Project Financing: Project cost estimation & working capital requirements, sources of funds, capital budgeting,

Risk & uncertainty in project evaluation , preparation of projected financial statements viz. Projected balance
sheet, projected income statement, projected funds & cash flow statements, Preparation of detailed project report,
Project finance.

PROJECT FINANCING

What is Project Financing?

Project Financing is a long-term, zero or limited recourse financing solution that is available to a borrower
against the rights, assets, and interests related to the concerned project.

If you are planning to start an industrial, infrastructure, or public services project and need funds for the same,
Project Financing might be the answer that you are looking for.
The repayment of this loan can be done using the cash flow generated once the project is complete instead of
the balance sheets of the sponsors. In case the borrower fails to comply with the terms of the loan, the lender is
entitled to take control of the project. Additionally, financial companies can earn better margins if a company
avails this scheme while partially shifting the associated project risks. Therefore, this type loan scheme is
highly favoured by sponsors, companies, and lenders alike.
In order to bridge the gap between sponsors and lenders, an intermediary is formed namely Special Purpose
Vehicle (SPV). The main role of the SPV is to supervise the fund procurement and management to ensure that
the project assets do not succumb to the aftereffects of project failure. Before a lender decides to finance a
project, it is also important that all the risks that might affect the project are identified and allocated to avoid
any future complication.

What Is Special Purpose Vehicle and Why Is It Necessary?

During Project Financing, a Special Purpose Vehicle (SPV) is appointed to ensure that the project financials
are managed properly to avoid non-performance of assets due to project failure. Since this entity is established
especially for the project, the only asset it has is the project. The appointment of SPV guarantees the lenders of
the sponsors’ commitment by ensuring that the project is financially stable.

Key Features of Project Financing

Since a project deals with huge amount funds, it is important that you learn about this structured financial
scheme. Below mentioned are the key features of Project Financing:
 Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring huge amount of equity
and debt, and is usually implemented in developing countries as it leads to economic growth of the country.
Being more expensive than corporate loans, this financing scheme drives costs higher while reducing liquidity.
Additionally, the projects under this plan commonly carry Emerging Market Risk and Political Risk. To insure
the project against these risks, the project also has to pay expensive premiums.
 Risk Allocation: Under this financial plan, some of the risks associated with the project is shifted towards the
lender. Therefore, sponsors prefer to avail this financing scheme since it helps them mitigate some of the risk.
On the other hand, lenders can receive better credit margin with Project Financing.
 Multiple Participants Applicable: As Project Financing often concerns a large-scale project, it is possible to
allocate numerous parties in the project to take care of its various aspects. This helps in the seamless operation
of the entire process.
 Asset Ownership is Decided at the Completion of Project: The Special Purpose Vehicle is responsible to
overview the proceedings of the project while monitoring the assets related to the project. Once the project is
completed, the project ownership goes to the concerned entity as determined by the terms of the loan.
 Zero or Limited Recourse Financing Solution: Since the borrower does not have ownership of the project
until its completion, the lenders do not have to waste time or resources evaluating the assets and credibility of
the borrower. Instead, the lender can focus on the feasibility of the project. The financial services company can
opt for limited recourse from the sponsors if it deduces that the project might not be able to generate enough
cash flow to repay the loan after completion.
 Loan Repayment With Project Cash Flow: According to the terms of the loan in Project Financing, the
excess cash flow received by the project should be used to pay off the outstanding debt received by the
borrower. As the debt is gradually paid off, this will reduce the risk exposure of financial services company.
 Better Tax Treatment: If Project Financing is implemented, the project and/or the sponsors can receive the
benefit of better tax treatment. Therefore, this structured financing solution is preferred by sponsors to receive
funds for long-term projects.
 Sponsor Credit Has No Impact on Project: While this long-term financing plan maximises the leverage of a
project, it also ensures that the credit standings of the sponsor has no negative impact on the project. Due to
this reason, the credit risk of the project is often better than the credit standings of the sponsor.

What Are the Various Stages of Project Financing?

1. Pre-Financing Stage
 Identification of the Project Plan - This process includes identifying the strategic plan of the project and
analysing whether its plausible or not. In order to ensure that the project plan is in line with the goals of
the financial services company, it is crucial for the lender to perform this step.
 Recognising and Minimising the Risk - Risk management is one of the key steps that should be focused
on before the project financing venture begins. Before investing, the lender has every right to check if the
project has enough available resources to avoid any future risks.
 Checking Project Feasibility - Before a lender decides to invest on a project, it is important to check if
the concerned project is financially and technically feasible by analysing all the associated factors.

2. Financing Stage
Being the most crucial part of Project Financing, this step is further sub-categorised into the following:
 Arrangement of Finances - In order to take care of the finances related to the project, the sponsor needs
to acquire equity or loan from a financial services organisation whose goals are aligned to that of the
project
 Loan or Equity Negotiation - During this step, the borrower and lender negotiate the loan amount and
come to a unanimous decision regarding the same.
 Documentation and Verification - In this step, the terms of the loan are mutually decided and
documented keeping the policies of the project in mind.
 Payment - Once the loan documentation is done, the borrower receives the funds as agreed previously to
carry out the operations of the project.

3. Post-Financing Stage
 Timely Project Monitoring - As the project commences, it is the job of the project manager to monitor
the project at regular intervals.
 Project Closure - This step signifies the end of the project.
 Loan Repayment - After the project has ended, it is imperative to keep track of the cash flow from its
operations as these funds will be, then, utilised to repay the loan taken to finance the project.

Types of Sponsors in Project Financing

In order to determine the objective of the project and the risks related to it, it is important to know the type of
sponsor associated with the project. Broadly categorised, there are four types of project sponsors involved in a
Project Financing venture:
 Industrial sponsor - These type of sponsors are usually aligned to an upstream or downstream business in
some way.
 Public sponsor - The main motive of these sponsors is public service and are usually associated with the
government or a municipal corporation.
 Contractual sponsor - The sponsors who are a key player in the development and running of plants are
Contractual sponsors.
 Financial sponsor - These type of sponsors often partake in project finance initiatives and invest in deals with
a sizeable amount of return.

PROJECT COST ESTIMATION & WORKING CAPITAL REQUIREMENTS

PROJECT COST ESTIMATION

Cost estimates comprise:
Base cost. Prepared on the basis of a detailed estimate of inputs, by expenditure category for each
output/component, expenditure category, and/or implementing agency;
Contingencies. Comprise separate physical and price contingency allowances. Physical contingencies are
computed as a percentage of the base cost. Price contingencies are computed by applying cumulative
cost escalation factors to the sum of the base cost and physical contingencies; and
Financial charges during implementation: Calculated on the basis of interest and other financing charges
applicable on ADB and other project-related debt.

Methods for Estimating Working Capital Requirement

There are broadly three methods of estimating or analyzing the requirement of working capital of a company
viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital
means calculating future working capital. It should be as accurate as possible because the planning of working
capital would be based on these estimates and banks and other financial institutes finance the working capital
needs to be based on such estimates only.
What Is Capital Budgeting?
Capital budgeting is the process a business undertakes to evaluate potential major projects or investments.
Construction of a new plant or a big investment in an outside venture are examples of projects that would
require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and
outflows to determine whether the potential returns that would be generated meet a sufficient target
benchmark. The capital budgeting process is also known as investment appraisal.

KEY TAKEAWAYS

 Capital budgeting is used by companies to evaluate major projects and investments, such as
new plants or equipment.
 The process involves analyzing a project’s cash inflows and outflows to determine whether the
expected return meets a set benchmark.
 The major methods of capital budgeting include discounted cash flow, payback, and
throughput analyses.

Understanding Capital Budgeting

Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder value and
profit. However, because the amount of capital or money any business has available for new projects is
limited, management uses capital budgeting techniques to determine which projects will yield the best return
over an applicable period.
Importance of Capital Budgeting
Long-term Goals
For the growth & prosperity of the business, long-term goals are very important for any organization.
A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has its
effect in a long time span. It also affects companies future cost & growth.

Involvement of a Large Number of Funds

Capital Investment requires a large number of funds. As the companies have limited resources, the
company has to make a wise & correct investment decision. The wrong decision would harm the
sustainability of the business. The large investment includes the purchase of an asset, rebuilding or
replacing existing equipment.
Irreversible Decision
The capital Investment decisions are generally irreversible as it requires large amounts of funds. It is
difficult to find the market for that asset. The only way remains with the company is to scrap the asset
& incur heavy losses.

Monitoring & Controlling the Expenditure

Capital budget carefully identifies the necessary expenditure and R&D required for an investment
project. Since a good project can turn bad if expenditures aren’t carefully controlled or monitored, this
step is a crucial benefit of the capital budgeting process.

Transfer of Information
The time that project starts off as an idea, it is accepted or rejected; numerous decisions have to be
made at a various level of authority. The capital budgeting process facilitates the transfer of
information to appropriate decision makers within a company.

Difficulties of Investment Decision

The long-term investment decisions are difficult because it extends several years beyond the current
period. Uncertainty indicates a higher degree of risk. Management loses his flexibility and liquidity of
funds in making investment decisions so it must consider each proposal very thoroughly.

Maximization of Wealth
Long-term investment decision of the organization helps in safeguarding the interest of the
shareholder in the organization. If the organization has invested in a planned manner, the shareholder
would also be keen to invest in that organization. This helps in the maximization of wealth of the
organization. Any expansion is fundamentally related to further sales and future profitability of the
firm and assets acquisition decisions are based on capital budgeting.

Other Important Aspect of Capital Budgeting

Capital budgeting involves two important decisions at once: a financial decision and an investment
decision. By taking the project, the business has agreed to make a financial commitment to a project,
and that involves own set of risk. Project delay, cost overruns & regulatory restriction that can all
delay & increase the cost of the project.

Risk & uncertainty in project evaluation

The following points highlight the four popular techniques for measuring risk and
uncertainty in different projects. The techniques are: 1. Risk Adjusted Discount
Rate Method 2. The Certainty Equivalent Method 3. Sensitivity Analysis 4.
Probability Method.
Technique # 1. Risk Adjusted Discount Rate Method:
This method calls for adjusting the discount rate to reflect the degree of the risk and
uncertainty of the project. The risk adjusted discount rate is based on the assumption that
investors expect a higher rate of return on risky projects as compared to less risky
projects.

The rate requires determination of:

(i) Risk free rate, and

(ii) Risk premium rate.

Risk-free rate is the rate at which the future cash inflows should be discounted. It is the
borrowing rate of the investor. Risk premium rate is the extra return expected by the
investor over the normal rate. The adjusted discount rate is a composite discount rate.

It takes into account both time and risk factors. In this technique, the discount rate is
raised by adding a risk margin in it while calculating the NPV of a project. For example,
if the rate of discount is 10% for the project, it may be raised to 11% by adding 1% to
take account of risks and uncertainties.

The increased discount rate will reduce the discount factor, thereby lowering the NPV.
Thus the project would be judged as undesirable. This method is used for ranking of
risky projects. But the problem with this method is that there is no ‘specified margin’
which should be added to the free risk rate.

Technique # 2. The Certainty Equivalent Method:

According to this method, the estimated cash flows are reduced to a conservative level
by applying a correction factor termed as certainty equivalent coefficient. The correction
factor is the ratio of riskless cash flow to risky cash flow.

The certainty equivalent coefficient which reflects the management’s attitude towards
risk is

Certainty Equivalent Coefficient = Riskless Cash Flow/Risky Cash Flow.

If a project is expected to generate a cash of Rs. 40,000, the project is risky. But the
management feels that it will get at least a cash flow of Rs. 24,000. It means that the
certainty equivalent coefficient is 0.6.
Under the certainty equivalent method, the net present value is calculated as:

Where αt = Certainty Equivalent Coefficient

At = Expected Cash Flow for year t
I = Initial outlay on the project

i = Discount rate

Technique # 3. Sensitivity Analysis:

The future is not certain and involves uncertainties and risks. The cost and benefits
projected over the lifetime of the project may turn out to be different. This deviation has
an important bearing on the selection of a project.

If the project can stand the test of changes in the future, affecting costs and benefits, the
project will be selected. The technique to find out this strength of the project is covered
under the sensitivity analysis of the project. This analysis tries to avoid overestimation or
underestimation of the costs and benefits of the project.

In sensitive analysis, a range of possible values of uncertain costs and benefits are given
to find out whether the projects desirability is sensitive to these different values. In this
analysis, we try to find out the critical elements which have a vital bearing on the costs
or benefits of the project.

In investment decision, one has to consider as many elements of uncertainty as possible

on costs or benefits side and then arrive at critical elements which affect the expected
costs or benefits of the project. How many variables should be tested to carry out the
sensitivity analysis in order to find out its impact on costs or benefits of the projects. It is
a matter of judgement.

In sensitivity analysis, one has to consider the changes in the various factors correlated
with changes in the other. In order to arrive at the degree of uncertainty, the decision
maker has to make alternative calculation of costs or benefits of the project.

When there are several uncertain outcomes, three cost-benefit calculations are
made in this analysis:

(i) The most pessimistic where all the worst possible outcomes are estimated.

(ii) The most likely where all the middle of the range outcomes are estimated.
(iii) The most optimistic where all the best possible outcomes are estimated.

It explains how sensitive the cash flows are under these three different situations. If the
difference is larger between the optimistic and pessimistic cash flows, the more risky is
the project. The most likely outcome can give a good guide to how ‘borderline’ is the
project.

Technique # 4. Probability Method:

Another method for dealing with risks and uncertainties is to estimate the probable value
for a result. Here one has to see a range of possible cash flows from the most optimistic
to the most pessimistic for each pertinent year. Probability means the likelihood of
happening of an event. It is the proportion of times an event occurs i.e. its frequency. It
is the ratio of favourable number of events to the total number of events.

In a particular situation, if all possible outcomes of an event are listed and the probability
of occurrence is assigned to each outcome, it is called a probability distribution. For any
probability distribution there is an expected value. The expected value is the weighted
average of the values associated with the various outcomes, using the probabilities of
outcome as weights.

If NPV1 NPV2 and NPV3 are three possible estimates of the net prevent value of a project
under uncertainty, and’ the probability of each outcome of NPV is P1 P2 and P3 then the
expected net present value is

Ev (NPV) = P1 (NPV1) + P2 (NPV2) + P3 (NPV3).

This method is conceptually sound. But it lacks objectivity as it is not possible to find
out the probabilities of different outcomes.

PREPARATION OF PROJECTED FINANCIAL STATEMENTS VIZ.

Prepare a Projected Balance sheet
A projected balance sheet is also referred to as a pro forma balance sheet. It shows the
estimation of the total assets and total liabilities of any business. A pro forma balance sheet
is a tabulation of future projections. As a result, it will help your business manage your
assets now for better results in the future.

The asset will contain long-term assets (non-current assets ) and current assets. The long-
term assets will include the building, land, machinery, and vehicles. Whereas the current
asset includes the cash in hand/bank, receivables, and sock for the short term.
On the liability side, we have non-current liabilities and current liabilities. In the non-
current liabilities, it includes the term loan and current liabilities include the account
payable and short-term loan such as a working capital loan.

You may need to prepare a projected balance sheet if you have applied for a business
loan for your new project or you are interested to buy new fixed assets. By showing a well-
crafted projected balance sheet from Finline, the bank will get the confidence that the
business unit is worth viable to invest/provide the loan.

How to Prepare Projected Balance Sheet

The following steps will help prepare the projected balance sheet:

Step 1: Calculate cash in hand and cash at the bank

If you have no booking record of your cash, you can show cash in hand after checking your
cash balance in the business’s pocket. You can check also the available balance at the bank.
Both will be your current assets on the balance sheet.

Step 2: Calculate Fixed Assets

See everything around you. Make the list of assets whose benefits are you taking more than
one year. Check its price from cash memo or past bills. Try to calculate the time of its use.
If you have used it for 3 years. Its value will surely decrease due to depreciation. Charge
10% to 20% per year on every fixed asset up to the used period with any method of
depreciation. Now, you will get the current cost of the fixed asset. Show it on the asset side
of the balance sheet.

Step 3: Calculate Value of Financial Instruments

If you invested your money in shares, bonds, and other financial instruments. Write its
purchase price. If it has decreased, then you can also show the current market price of
financial instruments.

Step 4: Calculate your Business Earning

If you have not made a profit and loss account. You can compare your expenses and your
incomes. If your incomes are more than your expenses, it will be your net profit. That will
 be transferred to the liability side of the balance sheet. You should only deduct expenses
whose benefits, you have obtained in one year.

Step 5: Calculate Business’s Liabilities

In these liabilities, you can add bank loans, secured loans, and other loans. That will be
added to the liability side of the projected balance sheet.

Step 6: Calculate Business’s Capital

Business’s capital, you can calculate by subtracting outside liabilities from total assets. That
will also add to the balance sheet on the liabilities side.

Non -finance/accounting people will be puzzled about how to create the projected balance
sheet. Make one with Finline in less than 10 minutes as you just need to fill in the
questions asked by the intelligent software, which will create the projected balance sheet.

Projected balance sheet

Projected income statement

A projected income statement shows profits and losses for a specific future period – the next quarter or the
next fiscal year, for instance. It uses the same format as a regular income statement, but guesstimating the
future rather than crunching numbers from the past. It's also known as a budgeted income statement.

Penetrate the Mystery

Your projected income statement is important for making business plans and for attracting investors. It has
to be as accurate as possible, even though it's about events that haven't happened yet. Strategies for making
projections depend on the age of your business and your own experience:

 If you're making projections for an established business, past sales and expenses give you a guide to the future.
 If your company is a startup but you have experience in the industry, use that experience to make your
projections.
 If you don't have experience, hire an accountant who does, or extrapolate from the market research you did for
your startup.

If your company is new, it's a good idea to make projections for the next three years. The first year's
projections should include monthly budgeted income statements. After that you can go quarterly.

Sales and Expenses

To begin making your projections, look at sales. How many customers do you expect over the projection
period? How many units sold, or hours of service, if you're providing services? What price are you charging?
Project the cost of goods sold as well.
Next, extrapolate your expenses. These include fixed costs such as leasing a vehicle and variable costs such
as marketing expenses. You don't have to break everything down item by item; a single item for "office
supplies" is probably enough, without detailing price per ream of printer paper.

Drawing up the Statement

Say you're making a projection for the next quarter. Start with the business's projected sales income. Subtract
the cost of goods sold to get the gross margin. Subtract other operating expenses to get net operating income,
then subtract any interest payments due to get your net income.

Using Your Knowledge

Use the projected income statement to decide whether your plans need changing. Is your projected sales
income too low? Then find a way to amp up the income, for example, by moving more units or increasing
unit prices.

If the projections show your business running in the red at first, that's not surprising: Lots of businesses start
out operating at a loss. However, the losses shouldn't be so deep they'll shut you down. It's a good idea to
draw up a projected balance sheet so you can see how much debt you'll be carrying.

PROJECTED FUNDS & CASH FLOW STATEMENTS

A projected cash flow statement is used to evaluate cash inflows and outflows to deter. mine when,
how much, and for how long cash deficits or surpluses will exist for a farm business during an
upcoming time period. That information can then be used to justify loan requests, determine
repayment schedules, and plan for short-term investments. This publication focuses on preparing
and using a projected cash flow statement in managing the farm business.

A projected cash flow statement is best defined as a listing of expected cash inflows and outflows
for an upcoming period (usually a year). Anticipated cash transactions are entered for the
subperiod they are expected to occur. The length of the subperiod depends upon whether a
monthly or quarterly cash flow statement is used. The word cash is crucial in this definition,
because only cash items are included in a cash flow statement.

Cash inflows include cash operating and capital receipts and can include nonfarm as well as farm
revenues. Cash outflows usually include such things as farm operating and capital outlays, family
living expenses, and loan payments. However, if the farming operation is completely separate
from the family, living expenses would not be included in the cash flow statement for the farming
operation. An example of such an arrangement would be a farm that is incorporated and pays
salaries to family members. Also included in the list of cash outlays are debt repayment
commitments, both principal and interest.

What Information Is Provided?

Operating expenses are usually not paid evenly over the course of a year for many farm
enterprises. Also, marketing patterns for many farm products are not evenly distributed throughout
the year. Therefore, revenues usually do not flow into the business, and expenses do not flow out
of the business on an equal and regular basis during the year. This results in periods of cash
deficits and surpluses.
Knowledge of the amounts of cash deficits and surpluses and the timing and duration of each aids
tremendously in setting up a line of credit with a lender. The projected cash flow statement clearly
identifies when loan funds will be needed and when the lender can expect to be repaid. This
information is extremely useful in justifying loan requests, especially during financially stressful
times.

In addition, a projected cash flow statement enables the user to identify the amount and duration of
cash surpluses, which is useful when deciding among the various short-term deposit instruments
currently available to the investor (i.e., 3-month certificates, 6-month money market certificates,
money market funds, etc.).

Of course, the accuracy of the information provided by a projected cash flow statement depends
upon the accuracy of revenue and expense projections, the detail included in the cash flow
statement, and whether the statement is prepared for quarters, months, or even weeks. Even though
it may lack accuracy be cause of being an estimate, a projected cash flow statement does provide a
projection of expected cash deficits and surpluses, which can be updated as the year progresses.

How Is The Statement Organized?

Perhaps the best way to understand how a projected cash flow statement is organized is to think in
terms of a calendar, with the columns representing the subperiods for the planning period used in
the projection. Usually the planning period is one year, but the subperiods can be as detailed as
you desire. The subperiods can represent quarters, months, and even weeks.

The rows represent various categories for the beginning cash balance, cash receipts, cash expenses,
borrowing, saving, and the ending cash balance. Of course, the beginning cash balance for each
subperiod is the ending cash balance for the previous subperiod.

What is cash flow projection?

First things first, if you want to learn about cash flow projections, you need to know what cash flow is.

Cash flow is the amount of money going in and out of your business. Healthy cash flow can help lead your
business on a path to success. But poor or negative cash flow can spell doom for the future of your business.

If you want to predict your business’s cash flow, create a cash flow projection. A cash flow projection
estimates the money you expect to flow in and out of your business, including all of your income and
expenses.

Typically, most businesses’ cash flow projections cover a 12-month period. However, your business can create
a weekly, monthly, or semi-annual cash flow projection.

Advantages of projecting cash flow

Estimating anticipated cash flow projections can help boost your business’s success.
 Projecting cash flows has many advantages. Some pros of creating a cash flow projection include being able
to:

 Predict cash shortages and surpluses

 See and compare business expenses and income for periods
 Estimate effects of business change (e.g., hiring an employee)
 Prove to lenders your ability to repay on time
 Determine if you need to make adjustments (e.g., cutting expenses)

Cash flow projection isn’t for every business. Your projected cash flow analysis can be time-consuming and
costly if done wrong.

Keep in mind that cash flow predictions will likely never be perfect. However, you can use your projected cash
flow as a tool to help manage cash flow.

The bottom line is, your cash projections give you a clearer picture of where your business is headed. And, it
can show you where you need to make improvements and cut costs.

PREPARATION OF DETAILED PROJECT REPORT

Meaning of detailed project report

After the planning and the designing part of a project are completed, a detailed project report is prepared. A detailed
project report is a very extensive and elaborative outline of a project, which includes essential information such as
the resources and tasks to be carried out in order to make the project turn into a success. It can also be said that it is
the final blueprint of a project after which the implementation and operational process can occur. In this
comprehensive project report, the roles and responsibilities are highlighted along with the safety measures if any issue
arises while carrying out the plan.

The following points play an essential role in deciding whether a project turns into success:

 Completion of the project within the stipulated period

 Priority to client satisfaction by delivering quality product after the completion of the project
 Completion of the project within the set limits of escalation of cost
The blueprint design's focus has to be to convert the corporate investment into a project idea that gives good monetary
returns. A detailed project report depicts a practical viewpoint for the implementation of the project. The
requirements and risks should also be highlighted in a detailed manner to prevent any troubles that can delay or halt
the execution of the project. Hence effective measures must also be stated so that the execution of the project can be
carried out hassle-free.

Contents of a detailed project report

A detailed project report must include the following information:
 Brief information about the project
 Experience and skills of the people involved in the promotion of the project
 Details and practical results of the industrial concerns of the promoters of the project
 Project finance and sources of financing
 Government approvals
 Raw material requirement
 Details of the requisite securities to be given to various financial organizations
 Other important details of the proffered project idea include information about management teams for the project,
details about the building, plant, machinery, etc.

What Is Project Finance?

Project finance is the funding (financing) of long-term infrastructure, industrial projects, and public services
using a non-recourse or limited recourse financial structure. The debt and equity used to finance the project
are paid back from the cash flow generated by the project.

Project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the
project's assets, rights, and interests held as secondary collateral. Project finance is especially attractive to the
private sector because companies can fund major projects off-balance sheet (OBS).

KEY TAKEAWAYS

 Project finance involves the public funding of infrastructure and other long-term, capital-
intensive projects.
 This often utilizes a non-recourse or limited recourse financial structure.
 A debtor with a non-recourse loan cannot be pursued for any additional payment beyond the
seizure of the asset.
 Project debt is typically held in a sufficient minority subsidiary not consolidated on the
balance sheet of the respective shareholders (i.e., it is an off-balance sheet item).

Understanding Project Finance

The project finance structure for a build, operate, and transfer (BOT) project includes multiple key elements.

Project finance for BOT projects generally includes a special purpose vehicle (SPV). The company’s sole
activity is carrying out the project by subcontracting most aspects through construction and operations
contracts. Because there is no revenue stream during the construction phase of new-build projects, debt
service only occurs during the operations phase.

For this reason, parties take significant risks during the construction phase. The sole revenue stream during
this phase is generally under an offtake agreement or power purchase agreement. Because there is limited or
no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their
shareholdings. The project remains off-balance-sheet for the sponsors and for the government.
Off-Balance Sheet Projects
Project debt is typically held in a sufficient minority subsidiary not consolidated on the balance sheet of the
respective shareholders. This reduces the project’s impact on the cost of the shareholders’ existing debt and
debt capacity. The shareholders are free to use their debt capacity for other investments.

To some extent, the government may use project financing to keep project debt and liabilities off-balance-
sheet so they take up less fiscal space. Fiscal space is the amount of money the government may spend
beyond what it is already investing in public services such as health, welfare, and education. The theory is
that strong economic growth will bring the government more money through extra tax revenue from more
people working and paying more taxes, allowing the government to increase spending on public services.

Non-Recourse Financing
When a company defaults on a loan, recourse financing gives lenders full claim to shareholders’ assets or
cash flow. In contrast, project financing designates the project company as a limited-liability SPV. The
lenders’ recourse is thus limited primarily or entirely to the project’s assets, including completion and
performance guarantees and bonds, in case the project company defaults.

A key issue in non-recourse financing is whether circumstances may arise in which the lenders have recourse
to some or all of the shareholders’ assets. A deliberate breach on the part of the shareholders may give the
lender recourse to assets.

Applicable law may restrict the extent to which shareholder liability may be limited. For example, liability for
personal injury or death is typically not subject to elimination. Non-recourse debt is characterized by
high capital expenditures (CapEx), long loan periods, and uncertain revenue streams. Underwriting these
loans requires financial modeling skills and sound knowledge of the underlying technical domain.

To preempt deficiency balances, loan-to-value (LTV) ratios are usually limited to 60% in non-recourse loans.
Lenders impose higher credit standards on borrowers to minimize the chance of default. Non-recourse loans,
on account of their greater risk, carry higher interest rates than recourse loans.

Recourse vs. Non-Recourse Loans

If two people are looking to purchase large assets, such as a home, and one receives a recourse loan and the
other a non-recourse loan, the actions the financial institution can take against each borrower are different.

In both cases, the homes may be used as collateral, meaning they can be seized should either borrower
default. To recoup costs when the borrowers default, the financial institutions can attempt to sell the homes
and use the sale price to pay down the associated debt. If the properties sell for less than the amount owed, the
financial institution can pursue only the debtor with the recourse loan. The debtor with the non-recourse loan
cannot be pursued for any additional payment beyond the seizure of the asset.