REGULATORY MECHANISM GOVERNING PROJECT FINANCE

FROM ABROAD

A Project Report on Submitted towards the partial fulfilment of the degree of M.B.A, M.B.L for
the subject

BANKING & FINANCE

Submitted by: Submitted to:

Amit Bikram Dey (189) Mr. P.K.Jain
Madhuri Boob (197) Dr. R.P.Das
Manoj Chhangani (198) Faculty in charge
Mohit Jain (201) Banking & Finance
Vikas Jain (208)
M.B.A., M.B.L Sem. IV

NATIONAL LAW UNIVERSITY, JODHPUR

WINTER SESSION
(JANUARY MAY 2010)
 Index

Serial Chapter Index

No.
a. Objectives 4

b. Research Methodology 4

1. Introduction 5-8

2. System of Project Financing 9-15

3. Project Viability 16-20

4. Project Financing Risks and their Allocation 21-25

5. Security Arrangements 26-29

6. Legal Structure 30-32

7. Sources of Funds 33-35

8. Conclusion and Future Prospects 36

9. Bibliography 37-38

10 Annexure 39-41
 ACKNOWLEDGEMENT

As anyone who has written a project work, or research work, it is quite impossible to
acknowledge by name every individual who has played some part in this work. We feel it
difficult to express in words our profound sense of gratitude to most respected persons who
helped us to make this work possible.
We acknowledge our gratitude to respected faculty Mr. P.K Jain & Dr. R.P. Das for
having laid the foundation of the work by providing the skeleton upon which this skinny body of
project is wrapped up and who have been kind enough to suggest improvement of this work and
make it broad, based.
An ample use of various reference readings has been very frequently made while
compiling data for this project. Such rich reading has been made available at hand by the
treasure-like well maintained library of the National Law University, Jodhpur. We are very much
grateful to the library staff of the university for their unfailing co-operation.
We are very much under obligation to mention here, the contributions of my batch mates
who have, knowingly or unknowingly, provided me the competitive edge which is the driving
force of the whole labour and extra labour put into the project.
Finally, we feel very much gratified to the administration of the National Law
University, Jodhpur for providing comfortable environment, rich infrastructure and the
accessibility to internet without which it is not possible to imagine the completion of this project
work.
Above all, mention has to be made of the Almighty God for continuously blessing us
and our family and friends to whom we owe our very existence.

Amit Bikram Dey, Madhuri Boob

Manoj Chhangani, Mohit Jain,
 Vikas Jain

OBJECTIVES:-

To understand the concept of project finance and its importance in Infrastructure and
Industrial development.

To study the various aspects of Project finance.

To analyse various sources of funds for financing the project.

RESEARCH METHODOLOGY:-

Secondary sources:

1. Internet

2. Newspapers

3. Books

4. Journals

Study and analysis of library references and information obtained from various journals and
Internet will be helpful in collecting secondary data. The method of research would be deductive,
as conclusion would be drawn after the analysis and interpretation of data collected.

Chapter 1
Introduction

1.1 Role of Infrastructure in Development

It is now well recognized that a countrys development is strongly linked to its infrastructure
strength. Infrastructure helps determine a countrys ability to expand trade, cope with population
growth, reduce poverty and a host of other factors that define economic and human development.
Good infrastructure raises productivity and lowers production cost, but must also expand fast
enough to accommodate growth. The precise links between infrastructure and development have
been subject to extensive debate. The link between infrastructure and economic growth has been
studied extensively in literature, the World Bank report (1994) of the World Bank for instance.
The results show that infrastructure development can have a significant impact on the economic
growth.

For low-income countries basic infrastructure such as water, irrigation and to a lesser extent
transportation are more important. As the economies mature into a middle-income category, their
share of power and telecommunications in the infrastructure and investment increases. An
estimate however shows that a 1% increase in infrastructure stock 1 is positively associated with a
corresponding growth in GDP across countries.

Infrastructure is a necessary but not a sufficient condition for growth. Adequate complements of
other resources must be present as well. In developing countries like India, infrastructure
development and financing has largely been the prerogative of the government. Since
infrastructure is typically a natural monopoly, the government considered it necessary to keep
control of the same, in public interest. The success and failure of infrastructure to meet the needs
of the people is largely a story of the governments performance.

In the case of India, the government has taken great strides in improving the infrastructure stock
of the nation since independence. However, when compared to developed countries we still have
a long way to go. For instance, per capita power consumption in India is a meagre 282 KWH

1
Infrastructure is taken to include road, rails, power, irrigation and telephones.
compared to 18,117 KWH for Canada. The situation has worsened in the 90s with frequent
revisions being made to the eighth plan document owing to the governments inability to bear the
cost of infrastructure anymore.

The simple truth is that public money is no longer sufficient to meet the burgeoning needs of the
nation in line with its economic aspirations. Reluctantly, therefore the government has to throw
open the doors to private participation in infrastructure.

1.2 Impact of Infrastructure on External Trade and Production

Reliable and adequate quantity of infrastructure is a key factor in the ability of countries to
compete globally. In particular, the competition for new export markets is specially dependant
on high quality infrastructure. According to studies, increased globalisation of the world trade
has been not only due to the liberalization of trade policy but also due to the major advances in
the communication, transport and technologies.

There is an increasing trend not only in terms of greater globalisation of trade but also in terms of
globalization of production. It is possible for companies located in different parts of the globe to
produce components. In the recent years India has been used as a base for sourcing by a host of
companies such as Sony, Toyota, ABB and the like for their raw materials as well as for
components. To be able to fulfil the requirements of sourcing MNCs world-class infrastructure
facilities including appropriate logistical support and multi-modal transport facilities are
essential.2

Infrastructure faculties are critical for the modernization and diversification of production. A
good system of EDI involving telecommunications and computer networking is essential for
efficient operations. In addition to sourcing, off shore software design, engineering and
development is possible, thanks to the advances made in the global market. Thus developing
countries can leap frog into hi-tech areas with the help of good infrastructure facilities.

1.3 Public Sector in Infrastructure Development

2
world Development Report 1994,p2
Infrastructure represents a strong public interest and so mer5its the attention of the government.
The dominant role that the public sector has assumed in the infrastructure
Recognition of the economic importance of infrastructure
Belief that the problems with supply and technology require highly active intervention by
the government.
Faith that the government could succeed where markets appear to fail

There is enough evidence to show that, despite significant growth in a number of developing
countries infrastructure facilities have fallen far short of the requirements, Though each sector
has special problems, there are common patterns in the provision of infrastructure services and
shortcomings such as:
Operational deficiencies
Inadequate maintenance
Extensive dependence on fiscal resources
Lack of responsiveness to the needs
Limited benefits to the poor

1.4 Need for Increasing the Role of the Private Sector

In the mid 1980s evidence emerged in several countries that infrastructure services were not
meeting the demand. Many governments have realized that the traditional state owned utility
approach is no longer adequate. Although circumstances have varied across countries and
sectors, the shift towards greater private involvement has been driven by the need to provide
better services to more people at a lower cost.
The main reason for a shift towar4ds private infrastructure is the growing dissatisfaction with the
public ownership monopoly and provision of infrastructure facilities. Under-investment by
many state utilities has resulted in a back-log of unmet demand for infrastructure services: in
many countries this is the principal constraint to growth. Power shortages have led to a shortfall
in production, higher costs and a decline in investment. Similarly limited availability and the
poor quality of telecommunications have made it difficult for business in many developing
countries to participate in the new international information based economy, Fiscal constraints
faced by the governments and technological developments are other factors which have favoured
increased private participation

Technology developments have reduced the natural monopoly characteristics that have allowed
unbinding private entry and competition into many infrast5ructure services. Technology
developments in many cases have helped to create more competitive pressures. For example:
Containerization has facilitated competition in port services.
Falling costs of wireless telecommunications have enabled small operators to compete
with wire-based networks.
Independent power producers can construct and operate relatively small plants at unit
costs comparable to the large generators
Contract based relationships (eg. Build-Operate-transfer, Build-own-Operate,
Concessions) have allowed private entry even within the existing regulatory network but
with minor modifications.

Also, the private sector entry often sets up a pressure for further regulatory changes and
sometimes competition may mitigate the need for close regulation.

1.5 Financing Infrastructure.

Private financing is expected to ease the burden of infrastructure borne b the government. More
importantly it will encourage better risk sharing, accountability and management in infrastructure
provision. The task for the future is to channel private savings directly to private risk bearers
who make long term investments in institutions and financing instruments adapted to the needs
of different investors in different projects. Unless these financing needs can be met the country
will gain precious little from privatising infrastructure.

Chapter 2
System of Project Financing
There is a growing realisation in many developing countries of the limitations of governments in
a managing and financing economic activities, particularly large infrastructure projects.
Provision of infrastructure facilities, traditionally in the government domain, is now being
offered for private sector investments and management. This trend has been reinforced by the
resource crunch faced by many governments. Infrastructure projects are usually characterised by
large investments long gestation periods, and very specific domestic markets.

In project financing the project, its assets, contracts, inherent economic and cash flows are
separated from their promoters or sponsors in order to permit credit appraisal and loan to the
project, independent of the sponsors. The assets of the specific project serve as collateral for the
loan, and all loan repayments are made out of the cash of the project. In this sense, the loan is
said to be of non-resource to the sponsor. Thus, project financing may be defined as the scheme
of financing of a particular economic unit in which lender is satisfied in looking at the cash
flows and the earnings of that economic unit as a source of funds, from which a loan can be
repaid, and to the assets of the economic unit as a collateral forte the loan. 3 In the past, project
financing was mostly used in oil exploration and other mineral extraction through joint ventures
with foreign firms. The most recent use of project financing can be found in infrastructure
projects, particularly in power and telecommunication project.

Project financing is made possible by combining undertakings and various kinds of guarantees
by parties who are interested in a project. It is built in such a way that no one party alone has to
assume the full credit responsibility of the project. When all the undertakings are combined and
reviewed together, it results in an equivalent of the satisfactory credit risk for the lenders. It is
often suggested that the project financing enables a parent company to obtain inexpensive loans
without having to bear all the risks of the project. This is not true, in practice, the parent
company is affected by the actual plight of the project, and the interests on the project loan
depend on the parents stake in the project.4

The traditional form of financing is the corporate financing or the balance sheet financing. In this
case, although financing is apparently for a project, the lender looks at the cast flows and assets

3
Nevitt, P.K., Project Financing, Euro money Publications, 1983.
4
Breaket, R.A. and Myers, S.C. Principles of Corporate Finance, fourth Ed. McGraw Hill,pp.608-612.
of the whole company in order to service the debt and provide security. Figure 30.3 shows the
basic differences between balance sheet financing and project financing.

Balance sheet financing Project Financing

Lender Lender

Project Sponsor
Project

Sponsor Equity

Equity Loan Special Project

Entry

Owns
Owns
Project Assets
Project Assets
The following are the characteristics of project financing:
A separate project entity is created that receives loans from lenders and equity from
sponsors.
The component of debt is very high in project financing. Thus, project financing is a
highly leveraged financing.
The project funding and all its other cash flows are separated from the parent companys
balance sheet.
Debt services and repayments entirely depend on the projects cash flows. Project assets
are used as collateral for loan repayments.
Project financers risks are not entirely covered by the sponsors guarantees.
Third parties like suppliers, customers, government and sponsors commit to share the risk
of the project.
 Project financing is most appropriate for those projects, which require large amount of capital
expenditure and involve high risk. It is used by companies to reduce their own risk by
allocating the risk to a number of parties. It allows sponsors to:
Finance large projects than the companys credit and financial capability would
permit.
Insulate the companys balance sheet from the impact of the project.
Use high degree of leverage to benefit the equity owners.

Project Financing Arrangements

The project financing arrangements may range from simple conventional type of loans to more
complex arrangements like the build-own-operate-transfer (BOOT). The typical arrangements,
particularly in the power sector, include:
1. The build-own-operate-transfer (BOOT) structure
2. The build-own-operate (BOO) structure
3. The build-lease-transfer (BLT) structure

The Build-Own-Operate-Transfer (BOOT) Arrangement:

The build-own-operate-transfer (BOOT) is essentially an extension of the project-financing

concept. It is a special financing scheme, which is designed to attract private participation in
financing constructing and operating infrastructure projects. In BOOT scheme, a private project
company builds a project, operates it for a sufficient period of time to earn an adequate return on
investment, and then transfers it to the host government or its agency. Quite often, the value of
efficiency gain from private participation can outweigh the extra cost of borrowing through a
BOOT project, relative to direct government borrowing.5

BOOT projects can be either solicited or unsolicited. When proposals are solicited, the project is
identified and formulated by the government and the private sector is invited to submit
unsolicited proposals on their own accord.

5
World Bank, World Development Report 1994
The private group usually consists of international construction contractors, heavy equipment
suppliers, and plant and system operators along with local partners.

BOOT projects have been implemented or a rein the process of being implemented in many
developing countries. Power and roads are the two sectors with the largest number of projects.
BOOT projects have also been implemented for ports and mass transit and rail. There have been
only a few BOOT projects in the telecommunication se tore in Thailand Indonesia. According to
a recent World Bank study, the reason why BOOT schemes have not been p0opulare in the
telecommunication sector its he potential complexity associated with co-ordinating the BOOOT
operators distribution networks with those of the state-owned incumbent, Issues involving
interconnections, sharing of ducts, maintenance and new investments, all must be resolved.
These factors tend to increase risks for investors, make management co-ordination harder, and
raise the questions for investors as to whether the will have adequate control over the facilities in
which they have invested to achieve appropriate levels of productivity.6

The Build-Own-Operate (BOO) Arrangement:

The issue of transfer(the T in BOOT projects) is ambiguus because most of the BOOT projects
under operation or consideration have the transfer dates quite far away and, therefore, they are
not a real concern as yet. One problem with the transfer provision is the likelihood of the capital
stock of the project being run down as the date of transfer draws bearer.

6
Smith, P.L. and Staple. G. Telecommunication Sector Reform in Asia: Towards a New Pragmatism, World Bank,
Discussion Paper No. 232, the World Bank, 1994.
 Lenders

Contractor
Loan Debt Service
Fuel

Equity Transport
Investors Owner
Return on Operation &
Equity
Maintenance
Ownership Payment

Land Lease
Payment
Electricity Power Plant
Supply Company

KW Hrs

BOOT/BOO structure of power plant

This may take place in spite of legal agreements, which includes inspection plans and other such
measures. In any case, there does not seem to be any rationale for such a transfer if the very
basis of the projects was to run it outside the public sector. One alternative to transfer that has
been suggested is for the foreign shareholders to divest themselves of their equity either entirely
or up to some negotiated percentage at the end of the stipulated time period. Such an
arrangement is generally referred to as the build-operate-own (BOO) arrangement. In BOO
arrangement, projects are funded without any direct sovereign guarantee. Thus, it implies limited
recourse financing. Unlike in BOOT arrangements, in BOO structure, the project is not
transferred to the host government, rather the owner will divest his stake and seek investment =s
from investors in the capital markets. This facilitates the availability of finances. BOOT and
BOO arrangements are essentially similar except thT IN boo arrangement the sponsor preserves
the ownership.
Build-Lease-Transfer arrangement
In the build lease transfer arrangement, the control of the project is transferred from the project
owners to a lease. The shareholders retain the full ownership of the project, but, for operation
purposes, they lease it to a lessee. The host government agrees with the lessee to buy the output
or service of the project. The lessor receives the lease rental guaranteed by the host government.

Chapter 3
Project Viability

Investors are concerned about all the risks a project involves, who will bear each of them, and
whether their returns will be adequate to compensate them for the risks they are being asked to
bear. Both the sponsors and their adviser must be thoroughly familiar with the technical aspects
of the project and the risks involved, and they must independently evaluate a projects economics
and its ability to service project related borrowings.

There are certain vital aspects related to a success of a project. They are namely;

Technically feasible

Commercially desirable

Financially sound

Environment friendly

Managed by sound promoters

Adequately secured

Level of risk commensurate with the overall business risk and its corresponding returns.

The entrepreneur has to look into details of all the above aspect to ensure that the project will
yield better results for the organization.

Technical Feasibility:

Prior to the start of construction, the project sponsors must undertake extensive engineering work
to verify the technological processes and design of the proposed facility. If the project requires
new or unproven technology, test facilities or a pilot plant will normally have to be constructed
to test the feasibility of the process involved and to optimise the design of full scale facilities. A
well-executed design will accommodate future expansion of the project; often, expansion beyond
the initial operating capacity is planned at the outset. Rhe related capital cost and the impact of
project expansion on operating efficiency are then reflected in the original design specifications
and financial projections.

Project Construction Cost:

The detailed engineering and design work provides the basis for estimating the construction
costs for the project. Construction costs should in clued the cost of all facilities necessary for the
projects operation as a freestanding entity. Construction costs should include contingency factor
adequate to cover possible design errors or unforeseen costs. Project sponsors or their advisers
generally prepare a time schedule detailing the activities that must be accomplished before and
during the construction period. A quarterly breakdown of capital expenditures normally
accompanies the time schedule. The time schedule specifies (1) time expected to be required to
obtain regulatory or environmental approvals and permits for construction. (2) The procurement
lead time anticipated for major pieces of equipment and (3) the time expected to be required fro
pre-construction activities- performing detailed design work, ordering the equipment and
building materials, preparing the site and hiring the necessary manpower. The project sponsor
examines the critical path of the construction schedule to determine where the risk of delay is
greatest and then assesses the potential financial impact of any projected delay.

Economic Viability:

The critical issue concerning economic viability is whether the projects expected net present
value is positive. It will be positive only if the expected present value of the future free cash
flows exceeds the expected present value of the projects construction costs. All the factors that
can affect project cash flows are important in making this determination.
Assuming that the project is completed on schedule and within budget, its economic viability
will depend primarily on the marketability of the projects output (price and volume). To evaluate
marketability, the sponsors arrange for a study of projected supply and demand conditions over
the expected life of the project. The marketing study is designed to confirm that, under a
reasonable set of economic assumptions, demand will be sufficient to absorb the planned output
of the project at a price that will cover the full cost of production, enable the project to service its
debt, and provide an acceptable rate of return to equity investors.
The marketing study generally includes:

1. A review of competitive products and their relative cost of production;

2. An analysis of the expected life cycle for project output, expected sales volume, and
projected prices; and
3. An analysis of the potential impact of technological obsolescence.

The study is usually performed by an independent firm of experts. If the project will operate
within a regulated industry, the potential impact of regulatory decisions on production levels and
pricesand, ultimately, on the profitability of the project must also be considered.

The cost of production will affect the pricing of the project output. Projections of operating costs
are prepared after project design work has been completed. Each cost element, such as raw
materials, labor, overhead, taxes, royalties, and maintenance expense, must be identified and
quantified. Typically, this estimation is accomplished by dividing the cost element into fixed and
variable cost components and estimating each category separately. Each operating cost element
should be escalated over the term of the projections at a rate that reflects the anticipated rate of
inflation. From a financing standpoint, it is important to assess the reasonableness of the cost
estimates and the extent to which the pricing, and hence the marketability, of the project output is
likely to be affected by estimated cost inflation rates.

In addition to operating costs, the projects cost of capital must be determined. The
financial adviser typically is responsible for this task. He develops and tests various financing
plans for the project in order to arrive at an optimal financing plan that is consistent with the
business objectives of the project sponsor.

Adequacy of raw material supplies:

The project should have sufficient supplies of raw materials to enable it to operate at design
capacity over the term of the debt. Independent consultants mat be summoned to evaluate the
quantity, grade, and rate of extraction that the mineral reserves available to the project are
capable of supporting. The project should have the ability to access the nerves of raw materials
through contractual agreements like direct ownership, lease, purchase agreement etc.

Creditworthiness:

A project has no operating history at the time of its initial debt financing. Consequently, the
amount of debt the project can raise is a function of the projects expected capacity to service
debt from project cash flow- or more simply, its credit strength. A projects credit strength
derives from (1) the inherent value of the assets included in the project, (2) the expected
profitability of the project, (3) the amount of equity project sponsors have at risk and indirectly,
(4) the pledges of creditworthy third parties or sponsors involved in the project.

Expected profitability of the project:

The expected profitability of a project represents the principal source of funds to service project
debt and provide an adequate rate of return to the projects equity investors. Lenders generally
look for two sources of repayment for their loans: (1) the credit strength of the entity to which
they are loaning funds and (2) the collateral value of any assets the borrower pledges to secure
the loans. Also, there is a third source, the credit support derived indirectly from pledges of third
parties.

Amount of equity project sponsors have at risk:

Debt ranks senior to equity. In the event a business fails, debt holders have a prior claim on the
assets of the business. Given the value of project assets, the greater the amount of equity, the
lower the ratio of debt to equity. Therefore, the lower the degree of risk lenders face.

Credit support derived indirectly from pledges by third paries:

Although lenders look principally to the revenues generated from the operations of a project to
determine its viability and credit worthiness, supplemental credit support for a project may have
to be provided by the sponsors or other creditworthy parties benefiting from the project. The
contractual agreements among the operator / borrower, the sponsors, other third parties, and the
lenders, which are designed to ensure debt repayment and servicing, as well as the credit
standing of these guarantors, are necessary to provide adequate security to support the projects
financing arrangements.
Chapter 4
Project Financing & Their Risk Allocation

From the perspective of potential investors, the main risks relate to project completion, market,
foreign currency, and supply of inputs. The objective is to allocate these risks to those parties
who are in the best position to control particular risk factors. This reduces the moral hazard
problem and minimises the costs of bearing risks.

Project completion risk:

This is the major risk factor in most infrastructure projects. It is usually covered by a fixed price,
firm date, and turnkey construction contract with liquidated damages for delay supported by
performance bonds. The contract specifies performance parameters and warranty periods for
effects. Lenders require sponsors of the project company to provide a guarantee to fund costs
overruns. In addition, a standby credit facility may also be employed.

Market risk:

Having long-term quantity and price agreements covers this risk. In the case of power projects
where the electricity is likely to be sold to government controlled Distribution Company; this is
achieved through a take or pay power purchase agreement (PPA). Under this contract, certain
payments have to be made irrespective of the actual off-take as long as the company makes
available the capacity. The tariff is determined on a cost plus basis using standard costs. For
power projects in India, the government has evolved a system of two part tariffs. The first part
ensures recovery of fixed costs based on performance at normative parameters. Fixed costs
include depreciation, operating and maintenance expenses, tax on income, interest on loans, and
working capital and a return on equity. This part of the tariff is paid irrespective of the amount of
power actually taken. The second part covers variable expenses based on the units of electricity
actually supplied. Variable costs are the costs of primary and secondary fuel based on set norms
for fuel consumption. Apart from the PPA, payments may be made to a trustee, usually an
international bank, as additional security, in an escrow account, which then directly makes
payments to creditors and suppliers. In the case o transport projects, tolls have to be collected
from the public and not from the government agency. This can give rise to problems while
enforcing toll agreements. Competition from alternative roads or transit systems can also affect
the traffic flow. Therefore, unlike power projects, which have power purchase agreements, in
transport projects, lenders cannot rely on fixed revenue over the life of the project. Hence the
project continues to carry market risk. This is sought to be mitigated by other arrangements.

Foreign Exchange risk:

Foreign exchange risks are perhaps the single largest concern of foreign financiers investing in
developing countries. In the case of infrastructure projects, the risk is greater since most of these
projects, with the exception of some telecommunication and port projects, generate local
currency revenues. The risk is at two levels
Macro-economic convertibility i.e. whether the project will have access to foreign
exchange to cover debt service and equity payments and
Tariff adjustment for currency depreciation i.e., whether foreign exchange equivalent of
the projects local revenues will be adequate to service foreign debts and equity.
The risk of macro-economic convertibility will generally require a few government
guarantees. In many BOOT projects, there is a provision for tariff escalation to account for
currency depreciation and protect returns to investors in foreign currency terms. For Indian
power projects, the return on foreign equity included in the tariff can be provided in the
respective foreign currency.

Supply of inputs:

This is important for power projects, which require a reliable supply of quality fuel. The risk is
covered through a contract with a fuel supply agency. The price risk is usually covered through a
provision to pass on increases in fuel prices through higher tariffs. Such an arrangement i.e.
transferring the ris of increases in fuel prices from the project to the power purchaser may have
an adverse impact on the incentives of the project sponsor to control price increases. A corollary,
it increases the responsibility of the power purchaser to monitor the increase in input prices.
Hedging with forwards and futures:

A forward contract obligates the contract seller to deliver to the contract buyer (1) a specified
quantity (2) of a particular commodity, currency, or some other item (3) on a specified future
date to a stated price that is agreed to at the tie the two parties enter into the contract. A futures
contract is similar to a forward contract except that a futures contract is traded on an organized
exchange whereas forwards are traded over the counter and a futures contract is standardized
whereas forwards is customized.

Interest rate Cap Contract:

An interest rate cap contract obligates the writer of the contract to pay the purchaser of the
contract the difference between the market interest rate and the specified cap rate whenever the
market interest rate exceeds the cap rate.

Interest rate swap agreement:

An interest rate swap agreement involves an agreement to exchange interest rate payment
obligations based on some specified notional principal amount. A project that borrows funds
from a commercial bank on a floating-rate basis an enter into an agreement with a financial
institution under which it agrees to pay a fixed rate of interest and receive a floating rate of
interest. The floating rate receivable under the swap agreement is designed to cancel out the
floating rate payable under the bank loan agreement.

Eg.:- The project borrows funds from a bank at an interest rate of LIBOR + 1 percent. It agrees
to pay 8 percent and receive LIBOR under the swap agreement. Its net interest cost is 9 percent
(fixed rate).
Government guarantees and risk mitigation:

Most BOOT projects have guarantees by the government or government agencies in various
forms. Government guarantees relate to following:

Country Risk:

Country risk includes risks of currency transfer, expropriation, war and civil disturbances, and
breach of contract by the host government. The multilateral Investment guarantee Agency
(MIGA) of the World Bank provides guarantee against country risk for an appropriate premium.
Export credit agencies also provide such guarantees but they usually seek counter-guarantees
from the host government.

Sector Risk:

Sector risk refers to the risk in certain sectors because of the role of government agencies in
those sectors. For example, in the power sector, the buyer is usually a government utility agency
that transmits and distributes power. The solvency of the utility is critical for the take or pay
power purchase agreement to have any value. For selected power projects, the Indian
government has agreed in principle to give counter guarantees to back up state guarantees for the
State Electricity Boards (SEBs), payment obligations to private generating companies, on a
specific request to the state government concerned and subject to the state government agreeing
to certain terms and conditions.

For toll roads, government support may be necessary to enforce toll collections. Similarly, in the
case of municipal services such as water supply and solid-state disposal, the support of municipal
authorities is important. In each case, the government may guarantee contract compliance of the
respective agencies.

Commercial risk:

Commercial risk refers to the risk to profitability arising from market demand and price;
availability of inputs and prices; and variations in operating efficiency. These risks, except to the
extent they are induced by country risk and sector policy risk, should ideally be borne by the
investors. However, as noted in the World Developmental Report, 1994, in such projects, the
market risk or the risk arising from fluctuation in demand is effectively transferred to the
government through the take or pay formula. This becomes necessary because the market risk
is intermingled with the danger that financially troubled power purchasers or water users may not
honour their commitments. Overall sector reform is required to eliminate policy-induced risk and
thus reveal the market risk.
Chapter 5
Security Arrangements

Arranging sufficient credit support for project debt securities is a necessary precondition to
arranging debt financing for any project. Lenders to a project will require that security
arrangements be put in place to protect them from various risks. The contractual security
arrangements apportion the risks among the project sponsors, the purchasers of the project
output, and the other parties involved in the project. They represent a means of conveying the
credit strength of going-concern entities to support project debt.

Security arrangements covering completion of project:

The security arrangements covering completion typically involves an obligation to bring the
project to completion one else repay all project debt. Lenders normally require that the sponsors
or creditworthy parties provide an unconditional undertaking to furnish any funds needed to
complete the project in accordance with the design specifications and place it into service by a
specified date. The specified completion date normally allows for reasonable delays. If the
project is not completed by the specified date, or if the project is abandoned prior to completion,
the completion agreement typically requires the sponsors or other designated parties to repay all
project debt. The obligations of the parties providing the completion undertaking terminates
when completion of the project is achieved.

Direct security interest in project facilities:

Lenders require a direct security interest in project facilities, usually in the form of a first
mortgage lien on all project facilities. This security interest is often of limited value prior to
project completion. Following completion of the project, the first lien provides added security for
project loans. The lien gives lenders the anility to seize the assets and sell them if the project
defaults on its debt obligations. It thus affords a second possible source of debt repayment apart
from cash flows of the project.
Security covering debt service:

After the project commences operations, contracts for the purchase and sale of the projects
output or utilization of the projects services normally constitute the principal security
arrangements for project debt. Such contracts are intended ensure that the project will receive
revenues that are sufficient to cover operating costs fully and meet debt service obligations in a
timely manner.

Purchase and Sale Contracts:

Take-if-offered contract

Such a contract obligates the purchaser of the projects output or services to accept delivery and
pay for the output and services that the project is able to deliver. It does not require the purchaser
to pay if the project is unable to deliver the product. That is the contract protects the lenders only
if the project is operating at a level that enables it to service its debt. Lenders would therefore
require additional credit support or security arrangements in order to provide against unforseen
events.

Take-or-pay contract:

A Take-or-pay contract is similar to a Take-if-offered contract; it gives the buyer the option to
make cash payment in lieu of taking delivery, whereas the take-if-offered contract requires the
buyer to accept deliveries. Cash payments are usually credited against charges for future
deliveries. Like the take-if-offered contract, a take-or-pay contract does not require the purchaser
to pay if the project is unable to deliver the output or services.

Hell-or-high water contract:

This is similar to a take-or-pay contract except that there are no outs even when adverse
circumstances are beyond the control of the purchaser. The purchaser must pay in all events,
regardless of whether any output is delivered. It therefore provides lenders with tighter security
than other contracts.
Step-up provisions:

The strength of these various agreements can be enhanced in situations where there are multiple
purchasers of the output. A step-up provision is often included in the purchase and sale contracts.
It obligates all the other purchasers to increase their respective participation in case one of the
purchasers goes into default.

Raw material supply agreements:

A raw material supply agreement represents a contract to fulfil the projects raw material
requirements. The contract specifies certain remedies when deliveries are not made. Often both
purchase and supply contracts are made to prove=ide credit support for a project. A supply-or-
pay contract obligates the raw material supplier to furnish the requisite amounts of the raw
material specified in the contract or else make payments to the project entity that are sufficient to
civer the projects debt service.

Supplemental credit support:

Depending on the structure of a projects completion agreement and the purchase and sale
contracts, it may be necessary to provide supplemental credit support through additional security
arrangements. These arrangements will operate in the event the completion undertaking or the
purchase and sale contracts fail to provide the cash to enable the project entity to meet its debt
service obligations.

Financial support agreement:

A financial support agreement can take the form of a letter of credit or similar guarantee
provided by the project sponsors. Payments made under the letter of credit or similar guarantee
are treated as subordinated loans to the project company. In some cases it is advantageous to
purchase the guarantee of a financially able party to provide credit support for the obligations of
a project company.
Cash deficiency agreement:

It is designed to cover any cash shortfalls that would impair the project companys ability to meet
its debt service requirements. The obligor makes a cash payment sufficient t cover the cash
deficiency. Payments made under a cash deficiency agreement are usually credited as cash
advances toward payment for future services or product from the project.

Escrow Fund:

In certain instances lenders may require the project to establish an escrow fund that typically
contains between 12 and 18 mnths debt service. A trustee can draw money from the escrow fund
if the projects cash flow from operations proves insufficient to cover the projects debt service
obligations.

Insurance:

Lenders typically require that insurance betaken out to protect against certain risks of force
majeure. The insurance will provide funds to restore the project in the event of force majeure,
thereby ensuring that the project remains a viable entity. The project sponsors normally purchase
commercial insurance to cover the cost of damage caused by natural disasters. They may also
secure business interruption insurance to cover certain other risks. In addition lenders may
require the sponsors to agree contractually to provide additional funds to the project to the extent
insurance proceeds are insufficient to restore the operations.
Chapter 6
Legal Structure

One of the most critical questions project sponsors need to address is whether a legally distinct
project financing entity should be employed and how it should be organized. The appropriate
legal structure for a project depends on a variety of business, legal, accounting, tax, regulatory
factors.

Undivided Joint interest:

Projects are often owned directly by the participants as tenants in common. Under the undivided
joint interest ownership, each participant owns an undivided interest in the real and personal
property constituting the project and shares in the benefits and risks of the project in direct
proportion to the ownership percentage. The ownership interests relate to the entire assets of the
project; no participant is entitled to any particular portion of the property.

When the project is organized, the participants choose someone in their ranks to serve as the
project operator. This arrangement is particularly suitable when one of the owners already has
operations in the same industry that are of a similar nature, or otherwise has qualified employees
available. The duties of the operator and obligations of all other parties are specified in an
operating statement. The joint venture will require each participant to assume responsibility for
raising its share of the projects external financing requirements. Each sponsor will be free to do
so by whatever means are most appropriate to its circumstances. Thus for example, if a sponsor
owns 25 percent of the project, it will be required to provide, from its resources, 25 percent of
the funds necessary to construct the project.

The undivided joint interest has particular appeal when firms of widely differing credit strength
are sponsoring the project. By financing independently, the higher-rated credits can borrow at a
cost that is lower than the cost at which the project entity can borrow based on its composite
credit. Depending on the sponsors ability to take immediate advantage of the tax benefits of
ownership arising out of the project, direct co-ownership may also provide the project sponsors
with immediate cash flow to fund their equity investments.

Corporation:

The form of organization most frequently chosen for a project is the corporation. A new
corporation is formed to construct, own, and operate the project. This corporation, which is
typically owned by the project sponsors, raises funds through the sponsors equity contributions
and through the sale of senior debt securities issued by the corporation. The senior debt
securities typically take the form of either first mortgage bonds or debentures containing a
negative pledge covenant that protects their senior status. The negative pledge prohibits the
project corporation from granting a lien on project assets in favour of other lenders unless the
debentures are secured rateable. The corporate form permits creation of other types of securities,
such as junior debt (second mortgage, unsecured, or subordinated debt), preferred stock, or
convertible securities.

The corporate form of organization offers the advantages of limited liability and an issuing
vehicle. Nevertheless, the corporate form has disadvantages that must be considered. The
sponsors usually do not receive immediate tax benefits from any investment tax credit (ITC) the
project entity can claim or from construction period losses of the project (see Tax
Considerations below). Also, the ability of a sponsor to invest in the project corporation may be
limited by provisions contained in the sponsors bond indentures or loan agreements. In
particular, the provisions restricting investments either by amount or by type may impose such
limitations.

Partnership:

The partnership of organization is frequently used in structuring joint venture projects. Each
project sponsor, either directly or through a subsidiary, becomes a partner in a partnership that is
formed to own and operate the project. The partnership issues securities (either directly or
through a corporate borrowing vehicle) to finance construction. Under the terms of a partnership
agreement, the partnership hires its own operating personnel and provides for a management
structure and decision-making process.

A partnership is particularly attractive for so-called cost companies; a profit is not realized at
the project level but instead is earned further downstream in the sale of the projects output. The
Uniform Partnership Act imposes joint and several liabilities on all the general partners for all
obligations of the partnership. They are also jointly and severally liable fro certain other project-
related obligations any of the general partners incurs in the ordinary course of business or within
the scope of a general partners apparent authority. A partnership can also have any number of
limited partners. They are not exposed to unlimited liability. However, there must be at least
one general partner who does have such exposure.
Chapter 7
Sources of Funds

Financing options:

(a) Equity finance:

Government policy allow a debt equity ratio of 8:2, however lending institutions advocate a
gearing ratio up to 7:3 as a prudent measure of lending. Specialised infrastructure and mutual
funds have come up to bridge the equity gap in mega projects such as Global Power
investment of GE Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund
of Peregrine Capital Ltd. and ICICI.

(b) Debt Financing:

In raising debt or financing the power sector projects he list of funds should be the lowest so
that the ultimate cost of electricity will be the lowest for the end consume.
The decision of the promoter to go in for equity or debt financing depends on various factors
like go guidelines for power projects, incentives available and return on equity as also the
cost of debt vis-a Vis equity.

(c) Domestic Capital market:

Bonds are issued by the Central / State Government and Publish/private Ltd. Companies t
augment the resources of the power sector in the capital market. Presently, internal rates are
regulated and credit rating is mandatory if the maturity of the instruments exceeds 18
months. NCDs with an option of buy back, debentures with equity warrants, floating rate
bonds and deep discount bonds are some of the innovative instruments offered in the market.
(d) Indian Financial Institutions:

The area of project financing in the Indian context is mainly limited to the Indian Term
Lending Institutions. In addition a large number of state level institutions, finance projects of
smaller size commercial banks also participate in the term loans to a limited extent, besides
meeting the working capital requirements.

As no individual FI can feed to the power sector because of the huge funds requirements and
the long gestation period of the projects. The concept of loan syndication amongst the FIs is
gaining momentum. This also helps in sharing the risk among the Fis apart from saving o the
efforts and the cost because of the appraisal done by the leading institution.

(e) Sources of International finance:

Due to the domestic finance viable for the power projects, the need to tap international
markets has become inevitable which is characterised by the long tenure of maturities and
availability of various modes of finance.

(f) Multilateral Institutions:

Institutions like the World Bank, IFC, ADB etc. have traditionally been financing
infrastructure in developing countries. The financing comer with restrictive covenants
affordable costs, long tenure and in an assured manner. The co-financing facility
extended by some of the multilateral institutions is gaining popularity. In many of these
loans, sovereign guarantee is required.

(g) Export Credit Agencies:

ECAs are a common source of bilateral funding. Credit is provided by ECAs such as the
US Exim Bank, Exim Japan, etc. ECAs have a long history of providing fianc for all
types of power generation equipment. There are certain limitations in ECA financing like
 exposure limits, exchange risk, transfer to IPP guarantee requirements and cost of
insurance etc.

(h) External commercial borrowings:

These include Yankee bonds, Dragon bonds, Euro Currency syndicated loans, US 144A
private placements, Global Registered Notes (GNRs) Global Bonds etc.

(i) Syndicated loans:

The special features of syndicated loans are that they are for medium to longer period;
specific to the requirements of the borrowers to suite their projects and availability of
floating rate of interest. Most of the investors are Asian/European Banks, Fis, Insurance
Companies and pension funds.

(j) US rule 144A Private placement:

Rule 144A allows for private placement of debt to financial institutions known as QIB,
without the kind of stringent disclosure requirements needed for equity issues. Long
tenure of bonds and less restrictive covenants makes this proposition conducive to the
financing of power projects.

(k) Global Depository receipts(GDRs):

GDRs present an attractive avenue of funds for the Indian companies. Indian Companies
can collect a lage volume of funds in foreign currency in Euro issues. GDRs are usually
listed in Luxembourg and are traded in London in the OTC market or among a restricted
group such as Qualified Institutional Buyers (QIBs) in the USA. The GDRs do not have a
voting right; there is no fear of loss of management control.
Chapter 8
Conclusion & Future Prospects

To arrange financing for a stand-alone project, prospective lenders must be convinced that the
project is technically feasible and economically viable and that the project will be sufficiently
creditworthy if financed. Establishing technical feasibility requires demonstrating that the
construction can be completed on schedule and within budget and that the project will be able to
operate at its design capacity following completion. Establishing economic viability requires
demonstrating hat the project will be able to generate sufficient cash flow so as to cover its
overall cost of capital. Creditworthiness will be established by demonstrating that even under
reasonably pessimistic circumstances; the project will be able to generate sufficient revenue to
cover all operating costs and to service project debt in a timely manner. The loan terms have an
impact on how much debt the project can incur and still remain creditworthy.

For the trend towards privatisation in infrastructure projects to continue, financial markets need
to respond by providing the necessary long-term resources. Considering the inadequate level of
development in the domestic capital markets that results in low levels of tradability and liquidity
of stocks traded in the stock market, there is a need to look towards the international financial
markets for rising.
BIBILIOGRAPHY:

Reports:

1. Benjamin C. Esty, The Economic Motivations for Using Project Finance, Harvard
Business School, February 14, 2003
2. Krishnamurthy V. Subramanian, Frederick Tung, Law and Project Finance, October
2009.
3. Marco Sorge, The nature of credit risk in project finance
4. Mansoor Dailami, Danny Leipziger, Infrastructure Project Finance and Capital Flows: A
new perspective, Economic Development Institute
5. Krishnamurthy Subramanian, Frederick Tung , Project Finance versus Corporate Finance
Goizueta Business School, Emory University
6. Vinay Deodhar , CDM project finance issues and opportunities,
7. Stefanie Kleimeier,William L. Megginson, Are Project Finance Loans Different From
Other Syndicated Credits?, January 19, 2003
8. Rachna Khurana, Financing Infrastructure Projects

Websites:-

http://www.iflr.com/Supplements.aspx
http://aajaycon.com/index.html
www.people.hbs.edu/besty/projfinportal
www.eagletraders.com/loans
www.developmentfunds.org
www.nedfi.com
www.projectfinancemagazine.com
www.ebookchm.com/ebook___project-finance
www.filestube.com
www.pdfqueen.com
 www.ebookchm.com/ebook
www.acrobatplanet.com
www.pwc.com/in/en/transaction/project-finance
www.gelending.com/Clg
www.investopedia.com
http://upload.wikimedia.org/wikipedia/en/2/27/Project_finance.png
http://www.iflr.com/Article/2027426/Project-finance-in-India.html
http://www.projectfinancemagazine.com/default.asp?
SM=ALL&DatePeriod=0&OB=D&Catalog=PF&Page=1113&searchstr=regulatory+fr
amework+in+india&x=0&y=0
http://aajaycon.com/guidelines.html
http://cib.bnpparibas.com/?
eclip=show&RevampingURLParam=BO_ITEM,BO_PORTAL-2,BO_MODE-
Show,BO_ID-6575,BO_PAGE-1
http://www.coolavenues.com/forums/showthread.php?t=8514
http://www.bus.emory.edu/ksubramanian/documents/projfinance_apr27.pdf
http://www.adb.org/Documents/RRPs/IND/41036-IND-RRP.pdf
http://www.iges.or.jp/en/cdm/pdf/india/04/08.pdf
Annexure:

CASE ONE: PROJECT FINANCING

Name of the company - Reliance Petroleum Limited
Type of project - fuel refinery project
Estimated capacity - 9 million metric tonnes per annum
Project cost :
(Land and site development, building and township, P/M, Technical know-how, miscellaneous
fixed assets, preliminary and pre-operative expenses, contingency provision and margin money
for working capital)
Means of finance:
(Privately placed PCDs, ECB, Leasing, Unsecured loans, FIIs, public issue of TOCDs)

PROJECT COST DETAILS

Type of cost Rs. in million

Land and site development 920

Building and township 880
Plant and machinery 28870
Technical know-how 1090
Miscellaneous fixed assets 2620
Preliminary and pre-operative exp. 5030
Contingency provision 9850
Margin money for working capital 2160
Total 51420
 MEANS OF FINANCE DETAILS

Type of finance Rs. in million

Privately placed PCDs 10000
Overseas suppliers credit/ECB 6000
Reliance Industries Ltd. and Associates
-TOCDs 5770
- Leasing / Unsecured loans 1430
Leasing by other cos./Unsecured loans 3500
Euro issue/FIIs/ NRIs/OCBs 3000
Public issue of TOCDs 21720
Total 51420

CASE TWO: (PROJECT: MANUFACTURE OF MOTORS)

Sale projections: Rs.900 lacs for 1st year and Rs.1200 lacs from 2nd year onwards
Capacity utilisation: 75% in 1st year and 100% from 2nd yr
Economic life of the project: 10 years
 Total project cost :Rs. 1619 lacs
Promoters contribution (proposed): 20.94% of proj. cost
ROI (before tax) :27.94 %
ROI (after tax) :23.27 %
IRR :19.77 %
Average DSCR :2.164
Debt equity ratio :About 1 : 1

SOLUTION TO CASE TWO:

The project should be financed, on account of the following reasons:

1. IRR is more than 15 % and therefore the project is worthwhile
2. Average DSCR is satisfactory
3. Promoters contribution is fairly good
4. ROI (before tax) and ROI (after tax) are good
5. Profitability ratios show that the project would earn sufficient returns on the capital
employed over its estimated life