Project Finance

INTRODUCTION TO
PROJECT FINANCE
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap
What Is Project Finance?

Definition
Major characteristics
Schematic example of a project
structure
Major project contracts
Definition:
Project Finance involves one or more corporate sponsors
investing in and owning a single purpose, industrial asset
through a legally independent project company
financed with limited or non-recourse debt.
A relevant question to investigate:

Finance separately with non-recourse
debt? (Project Finance)
SPONSOR + PROJECT?
Finance jointly with corporate funds?
(Corporate Finance)
Major characteristics:
Economically and legally independent project company

Founded extensively on a series of legal contracts that unite
parties from input suppliers to output purchaser
Project assets/liabilities, cash flows, and contracts are separated
from those of the sponsors, conditional on what accounting rules
permit
Investors and creditors have a clear claim on project assets and
cash flows, independent from sponsors financial condition
Debt is either limited (via completion guarantees) or nonrecourse to the sponsors
Highly leveraged project company with concentrated equity

ownership
Partly due to firms need for flexibility and excess debt capacity
to invest in attractive opportunities whenever they arise
Syndicate of banks and/or financial institutions provide debt
Typical D/V ratio as high as 70% and above
Debt has higher spreads than corporate debt
One to three equity sponsors
Sponsors provide capital in the form of equity or quasi-equity
(subordinated debt)
Governing Board comprises of mainly affiliated directors from
sponsors
Historically formed to finance large-scale projects

Industrial projects: mines, pipelines, oil fields
Infrastructure projects: toll roads, power plants,
telecommunications systems
Significant financial, developmental, and social returns
Examples of project-financed investments

$4bn Chad-Cameroon pipeline project
$6bn Iridium global satellite project
$1.4bn aluminum smelter in Mozambique
900m A2 Road project in Poland
Statistics as of year 2002

$135bn of capital expenditure globally using project finance
$19bn of capital expenditure in the US
Smaller than the $612bn corporate bonds market, $397bn asset
backed securities market and $205bn leasing market;
approximately same size with the $27bn IPO and $26bn venture
capital market
A simplified project structure example:

A nexus
of
contracts
that aids
the sharing
of risks,
returns,
and
control
Source: Esty, B., An Overview of Project Finance 2002 Update: Typical project structure for an independent power producer
Major project contracts:
The Offtake Contract:

A framework under which
Project Company obtains
revenues
Provides the offtaker
(purchaser) with a secure
supply of project output, and
the Project Company with the
ability to sell the output on a
pre-agreed basis
Can take various forms, such
as Take or Pay Contract:
Power Purchase
Agreement (PPA)
Input Supply Contract:

The Offtake Contract for the
input supplier
Provides the Project Company
the security of input supplies
on a pre-agreed pricing basis
The terms of the Input Supply
Contract are usually crafted to
match those of the Offtake
Contract (such as input
volume, length of contract,
force majeure, etc.)
Major project contracts:
Construction Contract:
A contract defining the
turnkey responsibility to
deliver a complete project
ready for operation (a.k.a.
Engineering, Procurement,
Construction (EPC) Contract)
Operation and Maintenance
Contracts:
Ensures that the operating
and maintenance costs stay
within budget, and project
operates as planned.
Permits:
Contracts that ensure permits
and other rights for
construction and operation of
the project, as well as for
investing in and financing of
the Project Company
May be provided by central
governments and/or local
authorities
Government Support
Agreements:
Provisions may include
guarantees on usage of public
utilities, compensation for
expropriation, tax exemptions,
and litigation of disputes in an
agreed jurisdiction
OUTLINE
value?
4. Case analyses
5. Recap
How Does It Create Value?

Drawbacks of using Project Finance
Value creation by Project Finance
Organizational structure
Agency costs, debt overhang, risk contamination, risk
mitigation
Contractual structure
Structuring the project contracts to allocate risk, return,
and control
Governance structure
Benefits of debt-based governance
Case examples to value creation
Drawbacks of Using Project Finance Structure:
Takes longer to structure and

execute than equivalent size
corporate finance
Higher transaction costs due to

creation of an independent entity
and complex contractual structure
Non-recourse project debt is

more expensive due to greater
risk and high leverage
High leverage and extensive

contracting restricts managerial
flexibility
Project finance requires greater

disclosure of proprietary
information to lenders
Still, the combination

of organizational,
financial, and
contractual features
may offer an
opportunity to reduce
net cost of financing
and improve
performance
Structure matters, contrary to

MM Proposition!
Why does structure matter?

Structural decisions may affect the existence and magnitude of costs
due to market perfections:
* Agency conflicts
* Financial distress
* Structuring and executing transactions
* Asymmetric information between parties involved
* Taxes
Value Creation
Governance Structure
Organizational Structure
Contractual Structure

mitigation
and control
Value creation by organizational structure:

Agency Costs
Problems
Structural Solutions:
Agency conflicts between

sponsors (owners) and
management (control)
High levels of free cash

flow leading to
overinvestment in
negative NPV projects
Risk shifting/debt
shifting by managers to
invest in high risk,
to recoup past losses
Refusal to make
additional investment
Concentrated equity ownership and

single cash flow stream provides critical
monitoring
Strong debt covenants allow both
sponsors and creditors to better monitor
management
High debt service reduces the free cash
flow exposed to discretion
Extensive contracting reduces
managerial discretion
Cash Flow Waterfall mechanism
facilitates the management and allocation
of cash flows, reducing managerial
discretion. Covers capex, debt service,
reserve accounts, and distribution of
residual income to shareholders
Given the projects are defined within
narrow boundaries with limited
investment opportunities, moral hazard
(risk shifting, debt shifting, reluctance to
invest) is minimized

Agency Costs
Problems
Cash Flow Waterfall mechanism

reduces potential conflicts in distribution
and re-investment of project revenues
Distribution of cash flows, reinvestment, and restructuring

during distress
Moral hazard (such as risk

shifting and debt shifting)
encouraged by full recourse
nature of debt to sponsor
Legally/economically separate project

company eliminates potential for risk
shifting and debt shifting
Concentrated debt ownership is preferred

(i.e. bank loans vs. bonds) to facilitate the
restructuring and speedy resolutions
Usually subordinated debt (quasi equity)

is provided by sponsors
Strong debt covenants allow better

monitoring
Single cash flow stream and separate

ownership provides easier monitoring
Agency conflicts between

sponsors and creditors:

Agency Costs
Problems
Conflicts between sponsors and

other parties (purchasers,
suppliers, etc.)
Vertical integration is effective in

precluding opportunistic behavior but
not at sharing risk. Also,
opportunities for vertical integration
may be absent.
Long term contracts such as supply

and off take contracts: these are
more effective mechanisms than
spot market transactions and long
term relationships.
Joint ownership with related parties

to share asset control and cash flow
rights. This way counterparty
incentives are aligned.

Agency Costs
Problems
Conflicts between sponsors and

government: Expropriation
through either asset seizure,
diversion, or creeping
Since project is large scale and the
company is stand alone, acts of
expropriation are highly visible in the
international arena which detracts
future investors
High leverage leaves less on the
table to be expropriated
Multilateral lenders involvement
detracts governments from
expropriation since these agencies
are development lenders and
lenders of last resort. However these
agencies only lend to stand alone
projects.
High leverage also reduces
accounting profits thereby reducing
the potential of local opposition to
the company.

Debt Overhang
Problems
Non-recourse debt in an
independent entity allocates returns
to capital providers without any claim
on the sponsors balance sheet.
Preserves corporate debt capacity.
The fact that non-recourse debt is

backed by project assets/cash flows
and not by the sponsors balance
sheet increases the chances of an
already highly leveraged sponsor to
separately finance a viable project
Sponsors under-investment in
positive NPV projects when
sponsor has:
limited corporate debt capacity
agency or tax reasons that

exclude equity as a valid option
pre-existing debt covenants

that limit possibility of new debt

Risk Contamination
Problems
A high risk project may

potentially drag a healthy
sponsor into distress, by
increasing cash flow volatility
and reducing firm value.
Project financed investment exposes

the sponsor to losses only to the
extent of its equity commitment,
thereby reducing its distress costs
Conversely, a failing sponsor can

drag a healthy project along with
itself.
Through project financing, sponsors

can share project risk with other
sponsors:
Very large projects can

potentially destroy the sponsors
balance sheet and lead to
managerial risk aversion
Benefit from portfolio

diversification is negative (risk is
higher) when sponsor and
project cash flows are strongly
positively correlated.
Pooling of capital reduces each

providers distress cost due to the
relatively smaller size of the
investment and therefore the overall
distress costs are reduced.
Separate incorporation eliminates

potential increase in risk when
financing a project strongly
correlated to sponsors existing
asset portfolio.

Other motivations
Problems
Joint venture projects with

heterogeneous partners:
Financially weaker partner
cannot finance its share of
investment through corporate
borrowings, and needs project
finance to participate
The stronger partner is better

equipped to negotiate terms with
banks than the weaker partner and
hence participates in project finance
even if it can finance its share via
corporate financing
Location: Large projects in

emerging markets usually
cannot be financed by local
equity due to supply
constraints. Investment specific
equity from foreign investors is
either hard to get or expensive.
Debt may be the only option and

project finance the optimal structure.
Besides, host government may grant

the project tax holiday, which
provides sponsors exemptions from
taxation

mitigation
Structuring the project contracts to allocate risk, return, and
control
Value creation by contractual structure:
An introduction to risk management
Risk management defined

Sources of risks
Who bears risk?
Mechanisms for reducing cost of risk
Contractual structure in Project Finance to reduce cost of risk and

create value

An Introduction to Risk Management
Risk Management:
The process of identification, assessment, mitigation, and allocation of risks to
reduce cost of risk and improve incentives
Sources of risk:
External:
Markets: Availability and quality of products, inputs, and services used
Financial markets
Government policy
Natural resource availability and quality
Natural disasters, politics
Internal:
Incentive problems during construction and operation stages
Relationships between management, sponsors, lenders, workers,
suppliers, government
(some addressed in the previous slides under value creation by
organizational structure)

Who bears risk?
Sponsors bear the residual gains and losses, and make key investment decisions.
In simple terms,
Return to equity = Revenues Material / service costs Labor costs Depreciation Interest expenses Taxes
Variability in RHS variables lead to changes in return to equity
Other earners of net income (or net value added) from investment can also share
risk:
Net Value added =
Return to equity + Interest expenses + Taxes + Labor costs
= Revenues Material / service costs Depreciation
Profit sharing mechanisms or tax incentives may change how variability in income
among sponsors, lenders, government, and labor
is shared
Output purchasers and input suppliers can also share the risks as they experience
variability in their markets

How are costs of risk reduced?
Some risks can be reduced by spreading the burden across many participants; some
other risks cannot be spread, but can be shifted or reallocated
Different stakeholders in a project may have different preferences, and hence

different willingness and capacity to bear risks
Cost of risk is lower to those with greater capacity and willingness to bear risk
Risk-return trade-offs may enable integrative (not necessarily competitive)
negotiations among different stakeholders and may create value in a project
setting
Gains in economic efficiency can be achieved if overall cost of risk declines through
risk shifting and reallocating:
The same risk will have a lower cost if born by parties better capable and willing
to do so

Mechanisms to reduce cost of risk:
Capital, financial, and futures markets:

Mix of debt and equity (capital structure) and probability of default
Risk spreading / pooling
Risk diversification
Insurance markets (for residual risks)
Derivative financial instruments (not available for asymmetric risks)
Futures markets
Real options: Design flexibility into project to allow for responses of new
information or market changes
Project design itself for risk mitigation (elements of production process,
technology used, etc.)
Project Finance mechanism: complex contractual arrangements involving all
mechanisms of contractual risk allocation and reduction to deal with risk in
large scale investments

Contracting and Project Finance to reduce cost of risk
Generally well developed capital, financial, and futures markets may not always be
available
Special contractual arrangements are often required to manage risk to make projects
viable
The aim of extensive contracting is to reduce cash flow volatility, increase firm value
and debt capacity in a cost-effective way
Guarantees and insurance for those risks that cannot be handled through contracting
Elements of contracting:
General form:
Exchange risk (x) for return (y)
Additional considerations:
Participation or partial transfer of ownership

Timing of x and y
Contingency of x and y (under what circumstances)
Penalties on non-performance
Bonus on performance

Contracting criteria:
Contract with lowest cost not necessarily best contract
Effective contracts may provide:
Better risk shifting: better distributions of cost
Better incentives: higher project returns or lower total project risk as a result of
incentives
Change the incentive structure to change the probabilities of different outcomes
stakeholders have incentives to increase probability of success and reduce probability
of failure in project
Zero Sum (Competitive) versus Positive Sum (Integrative) perspectives

Cost focus is implicitly a zero sum perspective: one stakeholder gains and the
other stakeholder loses
Integrative focus is explicitly a positive sum perspective: By crafting the right
contract, one stakeholder can gain without necessarily costing to the other one
(due to differences between perceived values, preferences, and risk bearing
capacity) contracts that create increased value through risk sharing and /or
improved incentives

Sources of contracting benefits:
Stakeholders differing risk preferences
Differing capability to diversify
Differing capability to manage risks
Differing information or predictions regarding future
Differing ability to influence project outcomes
Risks manageable via contractual structure or other mechanisms in
Project Finance:
Pre-completion risks: Resource, technological, timing, and completion risks

Post-completion risks: Market risk, supply risk, operating cost risk, and force
majeure
Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk,
expropriation
Financial risks: Default risk

Pre-completion risks:
Risk
Solution
Site acquisition and access, permits
A government support agreement
Risks related to contractor:

Is it competent to do the work?
Reputation, references for similar projects and

technology being used
Experience with the country, good relationships with
local subcontractors
Similar references for the subcontractors
Is it also one of projects sponsors?

(Conflict of interest)
Contract supervision by the project companys other

personnel not directly related to the contractor
The contractors credit standing? If the

contractors wider business gets into
difficulty, the project is likely to suffer
Careful review of contractors credit standing

Careful review of the project scale in relation to the
size of contractors overall business
If project too big for the contractor to handle alone, a
joint venture approach with a larger contractor
Guarantees of obligations by the contractor's parent
company

Risk
Solution
Construction cost overruns: reduce equity

returns, and DSCR
Pre-agreed overrun funding (contingency finding)

Fixed (real) price contract, as the EPC contract is
normally the largest cost item in budget (60-70%)
Contractor takes junior debt and/or equity stake in
operations (BOT or BOO)
Delay in completion: failure to meet the

milestones increase costs, reduce equity returns,
and reduce DSCR
Financing costs, especially as debt will be
outstanding longer
Revenues from operating the project will
be lost or deferred (significant risk also
especially if part of financing depends on
early revenues)
Penalties may be payable under contract
to input suppliers or off-taker
Completion guarantees, date-certain EPC contract

Performance bonds
Completion bonuses/penalties
Reputable contractor
Close monitoring / testing of project execution
(operational, financial, etc.) for early detection of
problems
Careful definition of completion in all the contracts
(EPC contract, input supplier contracts, off-taker
contract, etc) so that it is acceptable and manageable
by all parties involved
Process failures
Process / Equipment warranties

Tested technology

Risk
Solution
Nonperformance on completion: due to poor

design, inadequate technology
Debt recourse to sponsors (from lenders

perspective)
Performance LDs (liquidated damages): Pre-agreed
level of loss to be born by the contractor. Covers the
NPV of loss due to nonperformance over the life of
the project
The Project Company should be aware of the
uncertainty regarding the LDs and should allow a
margin when negotiating the calculations with the
contractor
Natural resource risk
Independent reserve certification

Risk
Solution
Third party risks:

The contractor may be dependent on third
parties such as suppliers of utilities to
complete the project
If the third party is not otherwise involved in the

project, incentive mechanisms to keep the timetable
If the third party is involved with a project contract,
the contract should include terms such that the third
party should be held responsible for the delay losses
Contractors good relationships and experience with
the third parties may be a plus
The project may be dependent on

completion of another project worst type
of third party risk especially when the
project financing is dependent on it.
Sponsor-related risks (Lenders perspective):
Sponsor commitment to the project
Financially weak sponsor
Financing the projects as one package may be

examined as a potential solution, as long as the
sponsors interests on both sides can be aligned
Require lower D/E ratio
Starting with equity: eliminate risk shifting, debt
overhang and probability of distress (lenders
requirement).
Add insider debt (Quasi equity) before debt: reduces
cost of information asymmetry.
Attain third party credit support for weak sponsor
(letter of credit)
Cross default to other sponsors

Post-completion risks:
Risk
Solution
Market risk: Uncertainty regarding the future

price and demand for the output
Volume risk: cannot sell entire output
Price: cannot sell output at profit
Long term off-take contract with creditworthy buyers:

take and pay, take or pay, take if delivered contracts:
Price floors
A fixed price growth path
An undertaking to pay a long-run average price
Specific price escalator clauses that would maintain the
competitiveness of the product, such as indexing price to
the price of a close substitute or cost of major input
Hedging contracts
Operating cost risk: Uncertainty regarding the
changes in the operating cost throughout the life
of the project
Risk sharing contracts to increase correlation

between revenue and some cost items:
If there is an off-take contract, linking input supply price
to it:
Basing the product price under the off-take contract on the
cost of the input supplies (more likely if input supply is a
widely traded commodity like oil)
Basing the input supply price to product price under the offtake contract: (more likely if the input is a specialized
commodity, or if there is no off-take contract and risk is
passed to the input supplier)
Price ceilings
Profit sharing contract with labor
Output or cost target related pay

Post-completion risks:
Risk
Solution
Input supply risk: Uncertainty regarding the

availability of the input supplies throughout the life
of the project
If there is an off-take contract, linking the terms of the

output contract with input supply contracts such as
the length of contract, volume, or force majeure
If there is no off-take contract, making the input
supply contract run for at least the term of debt
An input supply contract is off-take contract for the
supplier
Organizational risks: Incentive problems relating

to management or workers
Profit sharing / stock options

Output or cost target related pay for workers
Operating risk: operating difficulties due to

technology (being degraded or obsolescent),
processes used, or incapacity of operator team
leads to inefficiencies and insufficient cash flow
Performance warranties on equipment

Expert evaluation and retention accounts
Proven technology
Experienced operator/management team
Operating/maintenance contracts to ensure
operational efficiency
Allowances for service / upgrade built into equipment
supply contracts
Insurance to guarantee minimum operating cash
Force majeure risk: Likelihood of occurrence of

events like wars, labor strikes, terrorism, or
nonpolitical events such as earthquakes, etc.
Insurance for natural disasters

Sovereign risks:
Risk
Solution
Exchange rate changes: Uncertainty regarding

the changes in the exchange rate throughout the
life of the project
Implications of a sudden major local currency
devaluation in cases where the project revenue is
in local currency and debt in foreign currency
Revenues, costs, and debt in same currency

(indexing if they are not in the same currency)
Market-based hedging of currency risks (though not
widely used)
For protection from a sudden major devaluation, a
revolving liquidity facility can be utilized to cover the
time lapse between the devaluation and the
subsequent increase in inflation that should
compensate the project company for debt payments
Currency convertibility / transferability risk: As it

is often not possible to raise funding in local
currency in developing countries, revenues
earned in local currencies need to be converted
into foreign currency amounts needed by offshore
investors/lenders, and then need to be transferred
outside the country to pay for them. Additionally,
foreign currency may be needed to import
materials, equipment, etc.
Government Support Agreement: Government

guarantee of foreign exchange availability: However, if
the host country gets into financial difficulty and runs
out of foreign currency reserves, then the government
may forbid either the conversion of local currency
amounts to foreign currency, or the transmission of
these amounts abroad The support agreement
may become invalid
Enclave projects: If the project revenues are paid
from a source outside the host country, the project
can be insulated from foreign exchange and transfer
risks (Example: sales of oil, gas across borders)
Offshore debt service reserve accounts

Sovereign risks:
Risk
Solution
Hyperinflation risk: Relative changes in the price

of inputs and output may adversely affect the
project
Indexing the output price (in the long term sales

contract) against the CPI and or industry price indices
in the host country where the relevant costs are
incurred (Indexing means increasing over time against
agreed, published economic indices)
Expropriation: Direct, diversion, creeping

Governments breach of contract and court
decisions
Government guarantees or regulatory undertakings

to cover taxes, royalites, prices, monopolies, etc.
Involvement of multilateral/bilateral agencies
Offshore accounts for proceeds
Governments equity ownership
Using external law or jurisdiction
Legal system:
Government support agreement

Using external law or jurisdiction
Involvement of multilateral/bilateral agencies
A general principle is that the party who is paying for
the output under a project contract should pay for the
losses incurred due to changes in law specific to the
industry, because such change is reflected in the
entire industry and any extra costs will normally be
passed on to end users; therefore an offtaker who
does not bear this risk would earn extra profits at the
expense of the project company
Unclear and/or inconsistent legal/regulatory

framework for projects operations
Insufficient protection of private investment and
private ownership/control of project
Bureaucratic hurdles
Changes in law, such as imposition of new
environmental/health/safety requirements, price
controls, import duties/controls, increase in taxes,
royalties, deregulation, amendment or withdrawal of
projects permits, changing the control of company

Sovereign risks:
Risk
Solution
Political risks: Likelihood of occurrence of

political events like wars, labor strikes, terrorism,
etc.
Political risk insurance

Involvement of multilateral agencies (WB/IFC)
(structuring legal/financial documents, mediation in
negotiations, sovereign deterrence, halo effect)
Bilateral agencies: Export credits from ECAs (who
provide PRI)
The private insurance market
Contractual sharing of political risks between
sponsors and lenders

Financial risks:
Risk
Solution
Default risk:
Ensure sufficient debt service coverage

Decrease debt/equity ratio
Match term of loan to productive life of assets
Match repayment schedule to expected cash flows
Bonds with interest rates indexed to product sales
price
Match currency of loans to currency of revenues
Interest rate risk:
Interest rate swaps and hedging

Interest rate caps

mitigation
and control
Value creation by governance structure:
Tighter covenants limit managerial discretion and enforces

greater discipline via better monitoring
High leverage reduces free cash flow exposed to discretion
High leverage reduces expropriation risk
High leverage also reduces accounting profits thereby
reducing the potential of local opposition to the company
Tax shields
2. How Does It Create Value?

mitigation
and control
Costs and benefits of debt-based governance

Australia-Japan Cable Structuring a Project Company:
Background:
The project included a 12,500 km submarine telecommunications system
between Australia and Japan via Guam at a cost of $ 520M. The project
would use Telstras two landing stations at Australia. In Japan, it needed to
either obtain permit from the government for building new stations, or
contract or partner with other companies to obtain access to the existing
ones. Japanese Government seemed not likely to approve building of a new
landing station. Most significant risks were market and completion risks.
The lead sponsor, Telstra, has to structure the project company, selecting
an ownership, financial, and governance structure.

Issues:
1.
2.
3.
4.
Selection of strategic sponsors who would bring the most value to the
project
Mitigation of market risk: Growing demand and capacity shortfall that
triggers competition, rapid improvements in cable technology and resulting
price decline necessitates moving very quickly
Completion risk: Potential delays due to environmental approvals and
other permits
Management of possible agency conflicts between:
1.
sponsors and management
2.
sponsors and other parties (capacity buyers (purchasers), suppliers,
etc.)
3.
sponsors and creditors - decision of how many and which banks to
invite to participate

How project structure may help:
1.
Telstra partnered with Japan Telecom (who would bring its landing station
in Japan and was interested in buying capacity) and Teleglobe (a major
carrier who would bring significant volume) as sponsors (reducing cash
flow variability)
2.
Other equity investors to be selected would be high rated sponsors who

were also capacity buyers. They would be made to sign presale capacity
agreements ( reducing variability).
3.
Capacity agreements with high rated sponsors would also be

instrumental in raising debt with favorable conditions

4.
Contemplated on concentrated equity ownership to maintain more

effective management and monitoring
5.
As for an interim management team, sponsors would also be made equal

partners in control, regardless of individual ownership shares
6.
A permanent management team was discussed, that would work

exclusively for the project:
Management compensation package was easier to craft, since it was

a single purpose company with limited and well-defined growth
opportunities
Single cash flow easier to monitor

7.
Decided on high leverage and project finance structure to help:
limit the amount of equity they needed to invest to an acceptable size
share the project risk with debt holders
enforce management discipline by reduced free cash flow and

contractual agreements
8.
Bank debt with a small banking group was preferred rather than project
bonds to have flexibility
The initial tranche of bank debt would be secured and repaid in 5

years with presale commitments
The second tranche would also be repaid in 5 years, but from future
sales, acting as trip wires for the management team

Calpine Corporation
Background:
Calpine, a small power generator with high leverage (~80%), subinvestment grade rating, and little debt capacity, has to decide how to
finance its aggressive growth strategy, facing increasing pressure for
speed, efficiency, and flexibility in a soon-to-be competitive commodity
market.
The growth strategy includes building and operating a power system
consisting of multiple power plants. Project financing and corporate
financing alternatives are considered.

Issues:
1.
Speed was very important to gain first mover advantage
2.
Necessity to be a low-cost producer in a commodity market
3.
Operating a system of power plants to gain scale economies and also

the flexibility to switch between the plants to offer uninterrupted
service

Issues:
4. Using corporate finance as the financing method:
Benefits:
Issuing high yield bonds would not require collateral and reduce
legal fees
Bonds would leave Calpine free to switch between plants in the
power system
Costs:
The high-yield market was thinner and more volatile compared to
investment grade market, creating pricing and availability risk
As a firm with high leverage and sub-investment grade rating, the
high cost of corporate financing might lead Calpine to miss the
opportunity to invest in a positive NPV growth project (Debt
Overhang)
A large debt issue might further jeopardize Calpines debt rating

Issues:
5. Using project finance as the financing method:
Benefits:
Opportunity to finance the growth strategy even if Calpine had low
investment ratings and limited debt capacity
Costs:
Time consuming and expensive to set-up and execute individual
deals
Limited size and absorption capacity of the project finance market
Possible restrictions to flexibly switch between the plants in the
power system if each plant would be collateralized separately

A hybrid structure was crafted that combined elements of both project
and corporate finance:
1.
Project Finance:
i.
Calpine project financed a portfolio of plants rather than a single
plant. This reduced legal and other fees, transaction costs, and
saved time.
ii. Project finance allowed raising a large amount of debt on a nonrecourse basis, which was impossible at the parent level
2.
Corporate Finance:
i.
The structure gave Calpine flexibility to build the plants using equity,
and manage them flexibly as part of a power system (which would
be impossible with separately project financing the individual plants)

BP Amoco
Background:
A large and well-capitalized company, BP Amoco tries to decide on the
best way to finance its share in the $8 billion development project of
Caspian oil fields, undertaken by a consortium of 11 companies.
Each of the partners had a choice in how to finance its share of the total
investment. Of these companies, 5 formed a Mutual Interest Group
(MIG) to obtain project loan with assistance of IFC and EBRD. The
alternatives BP Amoco considered for its share were corporate financing,
project financing, or a hybrid structure.

Issues:
1.
Project Risks: The project had considerable political, financial, industrial

(price and reserve volatility), and transportation related risks largely due
to the unique region it was located.
2.
Risk management: Protection of BP Amocos balance sheet from risk

contamination or distress costs from investing in a risky asset
3.
Involvement of multilateral organizations: Increased capacity to raise

capital

Using corporate finance as the financing method:
Benefits:
Financially strong enough to support a corporate funding strategy with

favorable terms
Easier to set up and less costly
Costs:
Project might create additional risks in BP Amocos current asset portfolio

Risk contamination
BP Amocos absence in the IFC/EBRD finance deal for the MIG would make
it harder for the weaker partners to negotiate good terms, reducing flexibility
in operations and management
BP Amocos using corporate funding while at least some of the other

partners using the IF/EBRD deal might potentially create disagreements
Other partners might accuse BP Amoco as free rider, since BP Amoco would
benefit at no cost from the political risk protection IFC/EBRD deal would
have provided
How they funded the initial phase would change possibilities of financing for
the coming stages

Using project finance as the financing method:
Benefits:
Reducing projects potential negative impact on the balance sheet:

The project was very large and posed too many risks which BP
Amoco could not bear alone, meaning a potentially huge negative
impact on the balance sheet if financed solely by internal funding
More protection from the many project risks due to risk sharing
Accommodating the financially weaker partners in the consortium to

negotiate better deals with creditors for the sake of future managerial
and operational flexibility
Benefiting from IFC/EBRDs existence to shield from possible

conflicts with the host governments
Costs:
Harder, costlier, and more time consuming to set up
Less flexibility compared to corporate finance alternative
OUTLINE
value?
4. Case analyses
5. Recap
Project Valuation
Background
Approaches to calculating the Cost of
Capital in Emerging Markets
Country Risk Rating Model (Erb, Harvey and
Viskanta)
Background
Projects are characterized by:

unique risks
high and rapidly changing leverage
imbedded flexibility to respond to changing conditions (real options)
changing tax rates
early, certain and large negative cash flows followed by uncertain positive cash flows
Traditional DCF method is inaccurate:

Single discount rate does not account for changing leverage
Ignores imbedded options
Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor
Traditional CAPM method is inaccurate:

Many mega projects are in emerging markets
Many of these markets do not have mature equity markets. It is very difficult to estimate Beta with the World portfolio.
The Beta with the World portfolio is not indicative of the sovereign risk of the country (asymmetric downside risks).
E.g. Pakistan has a beta of 0.
Most assumptions of CAPM fail in this environment
More appropriate approaches to project valuation may include:

Usage of non CAPM based discount rates especially for emerging markets investments
Changing discount rate to account for changing leverage
Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate
Valuation of real options
Usage of Monte Carlo simulation
Approaches to calculating the Cost of Capital

in Emerging Markets
World CAPM or Multifactor Model (Sharpe-Ross)

Segmented/Integrated (Bekaert-Harvey)
Bayesian (Ibbotson Associates)
CAPM with Skewness (Harvey-Siddique)
Goldman-integrated sovereign yield spread model
Goldman-segmented
Goldman-EHV hybrid
CSFB volatility ratio model
CSFB-EHV hybrid
Damodaran
Approaches to calculating the Cost of Capital

in Emerging Markets
Many of these methods suffer problems because:
Method does not incorporate all risks in the project
Assume that the only risk is variance, and fails to capture
asymmetric downside risks
Assume markets are integrated and efficient
Arbitrary adjustments which either over or underestimate risk
Confusing bond and equity risk premia.
The Country Risk Rating Model

Erb, Harvey and Viskanta (1995)
Country credit rating a good ex ante measure of future
risk:
Some of the factors that influence a country credit rating are:
political and other expropriation risk,
inflation, exchangerate volatility and controls,
the nation's industrial portfolio, its economic viability, and its
sensitivity to global economic shocks
The credit rating may proxy for many of these fundamental

risks as it is survey based
Impressive fit to data

Explains developed and emerging markets
Cost of Capital = risk free + intercept (slope x Log(IICCR))
If cash flows are in local currency, convert into $US:

Calculate the difference between the multiyear forecasts of inflation in the host country and
those in US
Use the difference to map out the expected exchange rates
Use calculated expected exchange rates to convert cash flows into $
Adjust for industry risk:
Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating
Gives the cost of capital of an average project in the country in $).
Calculate the country risk premium from ICCRC:

Country risk premium =
Country cost of equity capital US cost of equity capital
Calculate US industry cost of capital by using industry beta
Add the country risk premium to US industry cost of capital
Adjust for project specific risks that deviate the project from the average level of risk in the
host country
Risks incorporated in cash flows or industry adjustment:
Pre-completion: technology, resource, completion.

Post-completion: market, supply/input, throughput.
Risks incorporated in discount rate:
Sovereign risk: macroeconomic, legal, political, force majeure.

Financial risk.
OUTLINE
value?
3. Project Valuation
4. Case analyses
5. Recap
Case analyses
Chad-Cameroon Petroleum Development

and Pipeline Project
Petrozuata and Oil Field Development

Project
Financing the Mozal Project
Chad-Cameroon Petroleum
Development and Pipeline Project
Background
Corporate finance vs. project finance
Why is there a difference between financing of field and export
systems?
The role of World Bank
Assessment of project risks and returns
Real options
Project update
Background
ExxonMobil, Chevron, and Petronas undertake a $4 Billion

petroleum development and pipeline project in Chad, which
presented a unique opportunity to stimulate Chads economic
development, and yet entailed environmental and social risks.
Corporate finance for the development of the field system and
project finance for the pipelines
Debate on unstable political structure and how Chad would use its
share of project revenues
WBs introduction of Revenue Management Plan to target Chad
Governments returns from the project for developmental purposes,
and debate on the likelihood of effectiveness of such a plan
Corporate financing for the field system:

The lead sponsor, ExxonMobil had AAA debt rating, very strong balance
sheet ($145M assets) and $16M cash flow Could afford the field
investment in a less costly way relative to project financing
ExxonMobil was actually a huge portfolio of upstream businesses
(exploration, development, production of crude oil and natural gas),
downstream businesses (transportation, marketing, and sales), as well
as chemical byproducts and operations in mining. With less than perfect
correlation among its assets, ExxonMobil might actually have been able
to eliminate the idiosyncratic risks via adding a field development project
to its portfolio. Corporate financing as opposed to project financing
helped ExxonMobil keep the project as part of its portfolio and reduce
the risks.
Besides, the vertically integrated business model made it a naturally
cost-efficient choice for ExxonMobil to hold the assets collectively with
corporate financing rather than individually with project financing
Corporate financing probably also enabled managerial flexibility and
discretion over the use of oil wells, drilling equipment, etc. that constitute
the field system
Corporate financing for the field system:

Field development was the less risky part of the entire project for the
sponsors, because upstream operations including field development
and production was one of the core business areas where they were
very strong at. This reduced the cost of bearing these risks themselves
since they were better equipped than anyone else.
Project financing for a field development project would also not be a
viable financing option, as the lenders generally would be reluctant to
finance until after all reserves are proven and capable of production.
The crude oil prices for the last 18 months ranged from $9 to $42,
averaging $20 per barrel, which, even after discounted for the lower
grade, was considerably higher than the projects $5.20 exploration and
development costs. With a total proven plus probable reserves of 917M
barrels, downside exposure to price and resource risk was already
mostly eliminated No serious need to protect from the downside risk
(via risk sharing )with project finance and incurring higher interest rates
and loan fees.
Corporate financing probably also helped save both the costly delays at
the development stage of the project and the structuring costs, which
would be incurred in project financing
Project financing for the export system:

Export system was the riskiest part of the project. Project financing for
the export system mainly enabled the sponsors to spread the political
risks as much as possible via the presence of outside lenders such as
WB, IFC, ECAs.
The expectation was that the Chad and Cameroon Govts would be less
likely to take or tolerate adverse actions against the project in fear of
jeopardizing future funding from the WB and other international
financing institutions who were lenders of last resort
Additionally, it facilitated alignment of Govts interests with the project
through equity ownership, which would not have been possible
otherwise as Govts could not afford on their own
Project financing also created the opportunity for the pipeline companies
(JV between Govts and the sponsors) to issue limited-recourse debt,
guaranteed by the sponsors through completion
Project financing enabled external monitoring from the lenders
ExxonMobil also reduced total investment commitment to the project
under the corporate/project finance structure, compared to that under a
complete corporate finance structure
The role of World Bank:

WB involvement assured sponsors the much needed protection against the
political risk
Besides direct investment through A loans, it mobilized other funding sources like
ECA and other banks through a syndicated B loan
WBs extensive lending and policy experience with Chad offered the leverage
that sponsors did not have
The project with potentially high returns and developmental impact for Chad was
also aligned with WBs policy objectives
WB facilitated extensive consultation process including supporters and
opponents: The process helped sponsors restructuring the project to minimize
the social and environmental impact (such as increasing the benefits to
indigenous people and changing the pipeline route to protect the natural habitat)
WB also initiated a Revenue Management Plan to help prevent probable
misuse of Chads revenues by the Govt, and target them for developmental
purposes to increase welfare
Insisted on an open and transparent project planning process
Established capacity building programs to develop the infrastructure for a wellfunctioning petroleum industry and investment climate in both Chad and
Cameroon
The role of World Bank:

WB involvement also ensured that sponsors did not abandon the
project due to huge political risks and looked instead for safer
opportunities in other countries, leading to a missed opportunity
for Chad
Without the WB, the Govt might turn to neighboring countries
such as Sudan and Libya for partnering in oil export. This
potentially would have adverse consequences in case the
project revenues were utilized to finance non-developmental
purposes such as war.
Such an alternative would mean longer and hence more expensive
pipelines
The projects exposure to social risks would increase, as the
pipelines would inevitably cross the northern part of the country with
social unrest and upheavals.
Subjects of opposition:
The environmental and social impacts were claimed to be irreversible
The revenue management plan was claimed to be flawed and to lack effective
oversight
Govt claimed to have little intention of allowing the plan to affect local
practice
Criticism on oversight committees composition and power
The RMP was a concept untested
According to Harvard Law School, Oil will not lead to development in Chad
without real participation, real transparency, and real oversight, none of which
currently exists
The revenue management plan also regarded as infringement of sovereign
rights
The sovereign rights controlled by undemocratic rulers versus people
The beneficiaries of the project were claimed more to be the corporate sponsors
and commercial banks, as opposed to people of Chad
Valuable funds could have been used in alternative causes, rather than
potentially strengthening a corrupt Govt
Assessment of Project Risks and Returns:

Chad
Benefits:
Project provides an important opportunity for Chad to reduce poverty, though
contingent on Govt commitment
Receive up to $125M per year from the project, increasing Govt revenues by more than 50%
Chad has few other alternatives if any for development
RMP provisions and future linking of developmental funds to Govt compliance may
deter potential misuse of project revenues by the Govt
Project helps leveraging WB and other financial resources which Govt could not have
mobilized by itself
Leveraging technical expertise of the reputable sponsors significantly reduces Chads
exposure to operational risks
Potential employment opportunities created for local people in operations
Environmental/social concerns seem to be well addressed in contingency plans with
extensive public consultation
Another positive externality may be WBs capacity building efforts to establish the
sufficient infrastructure for a well-functioning petroleum industry and investment climate
in Chad
Greatest protection from downside risk (i.e. price or volume risk) compared to
corporate sponsors, probably because bulk of the revenues (royalties) independent
from price or reserve levels.

Chad
Risks:
The realization of the opportunity for economic development strictly
dependent on Governments commitment in implementation of RMP
RMP is claimed to lack credible oversight and enforcement
mechanisms, which would work against the people of Chad due to
undemocratic and oppressive Govt in power
RMP was a concept yet to be tested with the project; even WB admitted
the project to be an experiment, which increases peoples exposure to
risk
Chad has to put its only natural resource into the project under project
finance structure and RMP, which considerably eliminates sovereign
discretion and flexibility
Impositions on the allocation of revenues may turn out to be
constraining for a future democratic government who wants to
implement other projects to the benefit of people of Chad
Governments compliance to RMP is a requirement for future WB loans,
which extends the potential influence of the project-specific impositions
and commitments to non-project specific areas, increasing Chads
exposure to risks

Chad
Risks:
Even if the project generates promised revenues for Chad, Chad might not gain
on an incremental basis, as it will no longer be eligible to certain types of
developmental funding due to increased revenues
Current aid is around $188M (Exhibits 7 and 8), which exceeds the expected
cash flow. Chad might not gain on an incremental basis due to displacement
of existing aid, and yet lose control on its single natural resource
Environmental and social risks mostly remain with Chad
Some adverse impacts are either irreversible or extremely hard to fix
Despite contingency plans, there may be leakages in the pipeline that would
go unnoticed for long time, due to limitations of even the most advanced
technologies
Less share of the gains in the upside (though balanced with the highest protection
from downside risks)
Although expected to be a highest priority issue from Chads perspective, the
timing of cash flows were not negotiated to the advantage of Chad
Considering the urgent need for funds, the allocation of cash flows should
have favored Chad more in the initial years
Compared to the timing of cash allocations for other sponsors, the late
allocation might be perceived as unfair and might increase the chances of
expropriation

Sponsors (Exxon Mobil)
Benefits:
The presence of WB/ECA/IFC along with participation on
governments in equity financing significantly reduced political risk
exposure
Project might have helped portfolio diversification
Low construction risks (sponsors expertise and reputation in the
industry)
Low operating risks (positive NPV under most scenarios in Exhibit 5
with different price and reserve levels)
Low financial risks, considering the DSCR (as high as 2:1) and low
breakeven finding and development costs compared to price
The presence of WB/ECA/IFC in the deal, alignment of Govt
interests via equity ownership through project finance structure, the
linking of installment of future development funds to Governments
compliance to the RMP significantly reduced political risk exposure.
However,

Sponsors (Exxon Mobil)
Risks:
Back-loaded cash flows to Govt may be perceived as unfair
and may result in expropriation
Still chances are low, as Govt would not probably want to
jeopardize future capital inflows by risking its relations with WB
and the rest of the financial community
The Govt would not want to forego serious amount of revenues
in the form of dividends, taxes, royalties.
Any social or political instability in either Chad or Cameroon

would adversely effect the export of oil through the pipelines
across the two countries
However, the construction of pipelines underground may have
helped reduce the negative consequences of being exposed to
such risk
Real options
Shadow costs: In case WB is not involved in the
project, it is likely that the Govt will go with Libya
Temporary stop option if oil price drops
Project Update
After WB approved the deal, President Deby used part of the proceeds to
buy weapons
Huge criticism by social activists/interest groups against WB and sponsors
WB responded by requiring that the proceeds should be repaid out of
general revenues, suspended new loan programs, and also set up a new
oversight body headed by external people
After these reforms, WB and IMF permitted debt relief to Chad
In December 2005, the National Assembly of Chad amended the countrys
Petroleum Revenue Management Law in the following ways*:
broadening the definition of priority sectors to include, among other areas,
territorial administration and security; and by allowing that further changes in
the definition of priority sectors can be made by decree;
eliminating the Future Generations Fund, thus allowing the transfer of more
than US$36 million already accumulated there to the general budget
increasing from 13.5 % to 30% the share of royalties and dividends that can
be allocated to non-priority sectors that are not subject to oversight and
control
* Chad-Cameroon Pipeline Project, World Bank Web Site
Project Update
WB considered these changes a breach of contract, and on January, 2006,

it suspended new loans and grants to Chad, as well as disbursements under
eight ongoing IDA operations in the country.
The suspension automatically freezed the flow of part of Chads oil revenues
within the offshore escrow account
WB states in its web site that it remains in dialogue with the Chadian
authorities, and is determined to safeguard the oil revenues intended for
poverty reduction programs included in its original agreement with Chad,
while recognizing the fiscal strains currently experienced by the government
of Chad.
Petrozuata and Oil Field Development Project

Background
Why use project finance?
Risk management
Pre-completion risks
Post-completion risks
Sovereign risks
Financial risks
Real options
Cost of capital calculation
Project update
Background
Petrozuata is a $2.4B integrated oil field development project in Venezuela.

The project is planned to be financed under project financing structure. The
project sponsors Conoco and Maraven are subsidiaries of Du Pont and
PDVSA, a Venezuelan state owned enterprise. The sponsors decide on
60% debt financing, and seek for alternative ways to raise the required
funds. The alternatives considered are project bonds, securing of which are
contingent on securing investment-grade rating for the project; or bank
loans, which may need to be covered by PRI provided by multilateral
agencies.
The priority and challenge for the sponsors is to craft the projects
operational and financial details so as for the project to achieve an
investment grade rating.
Why use Project Finance?
Strategic reasons in the long run: $2.4B Petrozuata will be the first in a
series of projects planned which total as high as $65 B.
PDVSA needs to preserve debt capacity for future funding needs.
Success in this project will be a proof of concept for the rest.
Project finance structure provides PDVSA a wider capital access
Debt financing for PDVSA more expensive under corporate finance

structure:
PDVSA has low credit rating (long-term senior unsecured debt rating B from
S&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b)
Under project financing, if the project can secure BBB investment grade rating,
lower cost of debt ~ 7.70%
A gain of 2.47%
However, huge transaction and contracting costs as well as the longer time
needed to structure a project financed deal should be weighed against the
potentially lower cost of debt to see if there is a net gain in terms of costs
Positive-sum as opposed to a zero-sum deal for PDVSA and Venezuela:

Cost focus would be a zero sum perspective for both PDVSA and Conoco (one
party gains and the other loses)
Involvement of experienced Conoco and Du Pont in the deal may help increase
the aggregate net cash flows to the project, due to efficiency gains as well as risk
sharing/allocation benefits (positive-sum perspective)
Massive tax benefits
Under project finance, the project is subject to significantly lower income tax rates (34% as
opposed to 67.7%) and royalties.
Avoidance of possible risk contamination
But losing the benefit of co-insurance which would come with corporate financing
Resolving possible agency conflicts

High leverage and dedicated cash flows via the cash waterfall structure helps
prevent opportunities for risk shifting, underinvestment, or cross-subsidization of
From lenders perspective, separated cash flows also allow easier

monitoring and possibly lower monitoring costs
Project finance allows better allocation or sharing of risks via contractual

relationships, thereby reducing the cost of risk
Risk management
Identification and mitigation of:

Pre-completion risks: Resource, technological, timing, and
completion risks
Post-completion risks: Market risk, supply risk, throughput risk,
and force majeure
Sovereign risks: Inflation risk, exchange rate volatility
convertibility risk, expropriation
Financial risks: Leverage risk under the constraint of investment
grade rating
Pre-completion risks and mitigation
Resource Risk: Quantity and quality of the crude oil

+ Petrozuata being a development and not an exploration project:
An independent evaluation found that the field contain 21.5
barrels of oil. Assuming production level of 120,000 BPCD
and 35 years project life, 7% of these reserves is sufficient to
sustain the project
+ Variability in the available crude oils quality was not deemed to
be significant to reduce the efficiency of upgraders
+ Additional value creation for Conoco from corporate perspective:
In addition to being an equity holder in the project, Conoco
would also benefit from low-cost reserves and long-run
supply of crude oil the project would provide (with off-take
contracts) for its refinery business
Technological risk: How proven is the technology used? How experienced

are the contractors to handle technological risks? The ability to handle such
risks are important to prevent likely cost overruns or construction delays
+ Conoco had sufficient project experience and technological knowhow with
its proven production and refining technology
+ Maraven also had significant production technology and experience
- The pipelines would run 125 miles between the oil fields and the coast,
increasing risk exposure
+ The terrain between the oil fields and the coast was relatively flat and
sparsely populated, which would ease pipeline construction
+ Most of the pipelines would be laid underground
+ The well drilling technology to be used had been an established one, used
in both the Oronoco belt and all around the world
+ EPC contracts for the downstream facilities and pipelines were planned to
put out to bid to a consortia of leading international contractors
+ Contracts for upstream constructions were planned for experienced and
authorized Venezuelan companies
Timing and completion risk: Failure to meet the intermediate milestones

in a complex project may jeopardize the timely completion of the entire
project as well as increasing costs
The project is a complex one consisting of multiple components including field
facilities, pipeline system, and the upgrader facilities
Sponsors dependent on proceeds from selling the early production oil to fund
part of the construction
Failure to meet completion criteria would make all non-recourse debt due and
payable
+ Both Conoco and Maraven had significant project experience to handle the
execution complexities
+ An independent evaluator assessed their execution plan and concluded that the
milestones are aggressive but within reach, and that the plan complies with local
and international regulations and standards (a factor that would help mitigate
likely regulative delays)
+ Both sponsors made commitments (such as contingency funding for unexpected
cost overruns) guaranteed by parent companies to ensure successful completion
of the project
Post-completion risks and mitigation
Market risk: Uncertainty regarding the future price and demand for the
output
The price of oil is volatile
+ The off-take agreement with Conoco secures a significant portion of
the output to be purchased for 35 years at a price pegged to market
price of Maya crude
+ Petrozuata being a low cost producer with breakeven price well
below industry average could still operate even if prices fell
dramatically
Currently there is no broader market developed for syncrude
+ However, in expectation of the development of such a market in the
near future, Petrozueta retained the option to sell the syncrude to
third parties if they demand at a higher price than Maya crude.
+ According to an independently conducted assessment, the
development of a third party market was expected in 3-5 years, and
that the syncrude output would sell at a $1/barrel premium.
Supply risk: Uncertainty regarding the availability of the input

supplies throughout the life of the project
+ The project will be self sufficient in terms of electricity, gas,
and water after completion.
+ During construction, the supplies such as water, electricity,
hydrogen supply and diluent supply will all be contracted to
firms owned by the Venezuelan Govt
Operating cost risk: Uncertainty regarding the changes in the

operating cost throughout the life of the project
+ An independent consultant assessed the project and
concluded that the cost estimates are reasonable
considering industry standards
Sovereign risks and mitigation
Exchange rate risk: Uncertainty regarding the changes in the

exchange rate throughout the life of the project
Free floating of the Bolivar against $ may result in appreciation
of the currency, leading to increased local costs and tax liabilities
+ Conversely, a likely depreciation of the Bolivar would increase
the revenues (in $) against the local operating expenses (in
Bolivar) in relative terms.
+ No strong signal inferred from the case as to either of the
directions
+ No significant risk as both revenues and debt service were
denominated in $
Inflation risk: Relative changes in the price of inputs and output

may adversely affect the project
- Serious inflation levels that reached 100% in 1996
Expropriation risk: Sovereign risk in the form of governments direct seizing of

project assets, project cash flows (diversion), or changing tax policy (creeping)
+
+
+
+
+
Risk of Governments changing the currently preferential tax and royalty

treatment
Possible negative influence of Govt on the effective functioning of offshore
proceeds account
History of nationalization in the 1970s
Govt cannot afford to risk the future funding opportunities for the planned series
of upcoming projects by getting involved in any form of expropriation
The Govt owns a serious portion of the assets anyway (PDVSA and Maraven as
sponsors)
Any expropriation attempt may face a retaliation from US where PDVSA has
assets (CITGO)
Govt interests aligned with the projects success, as Govt receives tax and
royalty payments, as well as benefits of employment opportunities created and
access to the refining technology
Project output syncrude has a narrow market limiting Governments motivation
for a diversion attempt
Force Majeure risk: Likelihood of occurrence of political events like

wars, labor strikes, terrorism, or nonpolitical events such as
earthquakes, etc.
Venezuelas historic political and economic instability
Oil facilities are generally targets of terrorism due to their
significance in economy
Projects agreements were defined to be invalid in case of force
majeure events
+ The pipelines will be constructed underground, and in a sparsely
populated area
Financial risks and mitigation
Leverage risk: Balancing the incentive to maximize the equity

returns (via leverage) against the likelihood of default and failure to
get an investment grade rating
+ The target leverage of 60% turns out to be just right to allow for
a minimum DSCR of about 2.08X (in year 2008), which exceeds
the minimum acceptable ratio of 1.80X allowed for an investment
grade rating
+ More equity commitment actually signals that sponsors perceive
the project as right
Real Options value of flexibility

Option to delay the project
Option to increase the production
Option to sell the excess capacity to future projects in
the area
Option to abandon the project, since the project consists
of several stages
Cost of capital calculation*
*C. Harveys International Cost of Capital Calculator
Cost of capital calculation*
*C. Harveys International Cost of Capital Calculator
What happened?
The project received ratings that exceeded the sovereign ratings by five
notches
Completed a $1B bond issue, which was five times oversubscribed, and a
total of $450M bank financing (with 14 years maturity at 7.98%, 12 years
maturity at 7.86%)
The project considered by analysts as one of the best structured and best
executed project finance deals ever done, 1997
PDVSA continued to structure deals for the Orinoco Basin
Venezuelan economy was hit hard by the decline in crude oil prices
S&P revised its outlook for Petrozuata to negative, as a result of the cost
overruns, lower than expected early production revenues, falling prices, and
political uncertainty
As economic situation worsened, Govt demanded and received
extraordinarily high dividends from PDVSA reaching up to 134% of projected
income in 1999
Hugo Chavez won the 1998 elections and announced not to interfere with
foreign oil investments
Financing the Mozal Project

Background
Risk management
Completion risks
Operation risks
Sovereign risks (Major risk group in this project and the reason
for project financing)
Financial risks
Real options
The role of IFC

Project update
Background
Mozal is a $1.4 B aluminum smelter project in Mozambique. The
sponsors are Alusaf, a subsidiary of a South African natural
resource company, and IDC, a government-owned South African
development bank with long-standing relationship with Alusaf.
The sponsors are interested in structuring a limited-recourse
financing deal with IFC involvement.
IFCs concerns are the size of the project, as well as the political
risks of doing business in Mozambique.
Risk Management
Identification and mitigation of:

Pre-completion risks: Technological, timing, and completion risks
Post-completion risks: Market risk, supply risk, and force
majeure
Sovereign risks: Inflation risk, exchange rate volatility,
convertibility risk, expropriation
Financial risks: Leverage risk
Timing and completion risk:

Mozambique has complex bureaucratic processes that may delay
getting the necessary permits to proceed with the construction
The conditions of the basic infrastructure (like the insufficiency of
connecting roads, or dependability of electricity supply) may slow down
the construction efforts
Sponsors dependent on cash generated during start-up for funding
$34M of the project
+ Sponsors had a proven track record with the Hillside project where they
were able to complete the project four months ahead of schedule and
21% under budget
+ The same contractors and construction team used in the completion of
the Hillside smelter would be called for the project.
+ Sponsors planned a $75M contingency budget for the construction
period
Technological risk: How proven is the technology used? How experienced

are the contractors to handle technological risks? The ability to handle such
risks are important to prevent likely cost overruns or construction delays
+ Mozal would use proven, state-of-the art smelting technology (Pechiney
technology from France) that was used in the Hillside smelter
+ Both sponsors have significant experience in the smelting industry with
Hillside being their most recent undertaking
+ Alusaf was the subsidiary of the South Aftrican Gencor group, which was
the worlds fourth largest aluminum producer
Market risk: Price of the output

The sponsors planned to purchase all of the output subject to long-term
purchase agreements, but at market prices
The market prices had been declining for the last couple of years, and
the trend was expected to continue due to the developing scrap market
+ Mozal would be a low cost producer in the industry (lowest 5% in terms of
cost) , having higher margins than other players to absorb potential
market price declines

Supply risk and operating costs: Availability, quality, and price of the alumina,
electricity, and labor
Alumina accounted for 33% of production costs
+ The sponsors planned to link the price for alumina to LME aluminum
market prices
+ Alumina would be imported from a supplier of Alusafs affiliated
company Billiton under a 25 year supply contract
Electricity accounted for 25% of production costs
+ The electricity price would also be a function of aluminum prices
+ Eskom and Mozambican Electric company would provide
inexpensive electricity under a 25 year contract whereby the price
will be fixed in the early years and then tied to aluminum prices
+ The majority of unskilled labor would come from Mozambique, decreasing
labor costs compared to industry averages
+ Other inputs would be supplied from the same contractors who supplied the
Hillside smelter under similar long-term contracts
Sovereign risks
Expropriation risks:
- Outright seizure of assets very unlikely:
- The scale of the project relative to the size of the poor economy (9% of
GDP), combined with short-term survival concerns may be tempting for
a shortsighted Govt to expropriate
+ Govt wouldn't want to curb the investments, because they are
interested in development
+ Govt cannot afford an outright seizure, due to potential reactions from
WB/IFC, as this would jeopardize the much needed future development
funds
+ Following a direct seizure, international suppliers may not be willing to
work with the Govt, and Mozambique does not have local suppliers of
the raw materials to go on with the business alone
Sovereign risks
Expropriation risks:
- Seizure of cash flows (diversion) low risk:
- Govt may divert the aluminum and sell it to others
+ However, the spot market for aluminum is very thin for Govt to divert
and easily sell the output
+ Potential reactions from WB/IFC
- Changing of taxation creeping moderate risk:
- Govt may remove the privileges that the smelter would be exempt from
customs duties and income taxes
- It is highly likely that the Govt may change the 1% sales tax, which is
more critical than the income tax
Sovereign risks
Political events:
Political instability
Risk of war: not completely eliminated
Legal instability
Bureaucratic hurdles
Underdeveloped infrastructure
Unskilled / untrained labor
Macroeconomic risks:
Currency exposure:
+ Not a major risk as the major inputs and all the output would be
denominated in $.
Convertibility risk:
+ Not a major risk since the proceeds will be kept at an overseas
trustee
Sovereign risks mitigation

Sovereign risk was the most important reason that Gencor/Alusaf chose to finance the project via
project financing, as opposed to corporate financing, in order to minimize their risk exposure and
be able to raise capital.
Project was structured in the following way to ensure that an expropriation would have international
consequences, and also lenders would be comfortable enough to participate in the project:
Existence of international commercial partners:

+ International suppliers: Power from Eskom of South Africa, alumina from
an Australian supplier, technology from France, most of the other inputs
(coke, petroleum, etc.) would be imported as well
+ Any expororpiation would jeopardize as well the trade relationships with
these countries as they were at the same time Mozambiques important
trade partners
Involvement of multilateral/bilateral agencies:
+ IFC: Almost totally reduces the risk of expropriation and default
+ French and South African ECAs
+ Any expropriation would have impact on future flow of development funds
Foreign trustee to keep the sales proceeds
Government and local commitment

+ The Govt and Mozambique would benefit from the developmental impact of a
successful project
+ Increasing GDP by 9%, exports by $430M, spurring local business,
upgrading and expanding local infrastructure (i.e. power, roads),
technology transfer, creating permanent employment opportunities (873
jobs) and 5000 construction jobs as well as human capacity building
+ Diligent environmental and social impact analysis by IFC
+ Social programs planned for Mozambican people
+ Govt established a special committee to ease the bureaucratic /
administrative hurdles for the Mozal project
+ Govt signed an Investment Protection Agreement with South African Govt for
cross-border projects
+ Government committed to economic and legal reforms
In addition to the positive externalities outlined above, Govt might have also
been given an equity share to better ensure it has a vested interest in the
projects success to minimize risk of expropriation (See Chad-Cameroon
Case)
Using high leverage:

+ Ensures cash flows are kept low so that temptation for seizure is low
+ Besides, the project structure was designed in such a way to allow
for higher interest payments when sales increase, minimizing the
cash balances
+ High leverage also ensures that as long as the sponsors provide ongoing benefits, it is to the Governments benefit not to expropriate
+ Even in case of expropriation, governments generally feel obliged to pay
for the projects foreign debt because of undesirable repercussions in
the international community for not doing so.
Financial risks and mitigation
Political risk insurance:

As much as IFC involvement was the critical issue, securing political risk insurance
was important as well to provide comfort to potential lenders:
+ Political risk insurance is an instrument to help shift (not mitigate) the political
risks (like expropriation, war, breach of contract, or currency inconvertibility) to
parties that are best able to bear it
+ PRI providers generally have a more diversified portfolio than banks to
absorb these risks
+ PRI providers are more competent in analyzing sovereign risks, whereas
commercial banks in analyzing commercial risks
+ A French ECA supporting the use of the French technology was expected to
provide 85% insurance for loans from French banks, and IDC was in advance
discussions with the South African ECA for insurance for $400 M senior debt
+ The French ECA may be more willing to bear the political risk than banks
do because it attaches a higher value to the project in order to be able to
export the technology
+ Similarly, the South African ECA may be more willing to bear the political
risk than banks do because it attaches a higher value to the project in
order to be able to promote the south African exports
Real options
Option to expand
+ Mozal would be constructed with all the infrastructure to double the capacity
when needed.
The role of IFC
Appraising the project

+ Helps uncover the information about the project, as well as sponsors and
governments involved, which may not be readily available to lenders
+ Acts as a mediator between the governments and sponsors to ensure all
issues are addressed and handled properly
+ Better qualified to do sovereign risk analysis given its development
experience and relationships with governments
Significant difference between ex-ante and ex-post economic and
financial return calculations
Structuring the legal/financial documents
+ Has a reputation for being an honest broker
+ Significant experience in mediating large and diverse groups and
resolving complex legal issues
+ Instrumental in harmonizing the legal structures of Mozambique and
South Africa to create an agreed-upon basis for dispute resolutions
+ Instrumental in facilitating creation of common legal terms for critical
issues like completion guarantees, which all parties agree to abide by.
The role of IFC
Providing long-term capital

+ Willing to lend senior debt and subordinated debt, and also equity
+ Longer maturities compared to bank loans: 7-12 years on senior debt
and 8-15 years on quasi-equity
+ Compared to commercial banks, willingness to bear higher risks for the
same return because of the developmental aims it attaches to projects
+ It provides a catalytic effect on other lenders once it agrees to
participate in a project
+ Empirical evidence suggests IFC involvement increases the country
credit ratings, encouraging future investment in high-risk countries
Deterring sovereign interference
+ IFC pays attention to structure fair deals that would benefit the
governments and then monitor them to preclude short-term
opportunistic behavior
+ Halo effect: IFC, with virtue of being a WB affiliate, receives
preferential treatment from the governments in terms of debt
obligations, and hence provides indirect protection for the lenders
What happened?
IFC approved the $120M investment in 1997, its largest investment by then
In 1998, Project Finance International declared Mozal as the Industrial Deal
of the Year
Construction temporarily stopped in 1998 when workers went on strike to
protest low wages and poor working conditions
Workers on strike held management hostage in 1999
Despite the ongoing strike, the project proceeded as planned, and was in
fact on time and below budget
Critics argued that the sovereign risk had been too high, showing the strike
as evidence
Critics also defended that sponsors were treated too generously in the deal
compared to Mozambique
Despite the criticisms, the Mozal project appeared to set the stage for an
inflow of additional private investments in Mozambique in the final analysis
OUTLINE
value?
3. Project Valuation
4. Case analyses
5. Recap
Recap - Type of assets/projects and

appropriate method of financing:
Corporate Finance:
When the asset is less than perfectly correlated to the rest of
companys asset portfolio, corporate financing may help eliminate
idiosyncratic risks via diversification
When the sponsor has strong balance sheet to secure debt in
favorable terms, and a vertically integrated business model (which
minimizes variability)
When the sponsor is better equipped than anyone else in assessing
and bearing risks
Corporate finance is preferred when it results in lower combined
variance due to diversification (co-insurance).
When the benefits of above told co-insurance outweighs cost of risk
contamination

Project Finance:
Discrete, non-core assets that can be separated from the rest of the
business) Example: power plants
Large, highly risky projects with cash flows highly correlated with those of
sponsor (no benefits from diversification under one portfolio)
Projects appropriate for high leverage (those with predictable cash flows,
low distress costs, and minimal ongoing investment requirements)
Projects that are more transparent and easier to monitor during
construction, development, and ongoing operations (transparency can
lower cost of capital by facilitating credit decisions)
Projects with a structure that minimizes overall costs associated with
market imperfections
When it is possible and cost effective to allocate the project risks
contractually
Projects whose cash inflows and outflows can be set by long-term
contracts (to reduce variability)

Project Finance:
For oil industry, production projects, rather than exploration or development: Banks
generally reluctant to lend on project basis until the underlying stock/flow is proven
and capable of production ( reducing variability and risk)
High risk projects such as first-time investments in new industries, markets,
technologies: project finance may bring added discipline and access to
experienced partners
Projects exposed to high degree of sovereign/political risk may benefit from the
existence of outside lenders in project finance structure: host governments cannot
risk project due to potential reaction from international finance community
Project financing may help accommodating critical partners (such as governmental
agencies) who cannot finance their shares via corporate borrowing (Joint venture
projects)
Project finance is preferred when it results in higher combined variance when
added to corporate portfolio
When firm value decreases due to cost of financial distress which increases with
combined variance.
Project finance is preferred when cost of risk contamination exceeds the benefits
of co-insurance.
When creation of an independent entity allows project to obtain tax benefits not
available to sponsors
Acknowledgements
The content of this presentation has been derived from:
Emerging Markets Corporate Finance Course materials taught by Campbell
Harvey at Duke University
Project Finance lecture slides by Campbell Harvey, Aditya Agarwal, Sandeep Kaul
at Duke University
Modern Project Finance: A Casebook, Benjamin Esty, John Wiley & Sons, 2004
Principles of Project Finance, E.R. Yescombe, Academic Press, 2002
Petrozuata, A Case Study of the Effective Use of Project Finance, Benjamin Esty,
Journal of Applied Corporate Finance
Contracting and Project Finance Lecture Notes, Program on Project Appraisal and
Risk Management, May 16-June 10 2005, Duke Center for International
Development
Risk Management Lecture Notes, Evaluating Projects in the Public Sector Course,
Program in International Development Policy, Duke University

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Project Finance

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INTRODUCTION TO

What Is Project Finance?

A relevant question to investigate:

Economically and legally independent project company

Highly leveraged project company with concentrated equity

Historically formed to finance large-scale projects

Examples of project-financed investments

Statistics as of year 2002

A simplified project structure example:

Major project contracts:

The Offtake Contract:

Input Supply Contract:

Major project contracts:

How Does It Create Value?

Case examples to value creation

Drawbacks of Using Project Finance Structure:

Takes longer to structure and

Higher transaction costs due to

Non-recourse project debt is

High leverage and extensive

Project finance requires greater

Still, the combination

Structure matters, contrary to

Why does structure matter?

How Does It Create Value?

Case examples to value creation

Value creation by organizational structure:

Agency conflicts between

High levels of free cash

Concentrated equity ownership and

Value creation by organizational structure:

Cash Flow Waterfall mechanism

Distribution of cash flows, reinvestment, and restructuring

Moral hazard (such as risk

Legally/economically separate project

Concentrated debt ownership is preferred

Usually subordinated debt (quasi equity)

Strong debt covenants allow better

Single cash flow stream and separate

Agency conflicts between

Value creation by organizational structure:

Conflicts between sponsors and

Vertical integration is effective in

Long term contracts such as supply

Joint ownership with related parties

Value creation by organizational structure:

Conflicts between sponsors and

Value creation by organizational structure:

The fact that non-recourse debt is

limited corporate debt capacity

agency or tax reasons that

pre-existing debt covenants

Value creation by organizational structure:

A high risk project may

Project financed investment exposes

Conversely, a failing sponsor can

Through project financing, sponsors

Very large projects can

Benefit from portfolio

Pooling of capital reduces each

Separate incorporation eliminates

Value creation by organizational structure:

Joint venture projects with

The stronger partner is better