact on the environment. The financial consequences of a project being unable to commence or operations being halted can be dire. You need to consider not only environmental laws and regulation, but also stakeholder and potential sources of opposition (e.g. political protests). As mitigation, preparing an Environmental Impact Assessment (EIA) early on to map our potential issues, is important. Project lenders have policies (Equator Principles) to ensure their clients adhere to minimum social and environmental standards. Macro-economic risks do not relate to the project in particular, but to the economic environment.  Interest rate risks: when the project loan you agree to does not have a fixed rate until the project completion date. The SPV needs to pay a lot of interest. These interest costs needs to be predictable. In financial markets, interest rates rise and fall. The three main interest rates are expressed as Euribor, Libor and Tibor. Mitigation: o Negotiate project loans with fixed rate of interest o Enter into ‘interest rate swap’: this swaps a ‘floating rate’ that is payable on the project into a fixed rate. o Pass on risk in the offtake agreement or the availability-based contract (this supposes that the off-taker / contracting authority is prepared to assume this risk)  Inflation risk. Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. It can lead to an increase in the costs as time goes by. It is not a problem if the revenues also increases with the same rate of inflation, but this is not always possible in a regulated industry. Mitigation: o Negotiate indexation in the price in offtake o Agreements / availability-based contracts  Exchange rate risks can appear when project costs and revenues are settled in different countries. Then, if the exchange rate moves, the project revenue may fall or costs may rise.  Refinancing risk: refinancing your loans when the long-term interest rates goes up. Regulatory & political risks  Regulatory risks are risks associated with government action, changes in the law. Several types of changes in law: o General changes in the law: affects country overall, and also the SPV o Specific change in law: affects industry of the SPV o Discriminatory change in law: specifically aimed at the SPV A project company must operate in a stable legal and regulatory environment. This requires: o General legislation that allows private ownership or control of project and adequately protects private investment o A clear legal and regulatory framework for the project’s operation o Consistency of legal and regulatory policies o Straightforward procedures for obtaining construction, operation and financing permits o The ability for the lenders to take and enforce security  Political risks are risks related to the host government where the project is located. For example, war, revolution, regime changes or nationalism. Mitigation: o Contact with the highest regime possible o Involve a multilateral development agency (e.g. WB, ADB, EBRD) o Contract under international law 8 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315 Lecture 5: The project financial model Primary purpose: confirm viability of the project to investors and other stakeholders. Besides, the model enables stakeholders to analyse the impact of changes. This is called the sensitivity analysis. Such analysis is important:  To determine the feasibility of a project  As a tool in the process of risk assessment and risk allocation  As a useful tool in contract negotiations: we can determine what aspects are most important to achieve in commercial negotiations. Risks with the largest financial impact are most important to manage carefully: so these analysis helps the project management focus on the most critical issues. It is important to log the sources of input carefully. In large project this is often done in the ‘Assumptions Book’, used by many different people with different educational backgrounds. Important aspects of the architecture of this model are:  All input assumptions are recorded together (not scattered throughout the model) and the source of these assumptions is identified.  A cash flows section which calculates the expected cash flows on an annual or semi-annual basis.  A loans section which summarises the development of the project loans.  A tax section which calculates the expected tax charges (these do not follow the cash flows).  A dashboard which summarises the most important inputs and shows the key outputs (e.g. the IRR and NPV). The dashboard is the key tool that is used for the sensitivity analysis. The model consists of 5 different sections: Typical inputs:  Timing of each phase, activity and costs. Important because: o In DCF-analysis the present value depends on the timing of cash flows o By changing the timing assumptions, you can calculate the financial consequence of delays  Construction costs / construction contract. It is important to record accurately when contract payment is due. Often this will be at different stages: e.g. an advance payment, certain milestone payments and a final contract payment. The model may also record certain retentions that the SPV has negotiated in case problems occur, e.g. contingent penalties that the contractor forfeits if he does not deliver on agreed items. Or the other way around: a developer can get a development fee for early development activities. The project may also need to provide for payments due for operation concessions and use of land.  Concession payments (when, what milestones) 9 Gedownload door Denisa Arsene ([email protected])  lOMoARcPSD|11547315  Operating and maintenance (O&M) costs. These include O&M of the assets owned by the SPV as well as costs of the SPV itself. O&M costs will usually occur spread out over the whole period of the project. The model needs information on how these costs keep track of macro- economic variables. O&M costs are often indexed, using a consumer price index (CPI).  Taxes. Tax is calculated on the taxable profit, which is not identical to the cash flows. o Value added tax (VAT, btw):  Rate is 21%.  Can be significant and ‘input VAT’ is generally due just after the cost to which it relates.  In the Netherlands the VAT can be claimed back early on, but in other countries a reclaim is not possible or takes a long time.  Even worse: if VAT cannot be reclaimed at all, but needs to be offset against ‘output VAT’. o Corporate income tax: tax optimisation often pays off in the Netherlands due to the high applicable tax rates (20/25%). This tax can add a significant negative cash flow.  Macro-economic variables and assumptions  Capital structure  Interest, typically shown as a base rate + margin Operating cash flows. When we calculated the operating cash flows, we will know for each year what the expected cash flows will be. This is important because in projects the costs usually precede the income: projects usually have negative cash flows in their initial years. Lenders require regular interest payments. Therefore, we need to assess on the basis of the cash flows, whether we expect to have sufficient cash flows to settle interest and loan repayment conditions. This is called the debt-service capacity or debt-service cover ratio (DSCR). The net cash flows expected in each year is the amount that is available for loan servicing (cash available for debt service (CADS)). Therefore, when we have done this analysis, we can determine how much the SPV can borrow safely. We subtract the financing cash flows (interest and principal repayment) from the net operating cash flows. In each year we need to have a positive balance, because you need to have enough cash to service your loans. Often lenders require that the DSCR is 1,5 or more, so the SPV has enough cash flow even if unexpected losses occur. A higher DSCR ensures that more can happen before the borrower needs to default. 10 Gedownload door Denisa Arsene ([email protected])